Many small businesses start organically – they’re a side gig, a project with friends or just a crazy idea. It’s not unusual to skip the whole “starting a business” phase, and then find yourself running a business that’s starting to show some profits.
When I was practicing law, I saw this all the time. I met many small business owners who were chugging along without any formal business structure at all – graphic designers, eco-preneurs, software developers, even other lawyers. They wanted to know if it was time to set up a corporation, limited liability company or other “real” business entity. The question has renewed urgency now that there’s a new tax law with lower rates for businesses.
As I told my clients back then, there’s no one-size-fits-all answer. What’s right for you depends on several factors, including the type of business you’re in, your income, and your plans for the future. Understanding your options starts with knowing how businesses are taxed and the reasons people form corporations, LLCs, and other business entities.
Business taxes and the new tax law
For tax purposes, businesses entities can be divided into two broad categories: C corporations, and pass-through entities. C corporations are the only type of business that pays corporate income tax on profits. These corporate taxes used to be as high as 35 percent, but under the new tax law, corporate income tax is a flat 21 percent.
This makes a C corporation sound like a great option, but there is a catch: when you distribute the profits to the owners, they will be taxed again on the owners’ personal tax returns. This double taxation is a major drawback of C corporations for small businesses.
Historically, most small businesses have had a lower tax bill by operating as “pass-through” entities. Pass through entities include sole proprietorships, partnerships, S corporations and LLCs. A pass-through entity doesn’t pay corporate income tax – company profits “pass through” to the owners’ personal tax returns. Owners of pass-through entities then pay personal income tax on these profits.
Under the new tax law, pass-through businesses will be able to deduct 20 percent of profits and will only pay tax on the remaining 80 percent. However, the deduction is subject to limitations and phasing out for taxpayers with taxable incomes above $157,000 for single filers and $315,000 for joint filers. For example, if your pass-through business has $100,000 in profits in 2018, you can deduct $20,000 on your tax return. The other $80,000 will be subject to income tax.
Should I form a corporation or LLC for tax reasons?
Since sole proprietors and general partners can take advantage of the new 20 percent tax deduction for pass-through businesses, the new tax law alone may not be a reason to set up an LLC or S corporation.
As described in this article, there may be tax reasons to look at forming a C corporation, particularly if you can’t take full advantage of the 20 percent deduction because your income is too high. When making this decision you have to consider the double taxation angle and the cost of forming and maintaining a corporation. The math can get complicated, so it’s best to consult with an accountant before you make any decisions.
Additional reasons to form a business entity
Taxes aren’t the only thing to consider when deciding whether to set up a business entity. You should also consider your liability risks, relationships with your partners and plans for raising money and growing your business.
A business entity may be a good choice if:
- You are concerned about risk. Your first line of defense against lawsuits should always be business insurance, but insurance can’t protect you from everything. If you are a sole proprietor or general partner, you personally are responsible for any business debts or lawsuits not covered by insurance, and that means your personal money and property are at risk. If you are an owner of a business entity, you may lose everything you have put into the business, but you won’t risk your house or your life savings.
- You have business partners. A business entity insulates the business from you and your partners’ personal financial struggles. It also forces you to put the details of your relationship with your partner in writing. This can save you thousands of dollars and a pile of emotional stress if you have misunderstandings or disagreements in the future.
- You are trying to raise or borrow money. Investors and lenders often prefer dealing with business entities.
If you decide to form a business entity, you will need to complete a series of steps including: preparing and filing paperwork with your state, maintaining responsibility for keeping certain records, filing annual reports, and paying annual fees. Ultimately, these responsibilities and costs will depend on the state you’re in.