Should You Formalize Your Business? The Pros and Cons

Should You Formalize Your Business? The Pros and Cons.jpg

Why the hell would anyone ever go through the pain of formally setting up a business as an entity? Well, while it is costly and annoying, all the drawbacks come with advantages as well. Let's break them down so you can to understand what to expect with each entity type.

For most people, it's much easier to just start working. If you're in that camp and you don’t set up an LLC or Corp, by default, you end up running a sole proprietorship. 


What’s Fantastic About A Sole Proprietorship?

Ease of Use. A sole proprietorship is the simplest form of doing business. There are no initial registration or annual filing requirements with the IRS or any federal agencies. 

You aren’t required to get a Federal tax ID (aka EIN), but you aren’t excluded from getting one either.  

At the state and county or city level, you might be required to get a business license or register with the city.  And you may want to file a ‘Doing Business As’ or Fictitious business name if you’d like to operate under a brand that isn’t your name.

For the most part, all you have to do is sell a product or service to an individual or business, take that money and put it in your account and congrats, you just became a sole proprietorship. 

What Are the Downsides of a Sole Prop? 

Risk. If you’re running a sole proprietorship, there isn’t a legal difference between you personally and your business. There is no legal distinction. You are one with your business. So that means, you are exposing your personal stuff (assets) to risk. 

There is this thing called self-employment tax. Self-employment tax is a tax imposed on ordinary net income generated by a sole proprietorship. The self-employment income tax rate is 15.3%. Let’s unpack that.

First, wtf is ordinary income? Ordinary income includes income from product sales, income from providing services, any commissions, or short-term income in real estate if you are a real estate professional. The self-employment tax does not apply to any passive income (such as rent, dividends, interest, or capital gain).

And in case you need a refresher on the definition of net income. Net income is the amount you have left over from revenue after you deduct your business expenses. 

That net income is subject to the ~15.3% self employment tax.

So, you know when you hear accountants say things like, “You don’t make enough money to justify setting up an LLC or Corp,”?. This is part of what they’re considering. The other thing they’re considering is the pain-in-the-ass factor of registration and filing requirements. 


What To Consider When Setting Up An Entity

There are hard costs involved in setting up an entity. Here are the main ones to consider:

  1. Filing fees and set up costs,
  2. annual maintenance fees, 
  3. state taxes on various entities on net (after deducting expenses) or gross (all the revenue before expenses are taken out) income,
  4. the cost of additional accounting for filing returns, setting up payroll and tax counsel throughout the year.

Most tax professionals advise their clients to run a sole proprietorship for as long as they can. But if you need liability protection, you’re forming a partnership, you’ve got tax issues or you’re making or expect to make a shit ton of money, then forming an entity is probably in the cards for you.

These are the main players:  The LLC, the S-Corp and the C-Corp

What’s So Fantastic About an LLC?

Oh, I’m so glad you asked. I’ve learned through all my boring conversations with accountants and lawyers that the LLC is loved by many. Here’s why the dorks love ‘em:

The LLC provides limited liability protection. One of the main reasons people set up LLC’s is to protect themselves from the risks of operating their business. Whether you’re buying real estate and renting it out or you’re selling organic, artisanal, gluten-free, non-GMO oyster crackers, an LLC protects you from being personally liable. So, if someone gets hurt while staying at your property or eating your weird crackers, the LLC will be the impenetrable force field between you and the people trying to steal your shirt. 

LLCs in some states are legally required to have an operating agreement. So, you might be forced to figure out how the business will be run among you and your partners because you have to outline it in the operating agreement. This sounds like it’s an annoyance and it is - unless you like writing legal language, it’s not fun, but it’ll give you an outline of how to operate if things go sour with you and your partners. 

Setting up a limited liability company is one entity you may set up to formalize your business. In order to setup your LLC, you need to file something called your “Articles of Organization” with the Secretary of State. Usually you’ll set the LLC up in the state you plan to operate in.

You get to use a business name and set up a brand. Or you can be boring and call the business Your Name, LLC. But you would never do that. 

What Are the Downsides of an LLC? 

The tax advantages are minimal. You don't get to write off more things because you set up an LLC. 

The self-employment tax still applies. And you can still be shocked by this number if you generate ordinary net income. 

It's not free. Many states have additional operational costs and/or high filing fees or taxes for an LLC.

Setting up an LLC isn't for everyone. They work great if you need investors or if you have business partners who aren't U.S. Citizens. For a lot of people who are running a small business, an S-Corp is where it's at. 


What’s So Fantastic About an S Corp?

Limited liability protection. Just like an LLC, the S corp also protects your personal assets.

S-corps avoid the dreaded self-employment tax. Your share of the S corp’s net income will not be subject to self-employment tax.

Lower audit risk. Corporations really do get audited by the IRS at a lower rate than sole proprietorships.

The S corp isn’t subject to corporate tax. S corps are designed for small businesses. As a result, shareholders avoid corporate tax (often referred to as double taxation) on their net income. Net income, after all business expenses are deducted, flows through to the shareholders of the S corp and their personal 1040 tax return on a Form K-1. This is why professionals often refer to the S-Corp as a "flow-through" or "pass-through" entity.


What Are the Downsides of an S Corp? 

You absolutely have to run a payroll to pay the owners. It's the law. Which means you need to either stumble through figuring this out yourself. It's not that bad, but it can be overwhelming if you've never done it before.  Or you need to hire someone to help you. 

Payroll taxes + fees. Since you're running a payroll, you'll need to pay payroll taxes and a fee for a payroll service provider like Gusto or ADP. 

More paperwork. S Corps require additional paperwork when you first set it up. Your accountant or lawyer or whoever is helping you set it up must file paperwork to elect the S-Corp status. Then you'll need to file a corporate return in addition to your personal return. And payroll tax returns too! A service like Gusto will handle those on your behalf, but you're still ultimately responsible for overseeing it.

Only meant for small businesses. S corps can't have more than 100 shareholders and an entity can't be a shareholder in an s corp. Investors typically wouldn't invest in an S corp. 


A Quick Note About C Corps

Then there is the C corp. Almost every Fortune 500 company is set up as a C corp. The specific reasons for setting up a company as a C-corp can be in order to raise capital and to abide by securities laws in order to go public. For the average small-business owner or startup, this is completely unnecessary. 

There are instances when it might make sense to set up a small business as a C corp. Speak to a tax planner or accountant and a lawyer to make sure you understand what your unique situation requires.