One of the questions that we get asked all the time is, “How should I setup my shop?” Should you be a C-Corp, S-Corp, LLC, etc? Before we worry about any of the tax effects, we need to worry about the legal implications of incorporating, forming an LLC, or just operating as yourself. By putting the business in a corporation or an LLC (Limited Liability Company) you are giving yourself legal protection from possible lawsuits. If the shop is not incorporated or in an LLC you are not protecting any of your personal assets, including the house you live in, from levies and collections from customers, vendors, or banks. The ideal choice for legal protection for most shops is an LLC. It gives you all the protection you need, is cheap/free to setup, and puts you in a favorable tax position with many options.
The natural progression that we see for most shops is they setup the business as an LLC and get to work. By default, these shops are now being taxed as a Sole Proprietor for tax purposes. For shops that are starting out and showing little to no profit, this isn’t the worst thing tax-wise, and possibly doesn’t make sense to make a switch until the business starts to make more money. However, all income for Sole Proprietors’ is subject to not only income tax, but self-employment tax as well. Self-employment tax is an additional tax on earnings and is roughly 15% additional tax on top of your normal income tax rates. Since owners of a Sole Proprietor do not take any salary, this self-employment tax is put in its place to make up for payroll taxes not paid. If you started the business with a partner or your spouse, you are by default a partnership. Partnerships are taxed in a very similar way to Sole Proprietors where each partner pays income and self-employment tax on their share of the profits.
Once a business’ profit reaches a certain level, usually $60,000 – $70,000, it makes sense to convert to an S-Corporation. By switching to an S-Corporation, you are still an LLC, you are just telling the IRS to tax you as an S-Corporation. After electing to be taxed as a S-Corporation, the owner of the business can go on payroll for a set amount and any profits above that can be distributed as distributions. The major advantage of an S-Corporation is limiting the amount of payroll/self-employment tax that a business is paying. If done correctly, a shop that makes $125,000/year of profit would save up to $10,000 annually by switching to an S-Corporation.
If you think that you are not setup correctly or would like to inquire about the benefits of making a change, please feel free to call or email us.