What business formations are best for the self-employed or small business? What do the different formations mean? How do I choose a business formation? These are common questions from the self-employed and small business owners. Whether you’re just starting your self-employment journey or having owned a small business for years, choosing a formation that fits your business is important. The answer will vary depending on your particular business — things like your business goals, legal protections, risk tolerance, and revenue. In addition, your business formation will determine your personal liability, how you pay taxes, and additional complexities.
In this post, I will cover the basic mechanics of the business formations you can choose as a self-employed person or small business owner. As a bonus, the last formation will include an election that can potentially save money on taxes!
A sole proprietorship is the most simple business structure because it requires no filing and forms to start. The IRS defines a sole proprietorship as someone who owns an unincorporated business by himself or herself. So, if you have a business by yourself, unincorporated, and earning money, this is you. You’ll pay taxes based on your social security number, or you can also get an Employer Identification Number (EIN). Once you have employees, you will need to apply for an EIN.
While a sole prop might be very simple, it does lack the protection of your assets. Therefore, should you end up getting sued or going bankrupt, your personal assets can be at risk.
If you are starting your business journey, a sole proprietorship is an easy way to start. However, as your business grows, you may grow out of a sole prop and need the additional layer of protection, which we will discuss next.
Simplicity is sometimes key to a new business. You need to start somewhere. Many large businesses you have heard of started as sole proprietors and grew into multi-million dollar companies. A few great examples of this are eBay, Wal-Mart, and Marriott Hotels!
If you are making income from a side hustle or without an employer, you are already a sole proprietor! However, you also get to enjoy business tax deductions that can help you pay less money to Uncle Sam! Here are some tax deductions you don’t want to miss!
A partnership is a business formation with two or more people. If you’re in business with a friend, family member, or have a business partner, you’ll have a partnership. It’s important to note from a business perspective, be very selective on your business partner! Depending on the type of partnership, you might be liable for the other partner’s decision-making. But first, here are the types of partnerships and what comes with them.
A general partnership (GP) is when all partners equally share and participate in the daily operations. This type of formation allows business partners to share business profits and losses. This means you’ll make business decisions together. All partners will be held liable for the business and financial decisions.
A limited partnership (LP) is when one or more partners run the business’s daily operations, and limited partners do not. The general partner makes business decisions and is liable for the business. The limited partners don’t actively participate in the business and have minimal control. In exchange for no control, limited partners aren’t liable for business debts or claims. Limited partners can lose their original investment in the business, but nothing more.
A limited liability company is a business structure that enjoys additional legal protection that a sole proprietorship and partnership do not have. In an LLC, personal assets are protected from business liabilities and debts. This is the case as long as you don’t mix personal and business transactions to maintain LLC status. This business structure is popular among small businesses, self-employment, and even larger businesses.
An LLC can have more than one owner or members. The difference between an LLC and a general partnership is that an LLC limits liability to contributions made to the business. In a general partnership, each partner may be held personally liable. You can also set up a limited liability partnership that offers each partner limited liability.
According to the IRS, an LLC is a “disregarded entity.” This means they don’t distinguish between the business and the owner. An LLC is a pass-through structure and doesn’t pay the tax directly. This means profits and losses “pass-through” to the LLC member’s tax return. By default, an LLC owner is taxed the same as a sole proprietorship. However, your LLC can elect S corp taxation, potentially resulting in a lower tax bill! Who doesn’t like paying less tax? We will cover S corp taxation next.
An S Corp isn’t a formation of an entity. It’s a tax election that an LLC may choose. Depending on your business profits and financial situation, an S Corp can lower your tax bill.
When you elect S corp taxation, you are an employee of the business. Earned income as an employee is subject to FICA tax. The remaining earnings are distributed to you which are not subject to self-employment or FICA payroll tax.
As an S corp, you must pay yourself a “reasonable salary.” Salary is subject to FICA payroll tax, which is a 15.3% tax.
Here is where the tax savings opportunity comes in. Your profits above “reasonable salary” pass to you as a distribution. This money is not subject to FICA payroll tax or self-employment tax. Instead, it passes through the S corporation and is reported as a distribution on your tax return. Because it eludes payroll tax, this can result in massive tax savings!
A common question when deciding to elect S corp: How much income makes sense for my LLC to make an S corp election? There isn’t a one size fits all answer, and with all financial planning answers, “it depends.” However, if your net business income is over $80,000/ year, your income is stable and expected to increase, it might be time to get with a CERTIFIED FINANCIAL PLANNER™ and your tax professional to see if it makes sense for you.
Choosing a business formation is no easy task. You can spend hours reading through articles and analyzing business formations for self-employed or small businesses. The best structure for your business will depend on your personal and business goals. You’ll want to work closely with your tax and financial professional when choosing a business formation. If you need help walking through your business strategy and maximizing your money, let’s chat!