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The Liability Tax Test: Choosing Your Small Business Structure

The Liability Tax Test: Choosing Your Small Business Structure

So you want to start a company and you’re not sure how to structure it. The internet is full of descriptions that make your head spin and plenty of comparisons but you still have no idea what’s best for your situation. Well read on and I’ll give you the real scoop based on experience.

Choosing your company structure is actually not the first step you need to take in forming a company; the first being a decision on what your company is going to do and the second perhaps being how you’re going to do it, but let’s assume for now that you’ve got all that decided and you’re ready to move forward. There are more than a few company structures to consider and I’d like to narrow it down for you to just a couple. Sorting through a Sole Proprietorship (SP), General Partnership (GP), Limited Liability Company (LLC) or Corporation (Corp) can be tedious and like I’ve said before – this doesn’t have to be complicated.

Spoiler alert:
I recommend a Sole Proprietorship if you’re solo, not worried about liability protection and expect to earn less than $50,000 per year. I recommend an S-Corp if liability is a concern, you have partners or expect to make more than $50,000 per year.

There are a lot of factors to consider when choosing your company structure, but I’m really only going to touch on two of them that I feel are the most important for small business: personal liability and taxes. From a liability standpoint there are company structures that protect you and structures that don’t. Taxation gets a little more complicated but in general there are also two main types: pass-through and non-pass-through (corporate taxation). We’ll also touch on the dreaded self-employment tax that hits some company structures as well.

What we want to achieve with our company structure as a small business is what I call the “Liability Tax Test”. We want liability protection with no corporate tax and as little self-employment tax as we can get away with paying to the IRS. Ahem… legally of course. So lets dive into a bit of detail.

Which Structures Support Limited Liability?

A Sole Proprietorship and a General Partnership both confer total liability of the company onto the owners while an LLC and Corp are treated as a separate entity and provide some liability protection to its owners. You may have noticed that an LLC stands for “Limited Liability Company” and that’s no accident. This type of structure was initially created for just that purpose.

What is liability protection? This means that you as an owner are not typically liable for the debts of the company. If your company gets sued for example they won’t typically be able to come after your personal assets. Wikipedia actually has a nice page describing it so I won’t plagiarize and instead refer you here.

Is liability protection a big deal for a small business? Well… that really depends on your business and whether you have a physical location and a few other factors. If you’re primarily in the service industry and work out of your home – like a freelance designer or programmer then you probably don’t have to worry about getting sued. If you own a rock-climbing facility that throws kids’ parties you’ve got an entirely different situation. If you feel you need liability protection then forming an LLC or corporation is the way to go.

I should mention that liability protection is the primary reason I see on the web for forming a corporation but it may not even be an important factor to your business. A bigger factor to me is maximizing profits and part of that is the taxes you pay. You’re lean and small and your tax situation can make a huge difference. A properly structured corporation can have a much better tax profile than an SP or GP so your best choice may be a corporation even if you don’t need the liability protection.

The Scoop on Business Taxes

Before I get into taxation it’s important to note that there are two main ways to pull money out of your company for personal use: a paycheck and a disbursement. A paycheck is how a company typically pays a standard W2 employee and I’m going to assume anyone reading this is familiar with that. A disbursement is an additional check that a company writes, typically to owners, from company profits. If your company makes $100,000 and pays $70,000 in payroll it can then distribute that other $30,000 to the owners as a disbursement and it isn’t subject to the payroll taxes. Remember payroll vs. disbursement – it’s important for tax calculations.

Taxation on a company comes in two general forms: pass-through and non-pass-through. This is simply a way of designating whether your company itself pays tax on company income (non-pass-through or “corporate” tax) vs. passing that income down to the owners to be added to the personal income of the owner (who then pays taxes on it at the personal income tax rate). In general as a small business owner we do not want the company to pay taxes on its own income because after it pays those taxes and then disburses the profits the owners then have to pay taxes on those profits again. This is known as double-taxation.

Double taxation costs you money and should be avoided if possible. It is a definite negative to a C-Corp or an LLC that elects to be taxed like a C-Corp. If you need to pull out company profits for your personal use then avoiding these business structures should be near the top of your criteria.

All other types of company structure automatically roll those company profits down to the owners’ income as if they were disbursed, whether they actually were or not, and owners then pay taxes on them at their personal tax rate. As a small business owner chances are good that you’ll want to pull money out of the company to live on so this situation, though it sounds horrible, is probably just fine.

Is there a time you’ll want to be taxed like a C-Corp? Absolutely. Once the company is making more money than you want to pull out for personal use you’ll want to calculate the corporate tax rate vs. your personal rate and see if it makes sense to leave the money in your C-Corp instead.

What a small business owner really wants to avoid is the self-employment taxes that come with a company structure that counts ALL income as self-employment income. Sole Proprietorships, General Partnerships and a default LLC fall into this category. These taxes consist of your Social Security and Medicare taxes that you typically see on your paycheck (W2 employees) plus an equivalent amount paid by your employer, which is in this case – you.

Remember my admonition to keep in mind payroll vs. disbursements? This is it: when you own a business that shows a profit on a federal 1040 Schedule C (the tax form for a Sole Proprietorship for example) you must pay both the employee and employer share of SS and Medicare on all profits. That’s a rate of 15.3% in 2020. Ouch. That’s the equivalent of writing a payroll check for 100% of your profits and paying payroll taxes on all of it.

Next time you get a paycheck add up your SS and Medicare and make a mental note that your employer has to set aside an equivalent amount for the IRS just for the privilege of employing you. It’s one of those employee costs that is above and beyond your salary. A disbursement however does not incur those taxes and that’s the main difference between payroll and disbursements. A company structure that allows you to be an employee and an owner, like a corporation, allows you to pay yourself a salary and receive disbursements in a ratio that minimizes taxes and still satisfies the IRS.

If you’d like to see more information on how you can save thousands every year by incorporating you can check out my companion article here. For now let’s assume you’re a small business that wants to avoid double taxation and wants to avoid self-employment tax.

The 4 Primary Company Structures

Now that we understand we want the best liability protection with the least amount of taxes how do the various company structures measure up?

Sole Proprietor

The Sole Proprietor (SP) company is the easiest of all the business structures to create. For a single owner company there’s a good chance in your area of the country you don’t need to file any startup paperwork at all. In most areas you’ll need to file a Doing Business As (DBA) statement and perhaps publish it in your local newspaper. You may also be required to attain a business license in your city or county as well, but no other formal formation documents are typically required.

This type of company is a great choice when you’re starting out if you’re not sure your business idea is going to work and you expect your income to be low for your first year. Remember also that this structure affords no liability protection so be extra careful not to upset any litigious customers.

An SP does have a few drawbacks such as the aforementioned self-employment taxes and liability concerns, but in addition to that it’s also difficult to get additional funding should you need it and you’ll most likely be working with banks only. If you’ve got great credit it’s similar to getting a personal loan though I wouldn’t expect the best interest rates.

On the surface an SP fails my tests for least liability and least amount of taxes, yet most of my companies started this way and a couple lasted under this structure for years before I incorporated them. So why? It’s really just so damn easy to use this structure that the simplicity of it made the extra taxes worth it.

I’m not talking about a lot of extra taxes when I say that – perhaps $3,000-$5,000 per year at most and this was also many years ago before the internet made forming a corporation so much easier. The incorporation cut-over point for me is when you hit about $50,000 in income. Anything higher than that and I start the process of preparing for it. There will be a later post on this in the coming weeks.

Liability was never a big concern of mine since I was just a freelance programmer for most of my career. At worst if I did a crappy job I just wouldn’t get paid at all and I’m happy to report that never happened. A Sole Proprietorship was the right place to start.

General Partnership

Many years ago I met someone at work who was interested in starting a business with me and we decided to form a partnership together. A General Partnership (GP) falls under the same categories of my test that the SP does with the primary difference being that there is more than one owner. But we were young and I hadn’t incorporated any businesses yet so we pushed forward with a GP.

I was not really prepared at the time for what a GP actually meant. Since I didn’t know this person very well we put together a partnership agreement that we felt covered all the bases. It was around 10-12 pages long and went over ownership percentage, compensation, time each of us was expected to dedicate to the business and so forth. It was a little painful but we felt it was necessary. In the end it didn’t make much difference because a GP has the same fatal flaw of a SP but with a twist: no liability protection and shared partner liability.

It was a close call with a near lawsuit when I realized that I was just as liable for his business mistakes as he was and I rapidly terminated our agreement. I suppose this isn’t a true failure of a GP but more of a failure to read his character before going into business with him – yet I will never do a GP again. Unlike a SP where you are only liable for your own actions, in a GP you are also personally liable for every other partner’s. Another potential issue is that profits are shared according to capital investment and not according to how much work you put in, so if you each own 50% and the other guy isn’t doing his job he still gets 50% of the profits.

I just can’t recommend this business structure at all if you can avoid it. Even if you’re going into business with your best friend a corporation is a much better vehicle and will pay for itself once you’re generating around $50,000 in revenue or even less. That’s only $25k each. You can do it!

Limited Liability Company

And now we move into the company types that provide some personal liability protection. As I said earlier both Limited Liability Companies (LLC) and Corporations are considered a separate entity from the owners and in most cases liability is limited to company assets and not the personal assets of the owners. That’s a definite positive for an LLC and Corp.

One thing you must absolutely remember however is to keep the finances of the LLC separate from your personal finances. In order to maintain its status as a separate entity you need to make sure it has its own bank accounts, loans and credit. This applies to corporations as well.

By default an LLC is a pass-through company whose income shows up on a Schedule C for a single owner or on a partnership form 1065 for multiple owners. Both types are subject to self employment taxes. But an LLC also allows you to file paperwork to be taxed as an S-Corporation which still has the pass-through taxation (avoiding double taxation) and also removes the self employment taxes. Win!

But why not just form an S-Corp instead? Honestly everyone seems to think forming an LLC is simpler than a corporation but I don’t always agree. Since there is so much flexibility with creating an LLC there are so many options to choose – and that can get complicated fast. However, you can do things with an LLC that you don’t seem to be able to do with any other company type, like distribute company profits according to rules in your company’s Articles of Organization or Operating Agreement instead of according to the ownership percentages. In a corporation if you own 25% you get 25% of the profits distributed, but an LLC can designate a different way to do it. All these options need to be documented.

An LLC can’t sell common stock, which means that your LLC will probably never become a publicly traded company. If that’s in your future plans then don’t bother with this structure from the start. Another downside is that an LLC isn’t recognized as a company in most foreign countries and you’ll most likely be treated as a corporation instead, so if you work internationally this may not be the structure for you.

A really odd trait of an LLC is that although it is considered a separate entity some states require it to be dissolved if a partner leaves and the LLC doesn’t have an operating agreement that addresses this situation. Make sure this is spelled out in your operating agreement if you form a multi-member LLC. A corporation will survive an owner leaving without this issue.

In California the taxes for an LLC are similar to a corporation with the difference in annual fees being negligible. In the interest of full disclosure I’ve never personally formed an LLC since I’ve never had a need for the flexibility it allows. If you need that then an LLC may be right for you, otherwise I suggest looking into an S-Corporation.

Corporation

The corporation is my favored vehicle for doing business and gets my recommendation most of the time. The two main types that I have experience running are C-Corps and S-Corps and each has a slightly different purpose. The good news is that with a small amount of paperwork you can switch between the two if the needs of your company change.

A C-Corp is the same structure used by practically every large company you can think of. It is highly flexible and can be publicly traded. Microsoft, Apple, Amazon and Facebook are all examples of C-Corps.

If you want to avoid the double taxation of a C-Corp then shortly after formation you can file with the IRS to elect to be taxed as an S-Corp. The IRS can technically refuse your request but I’ve never heard of it happening on a new company. As long as your company formation follows the rules of an S-Corp (such as having only a single class of stock and you must be a citizen or resident) you should be fine. Again I’ll have a later post showing exactly how to do all of this.

California automatically accepts the federal S-Corp election but some other states such as New York and New Jersey require a separate state-level S election also. There are other states with unusual rules and tax rates so make sure you check with your local Secretary of State’s office. You should be able to find the information on your state’s web site.

One possible downside to an S-Corp is the 100 shareholder limit and a single class of stock, but again we’re focusing on small business here. If you need to issue stock to more shareholders or have a need for multiple classes of stock you’ll have to convert back to a C-Corp.

If you need to remain a C-Corp and want to avoid double taxation there is actually a way to do it: simply don’t disburse the profits to the shareholders (you). The accounting term for this is “retained earnings”. The company can then use those profits to grow or in whatever way they see fit, but you won’t get to use those profits at the personal income level. Again as a small business you’ll probably want to elect S-Corp status.

Another benefit of a corporation is the wide range of funding sources. You can go beyond banks into issuing your own corporate bonds, or soliciting venture capital or even becoming a publicly traded company. Most Initial Public Offerings (IPO) are an excellent money raiser for the company, though as a small business this most likely isn’t on your radar yet. You might be more comfortable soliciting individual investors for private equity in your company.

The biggest complaints I see about forming a corporation all revolve around the paperwork and record keeping that a corporation needs to do to maintain its status as a separate entity. This includes meetings of the Board of Directors, annual meetings of shareholders and so forth. But as a solopreneur that Board of Directors is probably just you. Got a partner or two? Ok just the three of you. It’s not that hard to document a couple of important meetings a year and again I’ll show you how.

Recommendation

Rather than repeat everything I just wrote above how about a nice chart?

Company StructureMinimizes Personal LiabilityNo Double TaxationMinimizes Self-Employment Taxes
Sole Proprietorship
General Partnership
Limited Liability Company * *
C-Corporation
S-Corporation
* if structured correctly

From the chart above you can see that only an LLC and S-Corp satisfy the Liability Tax Test for a small business. While an LLC has greater flexibility in formation an S-Corp has greater flexibility as you grow and is most likely the choice you should make. It has liability protection, avoids double taxation and avoids self-employment taxes. It also has the option of an easy conversion back to a C-Corp if your company outgrows the S-Corp election.

If you’re starting out by yourself and liability isn’t an issue feel free to give it a go as a Sole Proprietor while you grow your revenue. I’ve got another post here where I show you the tax breakdown that gave me that $50,000 cut-off amount that I mentioned above where you should think about using a better company structure to optimize your tax liability and profits.

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