When starting your own business, one of the first decisions that you had to make, even if you didn’t realize it, was what type of ‘entity’ your business would be. Entity is a word used by the IRS to describe what type of business you have and, more importantly to them at least, how it will be taxed. There are several different choices, and as I said, even if you didn’t know that you were picking one, you were. The IRS isn’t going to let things slip through the cracks, even if you might, so they have it set up so that your business will default to something. And if it’s going to be something, it might as well be what works the best for you rather than what works best for the IRS, right? So, let’s look at some of the most common options, in order of increasing complexity, so you can decide which one is best for your business:
If you just up and start a business, without doing anything other than starting to sell your products or services, then you default to what is called a ‘sole proprietorship’, which is basically just a fancy way to say that you and your business are the same thing. There’s absolutely nothing wrong with that, and it works just fine for lots of businesses. Because you and your business are the same thing, it may not be as important for you to keep your personal and business finances separate. But, at the end of the year you’ll owe self employment tax on top of your personal income tax on every dollar that your business earned, after all applicable deductions of course. And, keep in mind that if the IRS shows up to audit you, they’ll want to see documentation (i.e. saved receipts) for all of those business expenses that you claimed on your taxes or they might disallow them and you’ll owe back taxes on that income!
If more than one person started your business together, instead of a sole proprietorship it’ll default to a partnership. That makes things a little more complicated. More than one person involved always makes things tougher, right? You’ll want to make sure that every partner is on the same page when it comes to how the finances will be handled. At the end of the year, a form will need to be filed with the IRS that shows how the income and expenses from the business should be divided between the partners. Then, each partner will pay self employment tax and personal income tax on their share of the income on their own personal tax return.
There is another option called an LLC, which stands for Limited Liability Company. This requires you to submit documentation with your state that forms your business as something separate from its owners. One of the benefits of an LLC is that you can choose to be taxed as if you were a sole proprietorship or as if you were a corporation (see below), depending on which is more favorable for you. Theoretically, it also offers some protection for your personal property as separate from your business’s property. However, if you expect that protection to actually be of some use to you, then you absolutely need to keep your business finances in line. You won’t be able to argue to the IRS that your personal home is separate from the business if you keep using it as collateral for your business’s line of credit.
The next step up is a Corporation. There are several types of corporations, but the overall gist is that your business is now completely separate from you, and you are simply an employee and a shareholder in that business. One of the big benefits of forming a corporation is much better protection for your personal assets, plus you get a regular salary. The corporation will withhold taxes from your paycheck and at the end of the year you won’t owe any self employment tax, just your regular personal income tax. Any profit that your business generates beyond your salary can either stay in the business or be paid out to you as dividends, which are taxed differently (and often lower) than your wages. This can save you money in the long run, maybe even quite a lot of money. The IRS does require that you pay yourself a ‘reasonable’ salary, but once your business is bringing in more than that, it might make sense to consider forming a corporation.
If you want to change from one type to another, you’re in luck. Odds are high that it’ll be fairly easy. If your business is currently a sole proprietorship, you just need to form one of the other entity types. One of the big benefits of an LLC is that it can be taxed as either a sole proprietorship or as a corporation. So, if you have an LLC already, rather than changing your entity type it might make more sense to change how it is taxed, You can change once anytime after the LLC is formed, but if you’ve already used that opportunity, you’ll have to wait 5 years from that date to change again.
Whatever your plans are for your business, selecting the best entity type will give your business the best chance for it, and you, to be successful.
For more information on how to spend less time on your bookkeeping, check out my free report: 8 Ways to Spend Less Time but have Better Bookkeeping. Or, schedule a free consultation to see how The Serenity Keeper can help you keep your serenity when it comes to your bookkeeping.