If you’re a new business owner, you may wonder whether or not you should incorporate your business. Well-meaning friends and business colleagues may even have encouraged you to look into the question of “forming an LLC vs. S corp.”
It often is a good idea to operate your business as what’s called a “statutory entity” (mainly corporations and LLCs) for two basic reasons. First, you usually obtain some liability protection. With a corporation or LLC, business creditors may only be able to get repayment from the legal entity. For example, if the corporation borrows $50,000 for some business purpose and then can’t repay the loan, the creditor may only be able to money from the corporation. If the corporation doesn’t have any money, the creditor won’t get repaid. And that might be true even if the shareholders who own and operate the corporation have money.
This liability protection isn’t perfect, I should note. Many situations exist where a business creditor can look beyond the assets of the corporation and to the managers and owners of the business for repayment. But when you incorporate your business, you always get additional liability protection over business forms such as a sole proprietorship or a general partnership.
A second benefit accrues when you form a corporation or an LLC, too. The right entity choice can produce big tax savings for businesses. Tax law views corporations either as C corporations or S corporations. C corporations can provide all their employees, including shareholder-employees, with generous tax deductible fringe benefit packages. S corporations allow shareholders to avoid double-taxation on profits and sometimes allow shareholder-employees to save on self-employment taxes.
An LLC is another way to get liability protection. And in a certain sense, LLCs can represent to small a superior form of liability protection compared to a corporation, since an LLC doesn’t require as much red tape. In addition, an LLC is also a chameleon for tax purposes—in other words, an LLC can elect just about any tax treatment. An LLC with one owner (LLC owners are called “members’) can be treated as a sole proprietorship, a C corporation, or an S corporation. An LLC with two or more members can be treated as partnership, a C corporation, or an S corporation.
You can set up a corporation or LLC yourself. Or you can pay an attorney to do the work for you. The actual set up isn’t difficult. Setting up an LLC in Washington State, for example, requires a simple one page form you can download from the Washington State Secretary of State’s website. But one advantage of paying an attorney, say, $1,000 to set up your entity is that the he or she can answer your questions about the liability protection you want to achieve. An attorney can also provide you with guidance on how your new entity can comply with both state and federal corporation law.
Whether you set up a corporation or an LLC, you have choices to make about how the new entity should be treated for tax purposes. For example, if you set up a corporation, should the corporation be a C corporation or an S corporation? If you set up an LLC, should it be taxed as a partnership, a sole proprietorship, a C corporation, or an S corporation? You should not perform this analysis yourself. People who don’t understand the tax laws tend to make very expensive mistakes—mistakes which can be difficult (and sometimes impossible) to undo.
One other point needs to be made concerning the option of forming a corporation or LLC: The business pays extra costs by incorporating—costs beyond those required to set the thing up. In Washington State, for example, you can expect to pay an extra $60 to $300 annually in corporate or LLC annual license fees, depending on the type of business. You may increase your personal property taxes by setting up a corporation or an LLC. You will almost certainly pay more for your tax return if you end up with an entity that, for income tax purposes, is a partnership, a C corporation, or an S corporation. Finally, you will need to put owners on the company payroll (even if the owners are the only employees), and this will increase both your payroll accounting work and subject the business to roughly $400 of federal unemployment tax for each owner-employee.
Let me try to distill all of this down to a few simple rules:
Rule 1
If you’re a sole proprietor making profits equal to what’s a fair salary for someone who does your job (or less) and you want liability protection, you should usually set up a single-member limited liability company. You’ll keep your accounting and taxes very simple because for tax purposes, you’ll still be a sole proprietor. Yet you’ll get a degree of liability protection.
Rule 2
If you’re a sole proprietor making profits in excess of what’s a fair salary, you should probably set up an S corporation. Your accounting and taxes will become much more complicated, but you’ll probably save thousands of dollars in self-employment taxes. One complication here: There are actually two routes to becoming an S corporation. You can incorporate as a regular corporation and then make a special election asking for S corporation status. Or you can set up a single-member limited liability company and make the S election. If you have the choice, an LLC usually works better because it means less red tape.
Rule 3
Partnerships and groups of investors will usually want to set up a limited liability company, an S corporation, or a C corporation. Choosing the optimal entity in these cases is tricky. And sequencing the elections correctly is easy to goof up. You want to get able tax planning help in order to pick the best business form and achieve that business form.
Rule 4
If you consult with your attorney for an explanation of the legal reasons for either setting up a corporation or a limited liability company, ask about the difference between tort liability (which is the sort of liability you have if you accidentally drop a hammer on someone’s head) and non-tort liability (which is the liability you have to creditors if your business gets into trouble). A corporation or limited liability company will not shield the owner against liability for his or her own tort actions. It’s also very possible—again, ask your attorney about this—that a corporation or limited liability company will not shield the owner against liability for tort actions on the part of employees.
If you’re interested in learning more about forming an LLC or a corporation, feel free to contact us.
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