During my time at AQBiz, Inc., one of several startup companies that I created, I helped incorporate hundreds of start-up entrepreneurs and established small business owners. Though we are not lawyers, we partnered with lawyers and CPAs whom we send our clients to when their business is so complicated that it will benefit them to seek their advice.
Many of our clients are confused about the several business entities that are out there and which is the best fit for their business. Incorporation is really not that difficult. You can even do it online. However, not all business structure or entity is right for you.
Here are some popular myths that add to the confusion of choosing a business entity.
5 Myths About Business Structures or Entities
Myth 1: Nevada is the best state to incorporate your business. Many online incorporation services claim that incorporation in Nevada is the best because you save in taxes; the state does not collect corporate or individual tax. That is true IF and that is a big if, you live and do your business in Nevada. For example, you incorporated your business in Nevada, but you live and do business in California. California will require you to file a “foreign company doing business in California”. The filing fee is an added expense and, you still have to pay corporate and individual tax in California.
The best state to incorporate your business is in the state you are doing business.
Myth 2: Sole proprietorship is the worst business entity. People say this because sole proprietorship does not have liability protection and tax savings. If someone sues you for damages, both your company and personal assets would be in jeopardy. We will talk about tax savings later in this article.
Sole proprietorship, however, is good enough for someone just starting her or his business. It is the cheapest business entity to start. It has the lowest setup cost and ongoing fees. You can try out your idea in the marketplace, test your business plan, track your revenues and expenses in its infancy.
When your business grows big enough, or if you added a partner, or that your business risk has increased , then it is time to convert your sole proprietorship to another business entity like a Limited Liability Corporation (LLC).
Myth 3: An LLC saves you taxes. An LLC provides you protection from legal or financial claims than a sole proprietorship. LLC gives you a “liability shield.” This is because an LLC is an entity apart from you. You will no longer be personally responsible for damages or business debts, unlike sole proprietorship wherein your personal assets could be in danger.
Having said that, LLC does not save you taxes. Aside from giving your business a “liability shield”, the tax setup for LLCs is the same as that of a sole proprietor.
Myth 4: A Corporation gives you more asset protection than LLC. Neither is it true that an LLC gives you more asset protection than a corporation. Remember what I said about “liability shield” offered by an LLC? Corporation also provides that and is commonly called “corporate veil”. Your liability is protected only IF you follow rules and regulations that govern these business entities.
One of the most common reasons why your “corporate veil” could be pierced (a business term meaning nullify) is commingling of funds. That is using your personal funds to pay for your business expenses or vice versa.
As long as you keep your “liability shield” or “corporate veil” from being pierced, then both business entities will give you asset protection. Keep in mind that unlike corporations, LLC formation differs by States. Each State has its way of enforcing LLC rules.
Myth 5: An S Corporation will save you taxes. Not in all cases. If your annual income is below $80,000, you will not get a big tax savings using an S-Corp. The minimal tax savings, if you get it, is often negated by (1) the cost of operating an S Corp compared to an LLC or sole proprietorship and (2) your added effort in documenting your accounting processes and legal requirements, such as conducting and documenting your annual board of directors meeting and such.
If your income is below $80,000 per year, you will be better off getting an LLC for liability protection or a sole proprietorship for simple set-up. Both LLC and sole proprietorship are taxed the same way.
These are not the only myths that you should be aware of. Choosing the right business entity for your business should be one of the first things you need to do before you launch your business. The entity or structure that is best for you depends on two major issues: (1) your business model – what is your business, what is the purpose of your business, how you earn money or revenue, and (2) your liability risk.
To explain the tax effect between an S Corp and a sole proprietorship, watch this video from Blumer CPAs.