Choosing a Form of Business: Options & Factors to Consider

form of business

When you own a business, one of the first decisions is what type or form of business you want. Or you may have an existing business and thinking you need to change the form of business. You might ask your attorney or accountant what you choose or which one is best. The challenge with this is that professionals often have their favorite to recommend, and it might not be the right fit for you. Learning about each option will help you make an informed choice. 

Overview

Here is a brief overview of each option but make sure to read the details below as well to be more informed. You will never regret finding out as much as you can before choosing. All the options are good and will be best for someone. This is one way to know if you are getting a biased or unbiased opinion. A bias opinion will simply tell you which one is best, might claim tax savings and even give a number, but will not be backed up by many details or a tax analysis. An unbiased opinion will explain the pros and cons of each option and leave the decision to you. 

  • Sole proprietor is the simplest option. You don't have to setup a business entity. It is great for solo owners with no plan to hire workers in the future.
  • Single member LLC is fairly simple, though there is a state level registration. This is also great for solo owners and it also works for those who want to hire workers later on. Some states require licensed professionals to form an PLLC, which is an LLC for professionals. 
  • Multi-member LLC or partnership: is a more complex structure. It requires state registration and a legal partnership agreement. There are more costs to set it up and annually to file taxes, as an extra tax return is due each March. 
  • Entity taxed as an S-Corp is a tax status. This means that an LLC or C-Corp has elected to be taxed as an S-Corp. It is best when the owner has had a full analysis showing the tax benefits and the many additional costs (see info below) and is ready for a more formalized business with additional rules and requirements. There is an additional tax return due each March. Due to the complexity, more research is needed to be sure it's a good fit before choosing this option. 
  • C-Corp is less common for small businesses, and many times when a C-Corp is necessary the owner then elects S-Corp tax status. However, there are a few cases where C-Corp can make sense. There is a Corporate return due each April in addition to your personal return. This option requires more research to understand the specific benefits and additional costs, including double taxation. Some states require licensed professionals to form a Professional Corporation, which is a Corporation for licensed professionals. 
  • Non-profit is a business that you do not own. It is run by a Board of Directors. It lets you fundraise and you can be a W2 employee as long as the Board of Directors wants to employ you. A tax form is filed annually and there are many rules to ensure you maintain the non-profit status. 

Additional considerations:

When you hear the term "self-employed" that refers to sole proprietors and LLC owners that are not taxed as S-Corp or C-Corp. However, to make it a little extra confusing, for certain tax provisions an S-Corp owner can be treated as if they are self-employed. 

No business formation will keep you from ever being sued, or from being sued personally if you have committed wrongdoing. See the section on LLC/Corp and being sued in the Other Resources section below. 

Switching can be more challenging if you have a health business that accepts insurance. Changing the business form, even if you can keep the same EIN, will sometimes create disruption with existing contracts because the form of business marked the W9 will change. Considering the long term best options is more important when you have insurance contracts. 

If you live or operate your business in California and are a licenced professional, you may not be able to elect LLC. If you want to hire workers, you may be stuck with forming a Professional Corporation and electing S-Corp status, even if there are extra costs and rules. 

S-Corporation decision

Prior to 2018, many small businesses formed an S-Corp once their business made a decent annual profit, over $50,000 or sometimes over $100,000. This is because an S-Corp reduces the social security and medicare tax paid by the business owner. Social security and medicare tax can be as much as 15.3% of business profit for a sole proprietor or LLC business and the opportunity to save 15.3% on a portion of earnings is appealing. 

However, in 2018 the tax law changed. Small businesses received a new deduction of up to 20%, significantly reducing income tax for most small businesses. This Qualified Business Income (QBI) deduction applies to pass through income from business. This means it improved taxes for sole proprietors, LLCs and to a lesser extent, S-Corps. It provides more of a benefit to self-employed businesses, because the deduction applies to the entire income earned from the business. It provides a smaller benefit to S-Corps, since S-Corp owners must be paid a salary and QBI does not apply to owners salary. 

Pass-through income: when net income of a business "passes through" to the owner this means it is taxed to the owners on their personal income tax return. The business does not owe any income tax on these earnings. 

The result is that while an S-Corp can substantially reduce social security and medicare tax, an S-Corp owner may pay more in income tax. An S-Corp also typically has higher expenses for payroll, accounting and tax preparation fees. The additional income tax and other costs may erode the tax savings entirely. 

How tax professionals get S-Corp recommendations so wrong

Many times a tax professional will quote the S-Corp tax savings as the amount of tax savings on the tax return, without adding up the many costs that will now happen off the tax return. When you elect S-Corp there are new costs the business would not have had before, there are taxes that shift off the tax return and will now be paid by the S-Corp, in addition to the income tax going up. All this has to be factored in when deciding in an S-Corp will save. 

The information below came from a real situation. Someone messaged me explaining they made $160,000 the prior year and their tax professional recommended electing S-Corp status because it would save them $14,000. Based on reading my info, they asked the tax professional for a detailed analysis of the savings and costs, which the tax professional could not provide, but continued pushing the S-Corp option. 

I reviewed this persons prior year tax return. The end result is that my estimate resulted in a potential savings of only $1,500, not the promised $14,000.

I developed my tutorial for estimating S-Corp savings after many people brought me an analysis to review, and almost all of them were incomplete or inadequate. I have also had many S-Corp owners help me analyze their taxes because they were promised significant savings but after a year of being S-Corp, they do not appear to have any extra funds. 

In the end this business owner would have been expecting almost $1,200 per month extra from the promised tax savings, but in realty, they have saved about $125 per month. 

Here is how it happens. The example below is based on one individuals situation. Your situation could be very different even if you are making the exact same amount of income. Other income, filing status and personal tax credits can impact the savings calculated. Each persons situation requires an individual analysis. But for this individual:

Taxes they would pay if they stayed self-employed 
$17,584 income tax after credits
$21,901 self-employment tax (social security & Medicare)
$39,485 total tax

This is their entire tax for the IRS for the year. No additional taxes. And it's all on the personal tax return. 

Taxes they would pay if the elect S-Corp on the tax return
$21,965 income tax after credits

Just looking only at the tax return, it actually looks like the S-Corp is going to save $17,520 in tax! Who would not elect S-Corp with that information! But wait, let's look at all the other taxes and costs. 

S-Corp total taxes and costs
$21,965 income tax after credits on the owner tax return (from above)
$7,038 payroll tax withheld from owners paycheck based (social security & Medicare) 
$7,038 payroll tax paid by the S-Corp (social security & Medicare) 
$203 federal unemployment tax for owner
$217 state unemployment tax for owner
$600 estimated cost for payroll service for the year
$1,000 estimated additional cost for S-Corp return in March
$38,061 total income tax, social security & Medicare, unemployment & other costs

When comparing the totals:

$39,485 total tax if remain self-employed 
$38,061 total tax & costs if elect S-Corp status
$1,424 estimated savings

The actual tax savings of $1,424 is less than $120 per month! It totally makes sense why a business owner would get to the end of the year and be confused where is that $14,000 promised tax savings, if the actual tax savings is less than $120 per month!

Getting an analysis done

Many accountants will do what appears to be an analysis considering just some of the costs of the S-Corp. I have looked at dozens of other accountants analysis and the top mistakes I see are 1) failing to consider the impact of the QBI deduction, which can raise income tax for an S-Corp entity, 2) only considering 1/2 of the payroll tax that will be paid when S-Corp status is elected, and 3) leaving out all the other costs which do add up. 

Simple Profit has a comprehensive spreadsheet tool that you can access and complete your own analysis using the prior year tax return and the current year income estimate. For a super low cost! It is available as one of the many tutorials in the https://www.simpleprofit.com/aboutmembership. The membership tutorial and analysis can also be used as a "second opinion" when your tax professional recommends S-Corp. S-Corp is easy to elect, but there is a lot of work to make the changes after that including additional reporting requirements, payroll, and more rules, so once you elect S-Corp you are more than likely going to stick with it the remainder of your business, so best to be sure. The analysis includes a page you can share with your tax professional for them to compare to their own. 

Unreasonable salary

A tax accountant can increase the appearance of S-Corp tax savings by making the owners salary unreasonable low. Sometimes it is set ridiculously low. Two issues to be keenly aware of in this scenario. One is that the IRS knows owners can save by setting the salary too low. They can see salary on the S-Corp return and if they audit an owner and find a low salary, they can re-characterize some distributions as salary and charge additional tax, interest and penalties. Two is that the lower the salary, the lower the social security benefits in retirement. You want to be aware of that going in and not surprised by it 20 or 30 years from now.

Make sure your owner salary is not set so low that you would not ever, with your current level of skill and ability, accept that level of pay from any other company. Imagine another company offering you that salary and if you balk, it might be too low. Also ask yourself if you could hire someone with your level of skill and ability at that salary. See my video here for more about setting a reasonable salary: Reasonable Salary video

What if I'm already an S-Corp?

The S-Corp does save some business owners substantially. But even if you find out that your existing S-Corp is not saving you much, there may be no compelling reason to switch back to a different form of business. The current tax landscape could change and S-Corp might start saving you tax again. If you are curious how much an S-Corp is saving you now, you can always ask your tax professional to calculate what it would cost to be taxed as self-employed, then count up the costs you would no longer have to pay. The estimated tax tutorial in the membership also has a reverse analysis for S-Corps to see what self-employed taxes would look like. 

Form of business details

This is a more detailed explanation of each option you might want to choose for your business. 

Sole proprietor

Sole proprietor means no separate business entity has been formed, the owner and the business are one in the same. The owner may have a doing-business-as (DBA) name, also known as a fictitious name, established with the state or county, or may operate under the owners legal name. Although there is no separate business entity, it's still important to open a business bank account and have accounting records. 

Taxes

All income from a sole proprietor business passes through to the owner in the year it was earned. 

  • Owners pay income at the owners ordinary tax rate,
  • Owners also pay self-employment tax of 15.3% on business net income. A deduction is provided for half of the self-employment tax, or 7.65%. This deduction of 1/2 of self-employment tax makes being self-employed comparable to an employer, as employers pay and deduct 1/2 payroll tax of 7.65%.
  • All income from the sole proprietor business is potentially eligible for the QBI deduction, the owner may avoid income tax on up to 20% of business earnings.
  • Taxes are filed on Schedule C with the individual tax return, no separate return is needed.

Other factors

A sole proprietor is the simplest form of business. Little to nothing has to be done to set it up. It can be a great for a business you are operating by yourself. A sole proprietor may not be best if you are hiring employees, as there's no liability protection for wrongful action of employees

Single-member Limited Liability Company (SMLLC)

Single-Member Limited Liability Company is a business entity established at the state level, and is separate from the owner. The U.S. federal government does not recognize the LLC and considers it a "disregarded entity." Which means sometimes the IRS treats the business as a sole proprietor when there is only one owner. Because it is a separate entity, bank accounts need to be opened in the name of the LLC, not the owners personal name, and contracts and debts also need to be in the name of the LLC.

A Professional Limited Liability Company (PLLC) is a special type of LLC reserved for certain licensed professionals applicable in certain states. Check your state law to understand the rules for forming an LLC or PLLC. For example, in California most licensed professionals are unable to form an LLC. In other states a PLLC can be an option or may be required, the only option, for licensed professionals. 

Taxes

Income tax and self-employment tax for a single member LLC are identical to the sole proprietor listed above, and business income is also reported on Schedule C as part of the individual 1040 tax return. 

Other factors

A single member LLC is also a simple form of business, and similar to a sole proprietor except there is a legal business entity to provide some protection if the business defaults on debts. Many mistakenly believe that an LLC protects the owner from all lawsuits, which is not correct, but there is some protection for debts and wrongful action by employees. Obtain legal advice and speak with an insurance carrier to learn how you can protect yourself from lawsuits.

Partnership/Multi-Member LLC (MMLLC)

Partnership/Multi-Member LLC is a business with more than one owner, with or without the LLC structure. Business bank accounts and credit cards are in the name of the partnership. A partnership agreement is required to show how the partnership operates and how profits and losses will be divided among the partners. 

Taxes

Partners pay Income tax and self-employment tax similar to a sole proprietor, however, profits and losses are divided according to the partnership agreement and taxes can be impacted by the agreement.

  • The partnership has to file a separate tax return, Form 1065, each year by March 15th for the partnership. No tax is due with this return.
  • After the 1065 is filed, each partner gets a Form K-1 showing their portion of profit or loss.
  • The K-1's are used by each partner to report their profit or loss on their individual tax return. Partners pay income and self-employment tax on profits.

Other factors 

Partnerships can be complicated, especially when operations don't go as expected. Choose partners wisely. Expect higher legal costs to have the partnership agreement periodically reviewed and modified, including whenever tax laws change. 

Entity taxed as an S-Corporation

Entity taxed as an S-Corporation means an LLC or a C-Corporation chose to elect to be taxed as a S-Corporation. This can happen if there are no more than 100 shareholders and certain other rules are met. If this election is made, owners that work in the business will be considered both owners and employees of the business and are expected to be paid a reasonable salary.

Taxes

Because an S-Corp owner is an owner and an employee both, they are taxed on the salary and the profit separately. 

  • Owners pay income and 7.65% payroll tax on the salary portion of their income. Owners get a W2 as any other employee. The S-Corp pays the other 7.65% of payroll tax. The S-Corp deducts the salary paid to the owner as a business expense, since owner will be paying the income tax on the salary separately. 
  • The S-Corp must file a 1120S tax form each year by March 15th showing the business profit or loss. The profit/loss represents the business revenue, less business expenses and owners salary. After the 1120S is filed, the owner(s) get K-1 forms showing their share of profit or loss. 
  • Owners include the K-1 form on their individual tax return. Income tax is calculated on the profit, less any QBI and other deductions. There is no self-employment or payroll tax on S-Corp profit. 

Other factors

The S-Corp return is more complex and so expect to pay double or triple the cost of tax preparation for an S-Corp return plus an individual return, compared to the individual return required for a self-employed owner. The owner will want to establish an accountable plan to be able to reimburse themselves for expenses without having to pay tax on the reimbursement. The owner cannot take the home office deduction on their personal taxes and instead must create an employee reimbursement for any home office expenses. Owners must be careful to only include revenue paid to the S-Corp in the accounting and tax records. Income earned by the owner as an individual cannot be assigned to the S-Corp. 

C-Corporation

C-Corporation is not a pass through entity. The C-Corp itself pays income tax each year on the profits of the business. Owners that work in the business are also employees and receive a salary via payroll and receive a W2 for those earnings. Profits can be held in the business for a period of time because they do not pass through to the owners automatically. When the Corporation declares a dividend, the profits are paid to the owners and the owner will pay tax on dividends in the year received. This is known as double taxation, because the Corporation paid tax on profits, and owners pay tax again when profits are distributed as dividends. 

Taxes 

  • A C-Corp pays corporate income tax each year
  • The owner(s) who work activity in the business receive a W2 salary and pay income and 1/2 payroll tax on the salary. The C-Corp pays the other half of the payroll tax.
  • Owner-employees do not pay tax on dividends until they are distributed, however, when the dividends are paid this is the second time they are taxed, as the C-Corp already paid tax on the profit in the year earned (double taxation).
  • A separate tax return is filed for C-Corporation by March 15.

Other factors

A C-Corp can offer more in the way of employee benefits to owners. Because S-Corps get special tax treatment, owner benefits can be limited. C-Corp owner-employees are treated more like regular employees when it comes to employee benefits. A C-Corp is one of the most complex business formations so explore carefully with an attorney and tax professional before forming a C-Corp. A C-Corp can elect to be taxed as an S-Corp. 

Non-profit 

A business may also be formed as a non-profit organization in which case you would not be the business owner. The non-profit is operated by a Board of Directors. If you do want to form a non-profit, seek a tax and legal professional who are experienced in that area.

Taxes 

While the non-profit will not pay income tax, there will be a Form 990 tax return due each year, typically May 15th for a calendar year business. As a W2 employee of the non-profit, you will pay income tax and 1/2 payroll tax (social security & Medicare) on your W2 wages, the non-profit pays the other half of the payroll tax and unemployment tax. 

Other factors

You do not own a non-profit and that means that you could be fired or let go from the organization from the Board of Directors. You may initially be of similar minds with the Board of Directors and you may select the initial Board. Over time, Board members may resign and new Board members elected by the current Board may not share your vision. When you discuss this option with a non-profit attorney, consider how many Board members will be required and how much control you will have or lose choosing this option. 

Other resources 

Here are some additional resources that may be helpful as you make your form of business decision.

Owners pay
To learn how business owners pay themselves from the various forms of business, watch this video: https://youtu.be/hEE6f4Y2yQc

Corp owner salary
S-Corp and C-Corp owners must pay themselves a reasonable salary for work they perform for the business, if there is income available to pay the owner.  This video explains how to set a reasonable salary and includes a free handout to use: https://youtu.be/7jotL9-APRo

LLC/Corp and being sued
We can all be sued if we engage in wrongdoing that harms our clients, patients or customers or harms the public. An LLC or Corp can help you if an employee is sued for wrongdoing and you as the owner are in now way connected or at fault. An LLC can also help if your business does not pay its debts, you may avoid having to pay them personally. However, banks and lenders know this and often get a personal guarantee from the owner for small business debts. Here are some legal articles on this topic:

"There is one extremely significant exception to the limited liability provided by LLCs. This exception exists in all states. If you form an LLC, you will remain personally liable for any wrongdoing you commit during the course of your LLC business."
https://www.nolo.com/legal-encyclopedia/limited-liability-protection-llcs-a-50-state-guide.html 

“While the limited liability of S Corporations can protect you from the actions of your shareholders or employees, these protections don't protect you from being sued for your own actions….”
https://www.upcounsel.com/liability-of-s-corporation

“Like any corporate organization, an S Corp allows you and any co-owners to restrict personal liability. If, for example, your company is unable to pay its debts, the business assets would be open to creditors, but your personal belongings would be off-limits. However, you do not have total protection from liability; if your company is in the business of offering advice, for example, you won’t be protected if the advice you offer is wrong.”
https://www.smithschafer.com/blog/advantages-disadvantages-of-s-corporations/ 

There is a reason that LLC and Corp businesses still need to carry insurance. See this blog for more info on what insurances can be deducted by the business: https://www.simpleprofit.com/blog/insurance Consult an attorney to find any other ways to protect your business from lawsuits. 

Employee reimbursements
If you have employees or you are an owner-employee of your S-Corp or C-Corp, it is important to establish an accountable plan for employee reimbursement. This ensures that your own and our employee reimbursements will not be taxed. Self-employed owners do not need this to be able to reimburse themselves tax-free: https://www.journalofaccountancy.com/issues/2020/feb/employee-expenses-accountable-plan.html

Other steps to start a business
If you are just starting your business, these 10 essential steps will help you get started: https://www.simpleprofit.com/start 

Bottom line

It can be overwhelming to choose your form of business. Making an investment upfront to learn your options and make a careful choice can save you the headache of having to switch your form of business later. Avoid choosing because someone else said it was best, unless you fully understand and agree it's the best choice. Makes some appointments to consult with professionals and discuss until you are confident you are making the best choice for you. Simple Profit members can sign up for 1:1 coaching or submit questions to discuss the options and get support for choosing. About the membership

 

 

The Simple Profit membership provides support to business owners. Get the education and resources you need to make informed business decisions and establish quality business processes, including bookkeeping and cash management tasks.

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