Most startups begin with a dream, a big idea that you want to act upon. Although that dream may seem simple enough, there are legal factors associated with it that will ultimately need to be set up.
The last thing we think about when it comes to making a living off of our dream is setting up a legal business entity. There’s a whole host of things you will need to consider when becoming an entrepreneur, and the most important of these decisions is the type of business structure you’re going to choose. Although the list of options are small, choosing the right structure can be quite difficult, especially for those just getting into the game and not having much experience, but it will make a huge difference in the long run. Not only does it affect your taxes, but it could also limit your future growth if not chosen carefully. Below, I’ll take you through the three main options available to small business owners and what to consider with each one, so hopefully it can help you make the right decision for your startup.
If you don’t have a whole lot of money to get started with, then registering as a sole proprieter might be your best bet. It’s often the business structure used by women who run the show themselves, such as wedding photographers, florists, hairdressers, and the like. However, despite what the name might suggest, sole proprietor's are able to employ additional staff- you just need to be careful to stick within the rules of your business license.
Setting up a business as a sole proprietor is quick and simple, and there aren’t any fees to pay in order to register. You can also report all your business income and expenses as part of your personal tax returns, meaning there’s minimal red tape once you’re trading. However, there are downsides to this system. Namely, the IRS doesn’t make any distinction between the business itself and the person running it. That means if you run up any debts, you might need to pay them off with your personal finances. Sole proprietorship can also hold you back if you start to earn more money, so once you reach that stage, it’s worth considering upgrading to another business structure.
Limited Liability Corporation
A limited liability corporation, or LLC, is a popular business structure because it protects you as an individual from the operations of the business. As a sol proprietor you will personally be responsible for debts or lawsuits regarding the business. With an LLC, on the other hand, you don’t have to worry about this- all your personal assets remain safe and protected. That makes this an excellent choice if your company will be holding rental property, since you’ve got a layer of protection between you and your tenants or contractors. Lastly, it’s a smart move if multiple people will be entering a partnership in forming the business, since it makes tax planning much easier, and protects each partner from the actions of the others.
Just like all legal structures, an LLC isn’t without its downsides. It doesn’t offer any tax advantages, since your company will still be taxed at the same rate as a sole proprietorship. That means if you wind up making a lot of money, a big chunk of that could be paid out in taxes. You’ll also need to pay fees and fill out a lot of forms to get your LLC up and running. So, an LLC is a smart choice for asset protection, but if you find your business grows significantly, then it might end up holding you back.
Just like an LLC, setting up your business as an S corporation means you are protected as an individual from the business’ debts and liabilities. What makes it different, though, is the fact that you are not subject to self-employment tax. That could mean huge savings in the long run, depending on how you structure the business itself. Essentially, it lets you act like a big business, but on a smaller scale. You can have up to 100 shareholders, and those shareholders won’t have to pay any corporation tax on their net profits from the company. So, if you take a salary from your S corporation, then you don’t have to worry about that high rate self-employment tax.
The downside to the S Corp affect shareholders and shares directly, for example, shares are subject to seizure and sale in court proceedings and high income shareholders are required to pay more taxes on their didtributions. Also, owners/employees that own more than 2% of the shares cannot receive tax free benefits, and any capital gain on the sale of assets will incur much higher taxes than other entities such as LLC's.
S Corps are a great choice, but they also endure a lot of scrutiny when it comes to the IRS, and if for any reason your tax status is compromised by either non-resident stockholder or stock that has been placed in a corporate entity name, the IRS will revoke the status of the S Corp, charge back-taxes for 3 years, and impose a 5-year waiting period before you are able to regain tax status.
There are other entities such as partnerships and C Corporations, but these three are the most commonly used, and the most difficult to choose from. Whichever you choose, just be sure its the right fit for you. Consider long term and short term goals and don't go with the satus quo, because every business is unique and requires different things, especially when it comes to the legal needs of the company.
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