I wanted to start this week with a great discussion that I’m having with one of my friends about starting her own business. She’s creating a comic book and wants to know how to structure her company that will distribute the comic and sell related merchandise.
It’s actually a question that I get a lot since many people have the desire to start their own business as a main source of income or as a side hustle.
Today, I’ll discuss the basic forms for a person going out on his or her own and then later in the week, I’ll get into more complicated concepts.
Here are the basic organizational structures for a single-member entity:
1. Sole Proprietorship: This is the easiest and least costly way to set up a business. There are no formalities as far as creating or registering your company. You can simply start selling your services or products. (You may need a business license or permit for certain types of businesses.)
At the end of the year, you file your business’ profit or loss on the Schedule C of your 1040 tax return. The advantages of this type of structure are the ease of formation and operation. The disadvantage is that you and your business are one in the same. As such, your personal assets have unlimited exposure if you get sued for faulty service or a bad product.
2. Single Member LLC: To avoid the unlimited liability of a sole proprietorship, you can turn to a single member LLC (Limited Liability Company). This type of entity still provides an ease of administration (i.e., you don’t have any business formalities, and you still file a schedule C), but it gives you some protection because the business is considered a separate entity.
You are only liable for damages up to the amount that you have invested in the business. However, you should make sure to keep your personal and business assets separate to prevent someone from “piercing the corporate veil.” Simply put, that means a creditor can sue for your personal assets because your business and personal assets are comingled and your LLC only serves as a shell for a separation that doesn’t actually exist.
You also have to take a few more steps to set up a LLC than you do for a sole proprietorship. You have to file articles or organization with your state, and you should have some sort of operation agreement that explains how the business will carry out its mission.
One last potential pitfall of the LLC is that you have to pay self-employment tax on all business profits because, for tax purpose, you and the business are one in the same.
3. S-Corp: This type of business entity completely separates you from your company, for both operational and tax purposes. The business is its own entity, and you as the owner are the sole shareholder and an employee. That division, however, comes with operational costs.
With corporations, you have to file articles of incorporation with the state, appoint officers and board of directors, and create bylaws for the business. In addition, you have to adhere to corporate formalities including meetings of the board of directors and taking meeting minutes. Lastly, you to the file a Form 1120s for the business and the business profit or loss will flow through to you personally on a Form K-1.
This type of formality may be exhausting and expensive for just one person. But you can obtain significant tax savings if your business ends up making a substantial profit. With S-Corps, the sole-shareholder will have to pay him- or herself a reasonable wage but won’t have to pay self-employment tax on any profits.
Obviously, each of these business structures have their positives and negatives. For me, the decision usually comes down to an LLC or an S-Corp because you should always limit your personal liability as much as possible. Moreover, for people going out on their own, I tend to recommend a single-member LLC over S-Corps because of the ease of administration and avoiding corporate formalities.
However, the discussion doesn’t end with limited liability and ease of administration. The laws of the state that you live in play a big role in which entity will serve you best. Plus, there are other aspects of each formation you should consider before making your final decision.
I’ll get to those later in the week. Stay tuned!