Yesterday I blogged about my decision to form a company and some of the benefits involved. Now it’s time for me to look at what type of company to form.
For advice on this I looked to the Small Business Kit for Dummies.
First Up: Sole Proprietorships
This is the easiest type of business to form. Basically, you just file a DBA, a document stating that “Jane Kalmes is Doing Business As (Company Name).” And that’s it. Filing your taxes as a sole proprietor is easy, which may mean savings in the form of low (or no) CPA bills.
The trouble is, most of the benefits sole proprietorships offer don’t apply to me. Sole proprietors can hire their kids without paying payroll taxes–but I don’t have any to hire. They can also cover their spouse with an HRA, a Healthcare Reimbursement Arrangement, provided their spouse is an employee and this benefit is also extended to any other employees. This can be a significant benefit, because it means they can deduct legitimate healthcare expenses twice: once from income taxes, and once from self employment taxes. But I don’t plan to employ Mark, and we get our healthcare coverage through him anyway.
So it looks like a sole proprietorship isn’t for me. Onward, then.
Next up: C corporations
These get the most tax breaks, but they’re not a great choice for a small businessman because their income gets taxed twice: once at the corporate level, and once after the profits have passed through to the shareholders. Unless you can hold a lot of income in your corporation (and I won’t pretend I’m savvy enough to even know how to begin), a C corporation is not the right vehicle for you.
Then we have: S Corporations
Now we’re talking. S Corporations use pass through taxation, meaning that the shareholders are taxed on the income they receive, but the revenue isn’t also taxed at the corporate level. Sounds more promising. S Corporations are still very complicated to form, though. There’s a lot of paperwork involved. Maybe I should hunt around for something simpler?
Last Up: LLCs
Limited Liability Companies, or LLCs, are the easiest company to form that affords limited liability. They’re flexible. They don’t require meeting minutes and stock certificates the way corporations do, and they have pass-through taxation. Sounds like a winner.
Here’s The Rub…
S Corps have one huge advantage over LLCs, though. The owner of an LLC has to declare all the company’s revenue as income, which means that she pays self-employment taxes on it. Self-employment taxes combine Social Security and Medicare. You’ll pay more for Social Security than you would if you were employed, but you won’t have to pay FICA, so it comes up about the same: 15.4%.
In contrast, the owner of an S Corp can pay herself a “reasonable salary,” and pay self-employment taxes on only that salary. Then she can allow the rest of the corporation’s revenue to pass through to her as stock dividends, thus avoiding the 15.4% tax. The salary really does have to be reasonable, though; if the IRS suspects that your $1 salary doesn’t meet industry standards, they’ll reclassify your distributions as salary, tax them, and then penalize you for making them go to the trouble.
So, in a nutshell, this is how a corporation saves you money. If you’re making more than a reasonable salary for your industry, you can save 15.4% of that excess.
Sounds good to me. S Corp, here I come!