When setting up a business and deciding on entity type, most people are looking for 1) liability protection and 2) tax savings – specifically lowering self-employment tax liability. For small businesses, the two best options are the LLC or the S-Corporation, and many tax or legal professionals seem to advocate for one team or the other so it is hard to know what entity is truly best for your business. Well, I am not your advisor and I have been on both teams, so hopefully I can provide you with some balanced information and after a couple rounds, hopefully we will have a winner for your business…
Will the business own appreciating property like real estate?
If your business has anything to do with real estate rentals or owning and managing commercial or residential property, then LLC is the early winner. This is vitally important – you should never put real estate into a corporation. If a CPA or tax practitioner recommends this for a new small business, I would consider it malpractice.
Basically, if you put real property into an S-Corporation, then you are going to have a taxable event if you transfer it out of the corporation in the future and you will pay tax based on the fair market value of the property at that time. I could tell you some horror stories on this issue, but trust me – if you have a residential or commercial property, put it in an LLC.
LLCs are perfect for real estate as you can move the property in and out of the entity without any taxable events. Plus, they are much easier to setup, administer, and report for tax purposes. Even better, if you have one owner, you can use the single-member LLC for your real estate and then the tax reporting is simplified so that you only have to complete a Schedule E as part of your personal return.
How many owners will the business have?
This is another important question to look at upfront, as it can result in a knock out in round one. If you will be the sole owner of the business, then your options are limited to the following:
Single-member LLC (SMLLC)
The only LLC offering for the single-owner business is a great option for easy setup, administration, and tax reporting; however, it is going to cost you in the form of self-employment tax. To the IRS, The SMLLC is no different than a sole proprietorship – in fact, the SMLLC is reported on Schedule C just like a sole proprietorship. Unfortunately, this means that you will pay self-employment tax (15.4%) on the entire amount of your net taxable earnings. This can really add up – especially if you are a consultant with few expenses and/or minimal capital asset needs. After a few years of paying a hefty tax bill, most business owners are willing to put up with some extra administration and tax prep costs in exchange for a much lower tax bill via use of the S-Corporation while paying themselves a reasonable wage.
The big winner for single-owner businesses is clearly the S-Corporation as most business owners can end up saving thousands. With an S-Corporation, you do not pay self-employment tax on the earnings, BUT the owner must pay himself a “reasonable” salary, which means you are paying payroll taxes on the Federal and state level. Usually, if you sit down with a CPA and lay this all out, they should be able to give you a ballpark of your tax savings each year; however, there are costs related with this:
- Legal costs – it is not cheap to setup, but I would never suggest a D.I.Y for an S-Corporation. Get it setup right and avoid legal problems later.
- Accounting Fees – keeping your accounting data on a spreadsheet may not cut it anymore – especially if you use a lot of credit cards and loans. Be prepared to pay a bookkeeper or an accountant to get your books setup right so that the tax preparation goes smoothly.
- Tax Prep fees – S-Corporation returns require much more work and typically range from $750 – $2000 or higher depending on complication. Plus, you now have to file quarterly payroll tax returns and payroll to process, which can run you about $95/quarter even with one employee using ADP, Paychex, of your CPA.
If your savings are still substantial after factoring in these costs, then you should definitely go with the S-Corporation, but make sure you have a good lawyer and a good CPA that you like as you will be talking to them frequently for the first few years.
Well, round 1 is in the bag and we are tied at 1 a piece. In round 2 we will deal with issues for businesses with more than owner.
Just remember – never choose an entity for your business without consulting a CPA and lawyer as every situation and business is unique. Give me a call at 503.224.8844 if you need a CPA or a lawyer to help you with your new business.