LLC, S-Corporation, or Sole Proprietorship? (A fly-by overview)
What business entity to choose? Don’t take these words to heart yet, as I am still learning, but I need to start writing what I learn to better manage the process as a whole.
My goal is to be self-employed. I want to avoid unnecessary taxes and legal grunt work that comes with some forms of self-employment (aka. “a business”).
The first option would be to use the simplest form of business called an “sole proprietorship.” While this is said to be the easiest to maintain, it has the negative of the highest amount of taxes you have to pay in and no liability coverage. What happens is that you include all business profit on your personal tax return. The negative here is that the government charges these people “self-employment” tax. This tax is probably about double a standard worker pays on taxes each year. A little known fact is that the standard workers’ employer plays the rest of your taxes each year, so come tax time you end up paying what the average person expects to pay.
If I opt for “sole proprietorship” I would get hit pretty hard cost and risk wise. I haven’t crunched the numbers yet, but taxes look to be about double a normal worker pays.
Form what I have read so far, an LLC is taxed the same as a “sole proprietorship.” That’s a big negative… Another negative is that it takes more effort to get started and maintain. It will cost you at least $600 to get started in Illinois. You have to register with the a state, which doesn’t necessarily have you be your own (I have not looked into that yet).
A few positives are:
1. It separates you from your business dealings, and gives you some automatic liability protection.
2. Your health insurance costs can be deducted, which can be a big plus.
S-Corporations are basically an extension of the standard corporation laws, but designed for smaller businesses. A big negative about starting a corporation or s-corporation is the amount of legal paperwork and upkeep effort involved. While I don’t know the specifics just yet, it looks like every year you have to document shareholder meetings and board member voting sessions. This is a big negative as it would take quite a bit of research to do this on my own. If I take this route it would be a good idea to have a lawyer or CPA handle the red-tape upkeep, but then I would be spending money on that, so a cost benefit analysis would be in order before opting for that.
A major benefit of and s-corporation comes tax time. What happens is that your corporation pays you a salary. This salary must be reasonable, but it doesn’t have to be 100% of your profits. Seeing this from the perspective of self-employment, this has a nice benefit.
So say you made $70,000 dollars in one year. You pay yourself $35,000 and the rest of the money is share-holder profit distributions. The benefit here is that the distribution money is not subject to self-employment tax. So on that $35,000 you only end up paying whatever the standard federal/state tax is for it, which I’m not sure of yet. The “salary” money is taxed on the higher rate though. Even so, if the card are played right, money should be saved.
If you add in the benefits of investing in an Health Savings Account and a self-employment 401k, I would be able to save even more money. What happens, or so I understand so far, is that the corporation can pay tax-free profit-sharing additions to the employee’s 401k, in addition to the employee’s tax-free contribution. All of that money should be tax free, thereby lowering both the businesses and employee’s income.
While the benefits of an s-corporation are great, do I want to manage all of the legal hassles? Well it looks like I have yet another option. I can start an LLC, once started, elect to have my LLC taxed as an S-Corporation. This is a special form that you send to the IRS after the LLC is formed saying that you elect *for tax purposes* to be seen as an s-corporation. As I understand it, this would provide me the relative ease of management of an LLC with the tax benefits of an s-corporation.
So as of right now I think I will be doing the LLC with the election of s-corporation taxation. I, of course, am not quite sure yet as I need to do a lot more research.