I am often asked by entrepreneurs if they should set up a separate entity for their small business. For many people, operating as a sole proprietor is sufficient. If you are doing a little work on the side and you are not in a risky industry, there is often no reason to set up a separate entity. However, if you feel that you need to protect your personal assets, you are making enough money to make self-employment taxes a burden, or you are looking to bring in partners or investors, you need to consider setting up a separate entity. This brief article will discuss the many advantages of my favorite entity, the limited liability company (LLC) taxed as an S corporation (S corp).
An LLC has many advantages over other business entities. An LLC, unlike a sole proprietorship, is designed to protect your personal assets from creditors. This “limited liability” means that if you put $5,000 into the entity and the entity owes a creditor $6,000, you are only liable for what you put into the entity, or $5,000. The earnings from an LLC are only taxed at the individual level instead of at the corporate and individual levels like in a C corporation. LLCs generally are much cheaper and easier to set up and administer than corporations. In fact, a single member LLC does not require the filing of a separate tax return as the earnings are reported directly on the owner’s individual tax return. LLCs can be flexible in the way that earnings are taxed and distributions are paid.
The major downside to an LLC when compared to an S corporation is the tax treatment of the earnings. LLC earnings are considered self-employed earnings which translate into an additional 15.3 percent in the form of Social Security and Medicare taxes for the owner. With an S corporation, the owner can pay himself a salary which will be subject to self-employment taxes, but any excess earnings are taxed as ordinary income. As long as the salary is “reasonable” in the eyes of the IRS, an owner can save substantial taxes with an S corp.
Luckily, this is one instance in which owners can have their cake and eat it too. LLCs can be taxed as sole proprietorships, partnerships, S corporations or C corporations. I suggest setting up an LLC taxed as an S corporation which will give you the ease and protection of the LLC and the tax savings of the S corporation.
The above is a summation of complex tax law. Please check with your tax professional before making a decision. Our CPAs at Milliken, Perkins and Brunelle are available to assist you any time of year.