Have you ever wondered how to best set up your small business? Which type of business entity is best?
Many solopreneurs get confused about which business entity to chose to get the most tax advantage from owning their own business. In the U.S., you can choose Sole Proprietor, LLC (Limited Liability Company), Partnership or Corporation- they each have advantages in various situations.
Sole Proprietor
For most solopreneurs starting out in the Sole Proprietor form of entity is the easiest and most cost effective way. There are no actual filings to make with the state or fees to pay to any government agency to start operating as a sole proprietorship. While there really is no requirement to get a separate federal identification number for the business if you are willing to have your Social Security number associated on official business documents (unless you have employees, of course!!) - it is probably a good idea to get one!
Because there is no additional tax return or payroll reporting for a sole proprietor without employees there is very little expense from a tax reporting side for a sole prospector. The low cost and ease of operation is often why many solopreneurs start out operating as a sole proprietor and you can easily form a more complex structure at any time. However, if you are looking to add a level of legitimacy to your endeavor an LLC can be a great choice as well.
Limited Liability Company (LLC)
If you form an LLC you can either do so as a single member or with partners. A single member LLC is taxed the same way as a sole proprietor and adds a level of separation between your business and personal dealings. You do need to register with the Secretary of State and get a federal Identification number but no separate tax return is required. All of the LLC activity will be reported on your personal return.
If you form an LLC with partners- you will need to file a separate partnership return each year before you can file your personal tax return since the partnership activity will be taxed on your individual return. If you are an active participant in running your business all the income from the LLC will be subject to self-employment taxes in addition to income tax.
The LLC remains an attractive choice for solopreneurs because as a single member LLC the cost remains low. There is not separate tax return required like a partnership or Corporation needs. Increasingly, the LLC form of organization has become much more popular in recent years.
Corporation
The most complex form of organization for a small business is to form a corporation. Most small businesses decide to make what is called an S- Corp election so they are not hit with the double layer of tax at the corporate and personal level that larger corporations are subject to. You have to meet certain requirements including a limitation of the number and type of shareholders to be eligible to make the election but most small business easily qualify.
The S Corp election allows the business owner to pay a salary to themselves. All the profit for the Corporation is “passed through" to the taxpayer and the tax is paid at the personal level. This is unlike a regular corporation that pays tax on all the earnings and then shareholders pay tax again on these same funds when they receive them as dividends.
Whichever entity you choose it is best to start off on the right foot with the bookkeeping for your small business. Capturing the data needed for the reporting for your business under any of the entity types is too hard if you wait until the returns are due to get the data together!
There are many simple and inexpensive software solutions including QuickBooks, Freshbooks and others that will help make this less of a burden in operating your small business. It is best to start out with an easy system that you can maintain from the start which tracks all your business expense including mileage form your business.
It also makes sense to consult with a tax advisor early in the operation of your business to make sure you are tracking the information you will need to be ready to meet with them at tax time! Most accountants will offer a complimentary "getting to know you" appointment to help you start out right.
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Deborah Daniel, CPA is an entrepreneur and expert in small business finance. By helping clients figure out what numbers really matter and showing them how to measure and evaluate these key indicators, she helps businesses take it to the next level.
