The 4 Best Business Structures and How to Pay Yourself From Each

Chip Schweiger: 0:00

Every asset of the business is owned by the proprietor, and all the debts of the business are also that of the proprietor. The business is not in any way a separate legal entity, and this is really the major downfall of operating your business as a sole proprietor. The owner of a sole proprietorship may be forced to use his or her Personal holdings to pay the debts of the business. The owner is the only one liable for all the business activities, and so if things go south, there is really nowhere to run Chip Schweiger here. Welcome to another edition of Things Entrepreneurs Should Know, the top business podcast for entrepreneurs, founders and business owners who want to build lasting financial value and supercharge the growth of their business. When you decide to start a business, the temptation may be to just open your doors and start selling things, but there's a step just before that and it's really important, and that's to decide what form of business entity you want to set up. So today on the show, we'll talk about the four primary types of business entities, as well as the features and benefits of each one. In Working with startup founders, a question that comes up a lot is how do I pay myself from each type of entity? So later in the show I'll also give you the basics of how to do just that. A fter the episode, check out the show notes at TESK pod. com. Hi and welcome back. When beginning a business, one of the first things that you'll do is decide what form of business entity you want to establish. So let's talk this week about the four main types of business structures. But first things first. You should always have your business set up an illegal entity, and we're going to talk about why that is the case. The most common forms of businesses are a sole proprietorship, which is really not recommended, and I'm going to talk about why. A a limited liability company, or what we hear is a LLC, either as a single member or as multiple members, something called a C corporation, and then something else that's called an S corporation. So first the sole proprietorship. So a sole proprietor is someone who owns an unincorporated business by himself or herself. Now it's important to note that there is really no legal distinction here between the owner and the business entity. The sole proprietor receives all the profits and has all the responsibility for all of the losses and the debts. Every asset of the business is owned by the proprietor and all the debts of the business are also that of the proprietor. The business is not in any way a separate legal entity, and this is really the major downfall of operating your business as a sole proprietor. The owner of a sole proprietorship may be forced to use his or her Personal holdings to pay the debts of the business. The owner is the only one liable for all the business activities, and so if things go south, there is really nowhere to run. Sole proprietors may use a trade name or a business name other than their legal name, and they may have to trademark their business name legally if it differs from their own legal name. Now, an LLC is a hybrid business structure, and that combines some of the most attractive features of Corporations and of sole proprietors. Ships like corporations, all types of LLCs provide limited protection Against personal liability, which is why you need one Once you have one. In general, business profits and losses are reported on your personal income tax return Rather than on a business tax return. Specific laws vary by state, but in general, llc owners are called members, and there can be as many members in your business as you like, and that's what makes the LLC one of the most popular types of business entities. It's ideally suited for smaller organizations and for startups. They're fast and easy to set up. They have a simple business structure and forming one is generally pretty inexpensive. Add to that that running an LLC is easier than running a C-Corp or an S-Corp. Now there are a few rules, regulations and legal compliance issues for LLCs, but they're really pretty manageable. But here's the big benefit of an LLC. Like the C-Corps and S-Corps that we'll talk about in a minute, llcs provide their owners with limited liability protection. So this means that the business assets are owned separately by the LLC, not by the owners. Any liability of the business is also fully the liability of the business and does not generally have any impact on the individual owner's personal assets. But you do need to be careful to run the business separately from your personal stuff, so different bank accounts separate your business and personal expenses and basically operate your LLC as what it is a separate entity under the law. As far as taxation goes, an LLC doesn't pay federal income taxes itself. Instead, any net profit or loss is passed through to the personal tax returns of the owners or of the members. It's then taxed as personal income by the IRS. In this sense, taxation of an LLC is very similar to taxation of a sole proprietorship or even of a partnership, but again, with an LLC you get that personal protection that's not available with a sole proprietorship. Okay, an S-Corps, or what we call an S-Corps, is a business entity that was created and enacted into law by Congress in 1958. It was created to encourage small and family business creation while eliminating the double taxation that conventional corporations had to pay. And really an S-Corps is not a business entity type but really a tax election. So people tend to get this confused sometimes. But you'll form your LLC with your secretary of state and then you'll elect to be taxed as an S-Corps for federal tax purposes. Same general benefits as an LLC, but a little bit more complexity and running because of how owners of an S-Corp pay themselves, and we're going to talk about that in a minute. But the biggest benefit of an S-Corp is that you can save some serious tax dollars, mostly the FICA and FUTA taxes that if you operate the S-Corp correctly. Now, a C-Corp, also known as a C-Corporation, is a type of business entity that is also formed and regulated on a state level. It's created by following what's called articles of incorporation with the secretary of state within whatever state you're going to incorporate. It's the most formal type of company and a corporate structure. Now the policies and costs of creating a C Corp vary from state to state. Factors affecting whether you want to create a C Corp include a C Corp has limited liability, so the investors and owners of a C Corp are generally not liable for business debts and other liabilities. And that's similar to an LLC, but unlike an LLC, ownership of a C Corp is determined by how many shares of stock you own in the company, rather than what percentage of the company that you own, and that stock for a C Corp ration can be actually several different types of classes. The ownership of a C Corp can be fluid and transferred depending on who owns the stock at any particular moment in time, so you can bring investors in and out fairly easily, which is why I think, if you're interested in taking on investors in the future, a C Corp is the way to go. Stock in a C Corp can be bought and sold on a public stock market if that C Corp had held an initial public offering on IPO, which is what makes that stock available to the public. But a C Corp in most states has a ton more compliance regulations to meet numerous rules and compliance considerations. Now, unlike a limited liability company and an S Corp, a C Corp is required to follow a corporate tax return and pay corporate taxes on any profits, any excess profits left over that are distributed to the shareholders as dividends. Well, they're also going to be subject to taxation on that individual's tax return, or what we call double taxation. But you know, currently the federal corporate tax rate is a flat 21%, so there's some benefit there when you think that the highest personal marginal tax rate is up to 37%. So a huge potential for opportunity to save tax dollars, even with the double taxation. If you're thinking about registering as a C Corp or converting to a C Corp, best to talk with a CPA and a lawyer, and that's really true of any of these NAD decisions. Now let's pivot a bit and talk about a question that comes up a lot, and I get it. That's how do I pay myself from these different business types? And most typically, the question is how do I pay myself from an LLC? Well, it depends on the type of entity and what tax election you've made. So here's what you need to know For a single member LLC, rather than taking a conventional salary. Single member LLC owners pay themself what's known as an owner's draw. So the amount and frequency of these draws is up to you, but it's ideal to leave enough funds in the business account to operate and to grow the LLC. So you simply write yourself a check, keep track of it for tax time and then you'll pay taxes on it at the end of the year on schedule C of your personal tax return. And when you do pay taxes, keep in mind that you'll pay both the personal and the company portion of FICA and other employment taxes. Now for a multi member LLC with two or more members so think owners. Generally they're viewing this as a partnership, and the partners or members also pay themselves. Through the owner's draw method. The members can each draw as little or as much as they want of their shares, as long as sufficient funds remain on hand for day to day business expenses and for growth. Now each member will be responsible again for their personal taxes and the company portion of the employment taxes, and these will generally show up on a K1 partnership statement at the end of the year. Now for an LLC that's elected to be taxed as an S-Corporation, members aren't actually allowed to take owner's draw. Instead, they're considered employees and must pay themselves a set salary on the company's regular payroll, with employment taxes with help. Now, the salary has got to be reasonable, but any leftover at the end of the year can be distributed back to the members and guess what? No personal or company employment tax liability on those distributions, so you can save yourself actually up to 15.3%. And finally, for C-Corporations, much like the S-Corp election, you're going to pay yourself a salary like a W-2 employee and then any excess profits that can be distributed to you as a dividend just like any other shareholder, and they're going to be taxed the same way. And one last thing if you're not happy with your current tax classification, you can change it. But there are rules around that, and namely that you can only change your tax classification once every five years. Now, if you do want to change the legal entity structure entirely rather than just changing the tax classification, you're going to need to go back to your Secretary of State to do that. If your entity structures are handled by your state, taxation is handled by the IRS. Well, that about wraps up another edition of the Things Entrepreneurs Should Know podcast. Be sure to check out our website at TESKPod. com, where you can find the show notes and archive of our past episodes and other resources to help grow your business. That's teskpodcom, and if you haven't done so already, I'd really appreciate it. If you take one minute to give us a review on Apple Podcasts or rate us on Spotify. It helps out a ton to get this into more entrepreneurs and business owners. And if you've already done that, please consider sharing the show with families and friends who you think might get something out of it. As always, thanks for your support. This is Chip Schweiger, reminding you that if you always do what you've always done, you'll always get what you've always gotten. We'll see you next time.