Imagine two different companies – let’s call them Company A and Company B – who both sell beer (writing about taxes all day induces thoughts of alcohol, it seemed appropriate). Company A and Company B both have exactly $150,000 in gross sales. They both have exactly $50,000 in expenses. And their net income is $100,000 for both. They are essentially the exact same company in every measurable way.
Both companies are owned by single men who are the exact same age and who have no dependents, no other income and no other expenses. Their only taxable activity comes from their business. Come tax time, both men go to the same CPA to have their taxes done. Knowing what we know so far, their tax bill should be exactly the same, right? Not quite.
Company A walked out of the CPA’s office with a total tax bill of $29,106, which included $12,282 in self-employment taxes.
Company B walked out of the same CPA’s office with a total tax bill of $23,885, including $6,141 in self-employment taxes.
How could this be possible? Every single aspect of their income was exactly the same. They were the same age, had the same amount of dependents and both used the standard deduction. They even used the same CPA, so there can’t be any tricky tax credits that one guy got and the other didn’t. Yet somehow Company B is paying $5,221 less in taxes.
The difference between the two companies tax bill comes down to one very simple thing, their choice of business entity. Company A is structured as an LLC. Company B is also an LLC, but has elected to be taxed as an S-Corp.
Your choice of business entity can be extremely important. It has several implications on both your business and you personally. These implications range from simplicity of taxes and record keeping, to legal liability to tax liability. In short, choosing the right entity for your business is extremely important.
There are several different entity options for a business, but for the market we are targeting here, I believe there are essentially three options to choose from. Here is a brief highlight of those three choices. We will go much deeper into the characteristics of each in future articles.
- Sole Proprietor- Being a sole proprietor essentially makes you and your business one and the same. There is no legal or tax separation between what happens in your business and you personally. This is the default entity for new business owners who don’t make a different election. It offers almost no legal protection to the owner and has no tax advantages. However, it is extremely easy to manage the records and prepare the tax return. If your business is fairly new, not yet making significant money and has no legal risks, it could be the right choice for you.
- Limited Liability Company (LLC.)- If you are the sole owner of the company, setting up your business in an LLC. offers much greater legal protection while also keeping the tax and record keeping as simple as a sole proprietor. If your business has more than one owner, the LLC. will file a separate tax return, but is otherwise the same. An LLC. is a great option for a business with net income around $40,000 a year or less who wants legal protection while keeping their taxes and records as simple as possible.
- LLC. Taxed as an S-Corp.- This option is the best kept tax secret among successful small business owners. It allows you to have the legal protection and relative simplicity of an LLC, while giving you the tax benefits of an S Corporation. Those tax benefits come down to one basic thing; relief from a significant portion of self-employment taxes. We will cover the details of an LLC. taxed as an S-Corp in much greater detail in later articles, but for now let’s just say it is a fantastic option for small businesses who are beginning to make a decent profit (I would say around $40,000 or more). It comes with some complications such as setting up payroll for yourself and filing a separate tax return, but as we saw with the example above, the tax savings can be thousands of dollars or more depending on the size of your business.
While there are other options for small business owners such as C-Corporations and traditional S-Corporations, I have found these three to be the most relevant for small business owners in the $150,000 a year or less category. Choosing the right entity is an area I see ignored way too frequently by small business owners. The consequences of choosing the wrong one could be enormous.
We will have many more discussions on business entities in the future, but if you are interested in getting set up in the right one now, see our services page and contact us for more information.
Question: When was the last time you reviewed if your business entity was the right choice for you?