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Sole Proprietorship: Unlimited Liability

The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

The primary downside to operating your business as a sole proprietorship is that a sole proprietor is personally liable for all of the debts of the business. This is known as having “unlimited liability.”

To elaborate, if anybody has a reason to sue your business, they’ll be able to come after your personal assets, not just the money that you have in your business checking account. This means that, if the suit is for enough money, you could end up losing almost all of your personal possessions — your car, your savings, and possibly even your home.

Oh My Goodness That’s Scary! (Right?)

For many people, just reading a description of what it means to have unlimited liability is enough to get them searching for information about how to form a corporation. And that’s understandable.

But before you go and spend a substantial amount of time and money forming some other type of business entity, spend a little time thinking about how big of a problem unlimited liability really is for your business.

For instance, do you offer a service, or do you create and sell a product? In either case, imagine the worst-case scenario, and think about how bad it really is.

Let’s say you provide a service. What’s the worst thing that could happen if everything goes wrong with a client? Does the client lose millions and millions of dollars? Does the client need a trip to the hospital? Or, perhaps, is the worst-case scenario simply that the client is out the money that you charged them?

If you create and/or sell a product, do the same type of analysis. If everything goes as terribly wrong as you could possibly imagine, what happens?

If the worst thing that you can think of isn’t really all that bad, then perhaps — despite nearly everything you read online — it isn’t necessary to incorporate or form an LLC.

EXAMPLE: A self-employed author who writes and self-publishes science fiction novels probably has much less to worry about regarding liability issues than, say, a restaurant owner.

Simple Summary

  • As a sole proprietor you will have “unlimited liability” for any debts of the business. This means that, in the case of a lawsuit, somebody could come after your personal assets as well as your business assets.
  • Depending upon the nature of your business, it’s possible that unlimited liability isn’t that big of a problem.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

How Much Does a Business Have to Earn Before S-Corp Taxation Makes Sense?

A reader writes in, asking:

“In your opinion as a CPA – is there a minimum annual revenue threshold where looking at S-Corp tax treatment for a single member LLC makes sense given all the reporting requirements?”

Unfortunately there’s no way to make a useful rule of thumb here.

The tax savings from S-corp taxation (relative to sole proprietor taxation) come from the fact that profit from the business is not subject to self-employment tax (i.e., Social Security and Medicare taxes). But before there can be any profit, the business is required to pay the owner a “reasonable” amount of compensation, which will be subject to Social Security and Medicare taxes.

And there are several downsides to S-corp taxation as well. For example:

  • The business will have to pay unemployment insurance tax to your state based on the wages the business pays to you,
  • You will likely have a lower contribution limit to your retirement plans (because it will be based on your wages, rather than being based on what would have been the full profit from the business if it were a sole proprietorship),
  • You will likely have a smaller Social Security benefit in the future (again, because it will be based on your wages, rather than being based on what would have been the profit from the business if it were a sole proprietorship),
  • You will have to file Form 1120S (for the business) and Schedule E (for yourself) rather than just Schedule C,
  • Your business will have to register with your state and with the federal government as an employer (if it has not done so already) and must satisfy all the related periodic reporting and tax-payment requirements. (A payroll service provider is super helpful here.)

So S-corp taxation doesn’t really become advantageous until the business can pay you a “reasonable” amount of compensation and then still have enough profit left over for the tax savings on that profit to outweigh all of the negatives mentioned above.

But the tricky point is that what constitutes “reasonable” varies dramatically from one situation to another. For example, a freelance writer would usually be able to get away with a much lower level of compensation than a cardiologist. Even within a given line of work it can vary significantly. For example, a business owner who spends very little time actually working for the business (e.g., because they have another full-time job) will generally be able to get away with a lower level of compensation than somebody who works full-time for their business.

The following are a list of factors that the IRS (or applicable court) will consider, in addition to any other factors that may be relevant to the situation:

  • Your qualifications;
  • The nature, extent, and scope of your duties;
  • Your background and experience;
  • Your knowledge of the business;
  • The size and complexity of the business;
  • The amount of time you devote to the business;
  • The economic conditions generally and locally;
  • The character and amount of your responsibility in the business;
  • Whether or not the compensation is pre-determined based on activities to be performed or not determined until the end of the tax year;
  • Amounts paid to you in prior years;
  • The salary policy of the business with regard to other employees; and
  • The amounts paid by similarly sized businesses in the same area to equally qualified employees for similar services.

Also, state laws play a significant role in the decision as well. In some states the cost of unemployment insurance tax is very minor because the tax rate is low, the wage base is low, or both. In some states it will have a larger impact. And some states (e.g., Illinois) impose an income tax on the S-corporation itself.

In short, there are simply too many moving pieces for a dollar-amount rule of thumb to be useful. The decision of whether or not to elect S-corporation taxation for a business really must be done on a case-by-case basis.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

Small Business Entity Selection (2018, New Tax Law)

A reader writes in, asking:

“How does the new tax law affect the decision of how a small business should choose to be taxed?”

As a bit of background, for a business with one owner, the three taxation options are:

  • Sole proprietorship (or LLC taxed as such),
  • C-corporation (or LLC taxed as such), or
  • S-corporation (or LLC taxed as such).

And for a business with multiple owners, the taxation options are:

  • Partnership (or LLC taxed as such),
  • C-corporation (or LLC taxed as such), or
  • S-corporation (or LLC taxed as such).

Sole Proprietorship/Partnership Taxation

As before:

  • Income from a sole proprietorship or partnership is taxed at normal individual income tax rates, and
  • Sole proprietorship income (as well as partnership income if the partner is active in the business) is subject to self-employment tax (i.e., a tax of roughly 15%, to replace the Social Security and Medicare taxes that would be paid by the employee and employer if this were wage income instead).

What’s new is that those individual income tax rates are now, in most cases, lower for a given level of income than they would have been prior to the new law.

In addition, income from such businesses will also qualify for the new deduction for pass-through business income (subject to phaseouts), which makes sole proprietorship/partnership taxation somewhat more advantageous than previously.

C-Corporation Taxation

C-corporations are taxed at their own rate (now a flat rate of 21%, whereas before they had progressive tax brackets like individuals). Then, when they distribute income to shareholders in the form of a dividend, the dividend is taxed at 0%, 15%, or 20% tax rates depending on the taxpayer’s level of taxable income. The dividend may also be subject to the 3.8% tax on net investment income.

Previously, C-corporation tax treatment was not usually advantageous because of this double taxation (i.e., taxation of income at the corporate level, plus taxation of the dividend paid to the shareholders). While the new flat 21% tax rate means that C-corporation income over $50,000 will now be taxed at a lower rate than previously, the overall concept of double taxation still applies. And the net result is that C-corporation tax treatment will still be undesirable for most small business owners.

S-Corporation Taxation

Profit from an S-corporation:

  • Is taxed at individual income tax rates,
  • Qualifies for the new deduction for pass-through business income (subject to phaseouts), and
  • Is not subject to self-employment tax.

In other words, it’s the same as income from a sole proprietorship or partnership, but without self-employment tax.

However, S-corporations are required to pay their owner-employees a “reasonable” level of compensation (i.e., wages/salary) before there can be any profits. And such wages:

  • Are taxed at normal income tax rates,
  • Are subject to regular payroll taxes (i.e., Social Security and Medicare taxes that are essentially the same thing as paying self-employment tax), and
  • Do not qualify as pass-through income for the new deduction.

In other words, the wages themselves are not very tax-efficient. So the savings from S-corporation taxation only kick in once there is enough income from the business to pay a reasonable level of compensation to owner-employees and still have a sizable profit left over.

So, in short, for people whose income level is such that they would be in or below the 24% tax bracket (and therefore unaffected by the phaseouts for the new deduction for pass-through income) sole proprietorship/partnership taxation is now somewhat more appealing relative to S-corporation taxation, because all of the sole proprietorship/partnership income would qualify for the deduction, whereas the wages that the S-corporation would have to pay to the owner-employee(s) would not qualify for the deduction.

Of note, however, is that the opposite conclusion may apply for people in the phaseout range (as well as for non-service business owners who are past the phaseout range). That is, S-corporation taxation may be relatively more advantageous, because it would be advantageous to have the business pay wages to somebody (i.e., the owner-employee), to minimize the impact of the wage-related limit for the deduction.

More than ever, discussing the matter with a qualified tax professional is likely to be advantageous.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

LLC vs. S-Corp vs. C-Corp (The 3-Minute Version)

One question business owners frequently ask is which legal structure is right for their business. So which is best for you? Let’s take a quick look.

Sole Proprietorships and Partnerships

There isn’t necessarily anything wrong with operating your business as a sole proprietorship or partnership, but you need to be aware that you will have unlimited liability for business debts. In other words, if your business is sued for any reason, the plaintiff will be able to come after your personal assets, not just business assets.

LLC

First, there are no tax advantages (or disadvantages) to forming an LLC. In fact, forming an LLC won’t change a thing for federal income tax purposes. Single-owner LLCs are taxed just like sole proprietorships, and multiple-owner LLCs are taxed just like partnerships.

You should, however, be aware that forming an LLC might subject your business to additional state taxes. Certain states (California for instance) subject LLCs to “franchise taxes” in addition to a typical income tax.

S-Corporation

S-Corporations have the ability to provide some tax savings as a result of the fact that profits from an S-Corp are not subject to self-employment tax. However, before you’re allowed to distribute any profits, you are required to pay any owner-employees a “reasonable salary.” This salary will be subject to Social Security and Medicare taxes (which total the same amount as the self-employment tax). As such, the tax savings only take effect once the business has a pretty sizable income.

Also, you should be aware that S-corporations are significantly more complicated from a tax and legal standpoint than LLCs. So if you form an S-corp, know that you’re going to be spending a great many more billable hours with your accountant/attorney.

C-Corporation

Unlike most other business structures, C-corporations are taxable entities. This means that the corporation itself is taxed on its income (as opposed to other structures which simply pass the income along to the owner(s), who are then taxed on it).

If you don’t plan to distribute all of the profits from your business, you might benefit from forming a C-corp and utilizing a strategy known as “income splitting.” The idea is to split the business’s income so that part of it is taxable to the corporation and part of it is taxable to the corporation’s owner(s), thus putting them each in a lower tax bracket than they’d be in if either one was earning all of the income.

The big disadvantage to C-corp taxation is that distributions of profits (known as “dividends”) are subject to double taxation. In other words, the corporation is taxed once on its income, and then the shareholders are taxed upon any dividends they receive.

Also, like S-corporations, C-corporations are more complicated from an accounting/tax/legal standpoint than sole proprietorships, partnerships, or LLCs. As such, C-corp owners tend to incur fairly high legal and accounting costs.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

Tax Forms for an LLC

A reader asks: This is my first year having an LLC. I’m getting started on my tax return, but I’m confused about which forms I need to file. I see in some places that it says I need to file a 1065, and in other places it says I just put the income on my 1040 (using schedule c?). Which one of these is right?

Answer: That depends on how many members (ie, owners) there are for your LLC.

If you’re the only owner, your LLC is going to be taxed as a sole proprietorship. In that case, yes, you’d fill out Schedule C, and you would include the profit from the business on your Form 1040.

If, however, your LLC has multiple owners, it will be treated as a partnership for Federal income tax purposes. In other words, you’ll fill out Form 1065, and each of the partners will receive a Schedule K-1 indicating their share of the business profits. Then each partner reports those profits on their 1040, using Schedule E.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.

What is Form W-9 | How to Fill Out Form W-9

Form W-9 is different from most other tax forms in that it is not sent to the IRS. The purpose of the form is simply to gather information from a business. (The business could be a sole proprietor/independent contractor, an LLC, a partnership, or a corporation.)

For example, Business A would send Form W-9 to Business B in order to request Business B’s legal name, address, and taxpayer ID (FEIN). Business B is then required to fill out the form and send it back to Business A. The information contained on the W-9 is then used by Business A to prepare the 1099 for Business B for the year. (Of course, if Business B is a corporation, no 1099 will be required.)

How to Fill Out Form W-9

Filling out a W-9 is pretty easy. On the first line, simply enter your legal name (if a sole proprietorship) or the legal name of your business (if an LLC, corporation, or partnership).

On the next line, enter your “Doing Business As” name, if applicable. (For instance, if you’re a sole proprietor doing business as “Jane’s Jewelry,” you would put your actual legal name on the first line and “Jane’s Jewelry” on the second line.)

In the next section, check the box that applies to your type of business (LLC, corporation, partnership, etc.). If your business is an LLC, you are then asked to indicate its tax treatment (ie, is your LLC taxed as a partnership, sole proprietorship, or corporation?).

What to put on the “Address” line should be pretty self-explanatory.

In the next section, if you’re a sole proprietor, enter your SSN in the appropriate box. If your business is anything other than a sole proprietorship, enter your Tax ID (a.k.a. FEIN) in the box labeled “Employer Identification Number.”

Now just sign and date the W-9, and you’re all finished. 🙂

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less

Topics Covered in the Book:
  • The basics of sole proprietorship, partnership, LLC, S-Corp, and C-Corp taxation,
  • How to protect your personal assets from lawsuits against your business,
  • Which business structures could reduce your Federal income tax or Self-Employment tax,
  • Click here to see the full list.
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