Creating your own small business is a huge endeavor, one that comes with a number of decisions. One of the most important decisions you’ll need to make is how you structure your business.
This choice will have major legal and tax implications down the road. Choosing between a sole proprietorship, LLC, or an S Corp for your company’s structure is not something you should take lightly. These are three common structures for small businesses, and each one has its advantages and disadvantages. Here’s a rundown of all three to help you decide which is best for your business.
You are legally considered a sole proprietorship when you first start your business until you structure yourself otherwise. There is no legal separation between the owner and the business as a sole proprietorship, even if you choose to operate under a DBA (doing business as) name.
Because of this, your personal assets are lumped together with your business assets. The advantage is that you avoid double taxation since you won’t be required to pay corporate taxes on your income. The disadvantage is that if someone sues you, they can go after your personal savings and property in addition to your business money.
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Many people stay as sole proprietorships because it’s simple and cheap. You essentially don’t have to do anything to structure your business this way since it’s the default. There are no required filings or registrations with the federal government.
Sole proprietorships are great for people who have a hobby that makes money. For example, if you sell crafts on Etsy as a side business, staying as a sole proprietorship may be just what you need.
You won’t have to file a separate tax return in this business structure. Your business income and expenses are reported on your personal tax return, along with other income you receive from other jobs and any other expenses you acquire.
You pay a similar income tax rate to what you’d pay on taxes from an employer. But you’ll also be required to pay the self-employment tax.
Once your small business reaches a higher level of revenue, you may want to structure your business in a way that protects you more than a sole proprietorship does. Typically, the next logical progression is a Limited Liability Company or LLC.
This option offers the same tax implications as a sole proprietorship but comes with a major legal benefit. Since an LLC is its own business entity, your personal savings and property are protected (subject to some exceptions) if someone decides to sue your company. Of course, you’ll have to accurately keep your business finances separate from your personal finances in order to properly protect your personal assets.
Structuring your business as an LLC comes at a cost. The price tag on the filing fee varies from state to state. It can also involve the cost of using a legal service (such as Legal Zoom) if you’re not comfortable setting it all up on your own. For example, the filing fee to form an LLC in New York is $200, while the same process costs only $95 in Indiana. Legal Zoom charges an additional $149-$369 to facilitate the paperwork on your behalf.
An S Corporation is the most difficult and expensive business structure to form of the three. It also requires additional tax filings each year, most notably Form 1120S.
Given these things, you may wonder why a small business owner would decide to structure their business as an S Corp. The answer is that it can offer major tax advantages.
Unlike a sole proprietorship or LLC tax treatment, S Corps may not pay taxes on all business revenue. As an S Corp, you’ll only pay taxes on the salary you decide to give yourself. The IRS requires you to pay yourself a reasonable salary for the work you perform.
Let’s say your business generates $100,000 a year. As a sole proprietorship or LLC, you’d have to pay self-employment tax on all that revenue.
But if your business is structured as an S Corp, you may be able to give yourself a salary of $50,000, and you’d only pay self-employment taxes on that $50,000. The other $50,000 would be considered company dividends, which aren’t subject to Medicare and Social Security taxes.
Read On: 11 Benefits of Being Self-Employed
As you can see, the more your business grows, the more financially attractive an S Corp structure could be. However, it’s important to note that you can’t take 100% of your income as distributions. You could get in trouble with the IRS if you don’t first pay yourself a reasonable salary first.
What’s considered reasonable can vary widely by industry. To get an idea of the average income for businesses similar to yours, you can visit the Bureau of Labor and Statistics (BLS). Another common rule of thumb is to make sure that you take at least 60% of your income as salary.
Of course, these issues are complex, so it’s critical that you consult with tax and legal experts before making any decisions.
LLC Taxed as an S Corp
It’s important to understand that an LLC is a business entity, not a tax status. An owner of an LLC can choose to be taxed like a sole proprietorship or an S Corp.
Choosing to set up your business as an LLC taxed as an S Corp can give you the best of both worlds. You get the liability protection and low cost of setup that comes with an LLC while getting the tax advantages that come with an S Corp.
This option usually emerges when a small business owner has an existing structure like an LLC and begins to make a lot more money. LLC owners can switch from a sole proprietorship to an S Corp tax classification at any time.
To do so, you’ll need to file Form 2553 with the IRS. The filing deadline is two months and 15 days after the start of the year in which you want to use the new tax status.
Which Company Structures Require a Business Checking Account?
Any structure that separates a business from its owner, whether in liability only or tax treatment, will require you to keep your personal and business finances separate. So you will need a business checking account if you want to form an LLC or S Corp.
When it comes to sole proprietorships, all income you derive is treated as personal income by the IRS. The sole proprietorship structure is simply a pass-through entity. For this reason, sole proprietors aren’t required to have business checking accounts.
But just because it’s not required doesn’t mean that sole proprietors shouldn’t still consider opening a business checking account. Separating your business and personal finances will make it much easier to file your taxes and take full advantage of the small business tax deductions you deserve.
Not all business checking accounts are created equal. Some charge fewer fees and offer more benefits than others. Here are a few top business checking account options to consider for your company.
Novo is a great option for entrepreneurs looking for an affordable and hassle-free business checking account. Here are a few of its key features:
- No monthly service fees
- No minimum balance requirements
- Refunds all ATM fees
- Free transfers, mailed checks, and incoming wires
Novo is an especially strong choice for freelancers and business owners who often travel or transfer money internationally. Its Transferwise Integration makes it easy for customers to make payments all around the globe. And its Novo debit card is chip-protected and accepted worldwide.
What if you need to withdraw cash while you’re traveling abroad? No problem. Novo will refund all ATM fees, even those charged at international ATMs. And, perhaps most impressively, Novo charges no fees for incoming wires.
Finally, Novo offers a wide array of third-party integrations with other business software companies, like Slack, Xero, and QuickBooks. To learn more about Novo’s features and benefits, check out our full review.
Do you often receive cash payments from your customers? If so, NorthOne may be the business checking account for you. Why? Because, unlike Novo, NorthOne can accept cash deposits at its ATMs.
Additionally, NorthOne makes it easy to accept digital payments from a large number of third-party websites and apps, including:
- Cash App
- And more
You can also open an account online in as little as three minutes. However, while NorthOne offers loads of convenience, it’s also pricier than other business checking accounts. NorthOne charges a monthly fee of $10 per month that cannot be waived. Read more in our NorthOne Review.
Which is Best for Your Business?
To aid you in your decision, here’s a quick table that sums up the pros and cons of each structure:
|Must pay self-employment taxes on all income
|Must pay self-employment taxes on all income (unless the LLC is being taxed as an S-Corp
|Pay self-employment taxes only on elected salary
|Personal assets are separate and protected
|Personal assets are separate and protected
A sole proprietorship is a good option for those who have a side hobby that earns them a little money. It’s the default business structure if you don’t file any papers with the IRS. The main downside is that your personal assets are not protected if someone decides to sue you. Also, you must pay self-employment tax on all of your income.
An LLC is a natural progression once your side hobby becomes more lucrative and transitions into an actual small business. There is a cost to structure your business as an LLC with the IRS: that cost varies by state. The main advantage here is that your personal assets are separate and protected. Like a sole proprietorship, you are required to pay self-employment tax on all income generated by your business.
For those making decent revenue from their business, an S Corp may be the best option. This structure requires you only to pay self-employment tax on your elected salary, which must be reasonable according to the IRS. This can result in major savings depending on how much revenue your small business generates.
As previously mentioned, another option is to structure your business as an LLC and have it taxed as an S Corp. This gives you the benefit of protecting your personal assets and keeping IRS filing costs low while getting the tax advantages of an S Corp.
Which business structure you choose will depend on how much revenue your business is currently generating and how much revenue you expect it to generate in the future. You can always change the structure at the beginning of the next tax year, no matter which structure you choose.
If you need assistance in deciding which structure is best for your business or need help filing the papers with the IRS, it’s best to consult a tax expert or small business attorney.