We are often asked to help clients decide what kind of entity they should create to operate a business or to hold investments. The choice they are trying to make is usually between a corporation and a limited liability company or LLC.
The first question which should be answered is whether an entity is needed at all. Most small businesses operate as sole proprietorships or informal partnerships.
A sole proprietorship is simply a person operating a business in his or her name without creating an entity. If you are operating a business with a partner as a partnership and do not have a written partnership agreement, you should have a written agreement.
What factors should you consider before deciding to move from operating as a sole proprietorship or partnership to an LLC or corporation? By far the most common reason is liability protection. Tax issues are the second most common reason for creating an entity.
If you are in a business or hold investments which create substantial liability which cannot be adequately covered with liability insurance, you are a prime candidate for creating an entity. For instance, if you own rental real estate, there can be substantial liability issues which justify holding the real estate in an entity. Many business operations can create liability for the owner. Maybe your business provides professional advice or perhaps you sell equipment which could be dangerous if misused. There can be a myriad of reasons to need liability protection. You must weigh the liability which could be created by your business and determine if it merits the protection which could be afforded by an entity such as a corporation or LLC.
It is not uncommon for a client to tell us they want to create an entity to save taxes. For most small businesses operating as a corporation or LLC will not save on income taxes. Payroll tax savings may be possible.
For 2021, the self-employment tax rate is 15.3% on all net income up to $142,800 which can mean a total tax of a little more than $20,000 per year. An entity can reduce payroll taxes.
Let me illustrate this with an example. Suppose Joe owns ABC, LLC and that a reasonable salary for managing Joe’s business is $60,000 per year. Suppose further than the company’s net income is $100,000. If Joe operates as a sole proprietor, his self-employment tax is 15.3% of $100,000 or $15,300.
If he forms an LLC and pays himself a salary of $60,000 his payroll tax is 15.3% of $60,000 or $9,180. The remainder of the income from the company can pass through to Joe free of payroll tax. Joe saves $6,120 per year in payroll taxes.
Joe could enhance the benefits of creating the LLC by investing the $6,000 he saved in payroll taxes in an IRA. This would reduce his income taxes because the $6,000 IRA contribution would be deducted from his taxable income. If Joe is in the 22% marginal income tax bracket, by creating an entity, Joe could save over $6,000 in payroll taxes and another $1,320 in income tax by investing the $6,000 in an IRA. He is also accumulating $6,000 per year for retirement.
Business owners are not free to just set their salary at an arbitrarily low amount. The amount must be fair and reasonable but there is a wide latitude in setting salary.
There are additional costs to operating an entity. Besides the cost of setting up the entity, you may need to file a business tax return each year. These typically cost $500 or more. In Texas, if your income is less than $1,180,000 no franchise tax is due, but you must file a franchise tax return. There may also be additional accounting costs if the business is operated as a separate entity.
Assume you will incur an additional $1,000 in annual costs. If creating an entity can save more than that in taxes, then it makes sense to create an entity to save taxes. If you need liability protection, then the entity serves a purpose even if there are no tax savings.
If you decide to create an entity, you must decide whether you will create a corporation or an LLC. The LLC is relatively new, at least when compared to corporations which have been around for hundreds of years.
LLCs are a hybrid between a corporation and sole proprietorship. They are much more informal to operate than a corporation. Corporations typically require annual meetings and the election of a board of directors and officers. Annual meetings can be virtually eliminated with an LLC. LLCs do not have to issue stock certificates. They are also very flexible when it comes to taxation. You can elect to be taxed as a sole proprietorship if you own the entire company or as a partnership if you have one or more co-owners. If it is advantageous, you can also elect to be taxed as a corporation.
For most small businesses, the LLC has become the entity of choice. If it will own investment real estate, it is the default choice. There are usually negative tax consequences when real estate is held in a corporation.
A good accountant can be invaluable to most businesses. If you do not have one, consider hiring one. Deciding whether to create an entity and choosing the type of entity can be complex. You should rely on the advice of competent legal and accounting advisors before deciding. The information in this article is generalized and should not be relied on when deciding.