Business Entity

If you’re remotely taking this endeavor seriously, you’re going to want to create an incorporated business entity. Filing an extra set of taxes every year is annoying but at least your personal assets will be protected.

According to the United States federal government, all you need to create a business is to start conducting some business. Fairly simple. Your business would be known as an unincorporated business, which basically means you are the business. An unincorporated business has unlimited liability. So if your business was sued, everything the business owns and everything you personally own is at stake. This is because you and the business are viewed as one.

To gain some protection, you’ll want to incorporate your business. Incorporating is turning your business into a Limited Liability Company (LLC). You’ll notice your protection is right there in the title: Limited Liability. You’re no longer unlimited. The LLC is what creates a line between you and your business. If you have an LLC and are sued, your personal assets are safe.

You can also choose to be incorporated as a Corporation. But for small businesses, LLCs are better. LLCs are designed to offer protection, affordability, and ease of use.

Whether or not your business is incorporated, you must choose how that business will be taxed. There are mainly three types of ways your business can be taxed:

Sole Proprietorship:        For a business with one owner.
Partnership:                    For a business with multiple owners.
S-Corporation:               For a business with one owner up to 100 owners.

An LLC is not a business entity for tax purposes. So if you are the Sole Proprietor of an unincorporated business, and then create an LLC to become incorporated, you will still be taxed as a Sole Proprietorship.  The LLC only offers protection on your personal belongings, it does not help you save money on taxes.

LLCs are known as “pass-through” entities, meaning there are no corporate taxes, all the earnings (or loses) are passed straight down to the owners. So you would file your personal taxes the same as always, except now your business income is on there as well.

LLCs are created under state law, not federal law. So the rules and costs associated with an LLC will vary from state to state.

So basically you will form an LLC for protection. And then you will elect how you want to be taxed. If you are the sole owner, then by default you will be taxed as a Sole Proprietor. If you have multiple owners, then by default you will be taxed as a Partnership. The only real decision you have to make is if you want to be taxed as an S-Corporation (S-Corp). Being an S-Corp is the goal of a small business. It takes a lot more work but the tax-saving benefits can be awesome.


Should I Choose an S-Corp?
Choosing to be taxed as an S-Corp does not mean your business is now a corporation, you are still an LLC. Real corporations are legally required to have by-laws and other crap. So you’re still an LLC, just choosing to be taxed like an S-Corp.

There is also a C-Corporation (C-Corp). A C-Corp must pay income tax at the corporate level before any profits can be passed down to shareholders, who then must pay their own income tax at the personal level. Double taxation, no fun.

What makes an S-Corp unique compared to a Sole Proprietorship or Partnership is that you are not only an owner but also technically an employee. This is good and bad.


The Good
As a Sole Proprietor or Partner you would withhold taxes from your paycheck, just like you would withhold taxes from any employee’s wage. It’s known as Self-Employment Tax. And it’s the same percentage that employees are taxed, roughly 15%.

As a Sole Proprietor:
If your business made $100k.
You would incur a Self-Employment Tax at roughly 15%, leaving $85k.
As the sole owner you would receive the entire $85k.

An S-Corp operates differently, since you are by default classified as both an owner and employee. As an employee you will be paid a wage, which will be taxed like any other employee. You basically must determine a reasonable salary for yourself and just pay yourself that wage. Then there’s the money you earn for being an owner. And for some miraculous reason the owners of S-Corps don’t have to pay Self-Employment Tax like the other LLC owners.

As the sole owner of an S-Corp:
If your business made $100k.
You could pay yourself a reasonable salary of $60k.
You would incur taxes like all employees at roughly 15%, leaving $51k.
The remainder of the $100k is now $40k (your initial profit minus your salary).
This 40k is your owner distribution, where Self-Employment Tax does not apply.
As the sole owner you would receive $91k ($51k in salary, $40k in distributions).

So that's 85k versus 91k. As you can see, an S-Corp can save you a lot of money.

A few notes:

All of the above profits are still subject to your personal income tax. So the $85k you made as a Sole Proprietor or the $91k you made from your S-Corp will then be taxed according to your tax bracket.

You can’t simply claim no salary and take all the income as an owner distribution, unless you want to get in serious trouble. You are expected to take a reasonable salary, reasonable meaning: what do other similarly-experienced professionals in your field make?

An owner’s distribution is not to be confused with a dividend. Your distribution is not a dividend. They are two separate legal terms, but often used interchangeably.

Distributions can be subject to long-term capital gains. If you distribute more money than your Stock Basis (your overall investment in the company), the extra money will receive a long-term capital gains tax.

Some owners do not need to be classified as an employee. If an owner does not perform any services or only performs minor services, the owner would not be considered an employee. This would be someone like a hands-off investor. Those types of owners don’t need to receive an employee salary, only their owner distributions. Obviously at least one owner at the company will need to be labeled as a hybrid owner/employee because someone has to do all the work and manage the actual employees.


The Bad
Did you already forget there was a bad? Here’s the main problem with S-Corps: you are an employee. So by default your business has at least one employee. Having employees is an absolute pain. You must withhold federal taxes, withhold state taxes, submit all those withholdings on a regular basis, submit numerous other forms on a monthly, quarterly, and annual basis, send out W2s, the list goes on. That is a lot of bookkeeping and energy.

Now to be fair, this problem exists among all LLCs that have employees. But usually when you’re a small business it’s just you or your partners (who are classified as owners not employees). So there’s no headache. Until you hire that first employee.

The next bad news has to do with Social Security. Social Security is basically your government-run retirement fund. Your employer withholds a Social Security Tax from your wage and submits that money to the government. The more you put into the system, the more money you’ll receive from the government when you retire. But if you’ve been using an S-Corp, you’ll remember that your owner distributions are not subject to employment tax, hence why you like receiving those distributions. But if there’s no tax being taken out, then you’re not paying into the Social Security program and your benefits will be small when retiring. Only your wage/salary counts towards your Social Security benefits, and you’ve been purposefully reporting a small reasonable salary this whole time to maximize those owner distributions. So basically, the distributions get you your money now, as opposed to waiting for retirement (should you survive that long). You’ll probably earn more money with distributions, but you’ll have to be smarter when planning for retirement.

Also, you can only become an S-Corp if you meet these certain requirements:

- Be a domestic business (you can still conduct business internationally).
- Cannot be a bank or insurance company.
- No more than 100 owners
- All owners must be individuals, estates, or tax-exempt organizations (no corporations or partnerships allowed)
- All owners must be legal residents of the USA.
- All owners must consent to becoming an S-Corp.