Now that we have all slept off the tryptophan from our Thanksgiving turkey, it is time to give a little thought to how your business will end 2015 and start 2016. Here is the first thing I want you to think about: is your business organized as a separate legal entity?
I wrote here that “the worst thing a business owner can do is operate without the protection of any legal entity structure at all.” There is a cornucopia (another gratuitous Thanksgiving reference) of good reasons why this is true, the two most important probably being liability protection and tax savings. One of my mottos for my clients is “decreasing liability and increasing profitability,” and this issue implicates both.
If you have a business that is not legally organized — usually as a corporation (Inc.) or limited liability company (LLC), but not necessarily — then your business is, by default, a “sole proprietorship.” The good thing about sole proprietorships is that they are easy to maintain — you don’t have to do anything at all to start one or maintain it. But . . . that’s pretty much the only good thing about a sole proprietorship. From a liability and tax standpoint, they are (as I have written before) a legal nightmare.
Let’s start with liability. Let’s say your business is sued. It doesn’t matter what the claim is — someone slipped and fell on your office floor, you sold a faulty product, your employee was involved in a car accident while on company time, you accidentally infringed on a trademark, whatever — if your business is a sole proprietorship, your personal assets are on the line for any judgment or settlement. That means that if you have to pay out money as a result of the lawsuit, your personal bank accounts can be at risk — as can your retirement accounts, your kids’ college funds, your house equity, etc. In fact, if you don’t have enough money to pay the judgment, the plaintiff can try to get your cars, your wife’s jewelry, Aunt Martha’s silver tea set, and other personal property. It’s all on the line.
In contrast, if your business is organized as an LLC or corporation, then the liability usually stops with the company assets. In other words, the victorious plaintiff can lay claim to any assets belonging to the company itself, but they usually can’t try to get your personal assets. (There are a couple of preventable exceptions to this, but that is a topic for another time.)
Now let’s turn to tax matters. As the proud owner of a sole proprietorship, you will (or, at least, you should) pay 15.3% self-employment tax on every penny your business earns for you. The good news is that your business will not have to file a tax return on this money. The bad news is that it will show up on your personal tax return, so you’ll have to pay it with your personal taxes. Keep in mind that this self-employment tax will be in addition to any income tax you will owe — which can wind up adding up to quite a hefty personal tax rate.
Again, in contrast, if your business is organized as an LLC or corporation, you can usually (with some exceptions) choose to be taxed as an S-Corp (more on that another time). This means that instead of paying self-employment tax, you can pay yourself a reasonable salary and pay payroll taxes on that amount. You will still pay the same tax rate (15.3%) on that amount, but you will only have to pay it on the amount of your salary. Any payments above and beyond your salary can be classified as dividends or distributions, and you will not have to pay any payroll or self-employment taxes on that amount (although you will still have to pay some sort of income tax on it).
So, for a very simple example, let’s say that you plan on paying yourself $100,000 in 2016. If you are a sole proprietorship, then you will pay 15.3% self-employment taxes on the entire $100,000 — the federal government gets $15,300 of your hard-earned money, and you keep $84,700. However, if your business is formed as a separate legal entity that has elected S-Corp tax status, then you can choose to pay yourself $50,000 in salary, and the other $50,000 in distributions. You will have to pay 15.3% payroll taxes on your salary, which means the federal government gets $ 7,650, and you get to keep $42,350 of your salary, plus the entire $50,000 in distributions. So, at the end of the year you make, after payroll taxes, $92,350. That’s better than $84,700, isn’t it? And worth the few dollars it takes to form and maintain a corporation or LLC. In addition, your company will be able to deduct half of the payroll taxes as a business expense — further savings for your company!
There are additional considerations and benefits as well — too many to go into in this already lengthy post (i.e. deductibility of fringe benefits and health insurance, ease of division and transfer of ownership, etc.).
All of which is to say that this December, give yourself a Christmas present that keeps on giving — reduced liability and increased profitability. Organize your company before the end of the year (or first thing next year).
Let us help.