Settling on a formal business structure – or, alternatively, choosing to forgo one – is one of the first things you should do after deciding to strike out on your ownas an independent. After leaving the W-2 ranks to work independently on a full-time basis, many solopreneurs choose one of two options: a single-member limited liability company (LLC) or an S-corporation (“S-corp”).
Not quite sure how to proceed? You’re not alone. Ask ten established Indies and it’s likely that most, if not all, will tell you they waited too long to come to a decision.
It doesn’t have to be so difficult. Let’s break down the distinctions between single-member LLCs, S-corps, and the status quo – unincorporated sole proprietorships.
A single-member LLC is an incorporated business entity with a single member (owner).
Protection from personal liability
Its biggest perk over an unincorporated sole proprietorship is limited liability: as the sole member, you’re usually not personally liable for the entity’s debts or obligations, meaning (for instance) a creditor can’t seize your house to settle a delinquent business debt.
This general protection from personal liability is not uniform across all jurisdictions, however. For instance, Delaware and Wyoming render owners of locally incorporated single-member LLCs all but immune from personal liability, while Florida and New Hampshire give creditors more leeway, writes Stephen Fishman, a small business attorney based in northern California.
Where to incorporate
Where you incorporate is therefore nearly as important as whether you incorporate. You’re free to incorporate your single-member LLC outside your home state, provided you have a local registered agent to receive official correspondence. Most states maintain current registered agent lists; see Delaware’s here.
Before you incorporate, confirm that your business activity is eligible for LLC status. In some jurisdictions, licensed professionals (lawyers, physicians) aren’t allowed to form single- or multiple-member LLCs. If you’re unsure, consult a business attorney in the state where you’d like to incorporate.
Paperwork and filing fees
Protection from personal liability doesn’t come cheap.
To get your single-member LLC off the ground, you’ll need to file incorporation paperwork – articles of organization – with your secretary of state or equivalent authority. This document needs to include basic information about your enterprise: name, principal place of business, registered agent address, business purpose. A free, customizable template (QuickBooks has one here) should do fine. When you file your articles of organization, you’ll need to pay a one-time incorporation fee ranging from $50 to more than $200, depending on state law.
Many states require LLCs to file annual renewals of incorporation. Fees generally come in under $75 for those. Some states, like Minnesota, don’t charge renewal fees at all. However, even if they don’t charge, some states require single-member LLCs to file separate annual reports. That adds more paperwork to the pile.
Some states charge annual franchise taxes and fees, too. California’s particularly onerous scheme pairs an $800 annual LLC tax with three- to five-figure annual fees for businesses with more than $250,000 in annual revenues. All the more reason to choose your incorporation jurisdiction carefully.
Paying income taxes
No matter where you incorporate, you’ll need to pay income tax – assuming you turn a profit. By default, single-member LLCs are taxed as pass-through entities, meaning their net income is reported as personal income on their owners’ federal and state (if applicable) tax returns.
For federal tax purposes, there’s no meaningful distinction between a pass-through LLC and an unincorporated sole proprietorship. You don’t need to formally incorporate as a single-member LLC to claim business expenses on Schedules C or C-EZ. Nor do you need to incorporate to open a tax-advantaged retirement account for self-employed individuals, such as a solo 401(k) or SEP IRA. Like unincorporated sole proprietors, single LLC members are required to pay self-employment tax – the employer’s share of Medicare and Social Security taxes – on net business income.
Provided the controlling member is human, virtually any single-member LLC can elect to be treated as an S-corp for federal tax purposes. Once you’ve incorporated your LLC, all you need to do is file IRS Form 2553 (Subchapter S election) within 2 months 15 days of the coming tax year’s start.
Potential tax advantages for S-corp owner-employees
Why go through the trouble? Because S-corp owner-employees – owners who actively engage in business activity on the entity’s behalf – may avoid self-employment tax on a portion of the entity’s income. S-corp owner-employees who pay themselves a “reasonable salary” commensurate with prevailing compensation in their line of work need only pay self-employment tax on that salary. Their remaining net income – the entity’s profit – is not subject to self-employment tax.
When an S-corp makes sense
Structuring your business as an S-corp may make sense if your entity’s net income is substantially higher than a reasonable salary for your profession. If you’re pulling down $130,000 a year as an independent workplace training consultant – double the prevailing salary for that occupation – then S-corp status looks pretty attractive. If your annual profit tops out at $68,000 or $70,000, not so much. You’ll have to decide whether setting up tax withholding for your salary income and filing a separate informational tax return is worth the potential tax savings.
Unincorporated Sole Proprietorship
Nowhere is it written that an Indy must incorporate. In fact, maintaining the status quo – remaining an unincorporated sole proprietorship – is sometimes the most sensible move.
If independent work is not your main source of income, paying to register (and possibly renew) your business entity might not make financial sense. Likewise, the tax advantages of S-corp status are unlikely to change your life if you’re taking on just a few side projects each year, unless you’re commanding an enviable hourly rate. Remember, you can write off business expenses on Schedule C or C-EZ without a formal business structure – just don’t get too creative before consulting a tax professional.
If you expect to hire employees or take on partners, you’ll want to explore other legal structures – and consult a small business accountant – before making your choice:
- C-corporation. Like pass-through entities, C-corps shield their owners (shareholders) from personal liability for business debts and obligations. For tax purposes, however, they’re wholly distinct from their shareholders. C-corp profits may be subject to double taxation: once at the corporate level, and again as individual income when passed through to shareholders as dividends. A creative accountant could talk all day about strategies for minimizing double taxation, but that’s beyond the scope of this article. C-corps do have notable advantages, such as different classes of ownership (which is useful for growing businesses seeking outside funding) and easier access to credit.
- Multiple-member LLC. A multiple-member LLC provides multiple members (owners) protection from personal liability. Unless they elect to be taxed as corporations, multiple-member LLCs are treated as pass-through entities. However, unlike single-member LLCs, they must file tax paperwork – Form 1065 – with the IRS. While not required in most jurisdictions, multiple-member LLCs are strongly encouraged to draft customized operating agreements that spell out members’ obligations to one another and spell out dispute resolution procedures, among other things.
- Partnership. Think of a general partnership as a multi-member sole proprietorship. Like sole proprietors, and unlike LLC members, general partners are personally liable for debts and obligations arising out of their business activity. By contrast, limited liability partnerships (LLPs) are similar to LLCs, in that partners are not directly liable for business debts and obligations. Some states restrict LLP ownership to certain professional groups; California, for instance, allows only licensed accountants, lawyers, and architects to form LLPs.
Overwhelmed? Join the club. Right now, countless aspiring independents are wrestling with this very question. Thinking intentionally about whether and how to create a formal business structure – and discussing the prospect with fellow Indies – will save time and stress when you’re ready to make your move.