In today’s post I will be talking about the business structure that I have chosen to use for selling online. Let me begin by saying that I am not a lawyer or CPA and what I am sharing is NOT legal or tax advice. It is simply what I have decided to use for my business, PLEASE consult your local professionals to find out what works best for your business.
Prior to February 2014, I was operating as a sole proprietorship. I had not set up a separate business entity, and was reporting my earnings on a Schedule C with my tax return. Earlier this month, I set up an LLC and have elected to be taxed as an S corporation. So, why did I do this? what alternatives did I consider? and why do I think this option fits my business best?
I decided that a business structure was necessary as I have been growing this business at what I feel is rather quick pace and I want to have a structure in place that allows me to scale the business quickly and want to protect my personal assets. One of the largest reasons for setting up a business structure are to limit my personal liability if something should ever go wrong with the business. For example, if a customer gets injured using an item that you sold them, and they end up successfully suing you for damages, you could be held personally liable for these damages. This would be the case if you are a sole proprietorship as there is no separation between you and the business entity. However, if you have set up an LLC or an S Corporation or other limited liability structure, then your liability will be limited to the assets within the business. For example, you are sued for $500K, your business has $200K in assets, and you personally have $300K in assets. With a limited liability structure your $200K in business assets would be wiped out, but your $300K in personal assets would be safe. Without the limited liability protection, then the $300K in your personal assets could be wiped out as well. There are certain rules that need to be followed to maintain your limited liability protection, so it is important you understand these and discuss with a legal professional if necessary.
So, limited liability protection is a good thing to have and either an LLC or an S corporation would have provided that. Let’s get into why I chose an LLC electing S corporation corporation.
On this issue, I chose to form an LLC due to a few fewer regulations and annual filling requirements. In short, LLCs in my opinion appear to be a little easier to setup and maintain on an annual basis.
After you decide to setup an LLC you must either elect taxation as a sole proprietorship, or to be taxed as an S corporation. This is REALLY important in my opinion, as choosing the wrong option could cost you thousands of dollars depending on how much you are bringing in from your business. The issue here is self-employment taxes. Self-employment taxes for 2014 are 15.3% of your first $117,000 in net income, and 2.9% of net income greater than $117,000. If you are an employee you pay 6.2% tax for social security, and 1.45% tax for medicare for a total of 7.65% tax coming out of your pay check for these taxes. What you may not know is that your employer is matching each of these payments and paying an additional 7.65% in taxes. When you are self-employed you are responsible for both the employee and employer portion of these taxes, and thus are responsible for 15.3% total in taxes on your income.
With an LLC electing to be taxed as a sole proprietorship, you are subject to self-employment taxes on all of your net income. For comparison purposes, let’s say you are bringing in $80,000 per year in net income. Your self employment tax liability would be $12,240, and this doesn’t include any additional federal or state taxes you will be incurring.
Now, let’s say you are an LLC and elect to be taxed as an S corporation. When you elect S corporation taxation, you are required to pay yourself a “reasonable” salary for the work you are performing. For me, let’s say I will be paying myself a salary of $55,000 per year. I will be subject to self employment taxes on this $55K, for a total of $8,415. The remainder of the $25,000 in net income will be taxed as ordinary income and will NOT be subject to self employment taxes. As you can see, a business can make the exact same net income, but structuring the business in one way over the other can save you $3,825 in self employment taxes just based on the way that it is set up. Reasonable salary is a VERY important part of the equation here, as if the IRS decides that the salary you were paying yourself was not a reasonable salary, then you will become liable for self employment taxes on the difference between what you actually paid yourself and what the IRS deemed reasonable. So again, a best practice would be to consult a tax professional.
For further clarity, I will literally paying myself a salary using the S corporation structure. I will be paying myself the salary, paying all taxes, and then most likely reinvesting the majority of these “paychecks” back into my business. This will add some compliance costs and time, but my projections lead me to believe that my self employment taxes savings will more than offset this time and cost of having to pay myself on a regular basis.
So, the limited liability protection, and the self employment tax mitigation are the main reasons that I chose to set up an LLC electing S corporation taxation.
Now as far as setting this up, here is what I did. I went to the Minnesota (I live in Minnesota) Secretary of State website, filled out their brief questionnaire, paid the $155 filing fee and I had my LLC setup. I then sent in IRS form 2553 to the IRS to elect S corporation taxation, and obtained a Federal Employer Identification Number through the IRS website. I completed all of these steps for a total cost of $155, and it took me less than 2 hours in total. I consulted with a lawyer through SCORE (free business consulting), and they recommended simply setting one up myself due to the relative ease, and the fact that I am the only owner. HERE is a link for more info on SCORE if you are interested.
I know taxes and legal stuff are not the most exciting, but setting things up correctly can save you a lot of money and it is time well spent. Again, I am not a lawyer or a CPA, and this is NOT to be construed as tax or legal advice. This is just what I have found is the best setup for me at this time.
Please let me know if you have any questions by leaving a comment below.
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