Do you own a sole proprietorship? Have you discussed the pros and cons of forming your business into an LLC or S-Corporation? While operating as a sole proprietorship has its benefits, you may be missing out on the liability protection and potential tax savings generated by registering your business and forming an entity.
As a sole proprietor you have the greatest flexibility and the simplest filing requirements of any business. All income and expenses are reported on your individual tax return and there are no other taxes or filing requirements related to your business. Your company does not need to register with the state nor do you need a formal operating agreement.
While ease of startup and minimal filing requirements are attractive, the informality of a sole proprietorship leaves you personally liable to pay the debts and obligations of the company. As the business owner, your personal property is at risk to pay creditors or settle lawsuits related to business activities. By forming and registering your business with the state you can limit your liability to the assets of the business, thereby protecting your personal assets.
The most common entity type formed today is called a Limited Liability Company (LLC). As the name suggests an LLC offers liability protection to the business owners, which are also called members. In addition to the liability protection, the major benefits of LLCs are that they are simple to create or terminate and allow members great flexibility in adding and removing assets from the business. What if you are the sole owner? You can form a single member LLC which offers the additional benefit of being disregarded for federal income tax purposes. This means that you report all income and deductions on your individual tax return the same way as you reported business activity as a sole proprietor and no additional federal tax return is required for the business. While many states follow the federal position that a single member LLC is disregarded and not required to file a tax return, a group of states, including California, require an annual LLC income tax return. If applicable, states typically calculate taxes for LLCs based on gross receipts rather than net income.
If you own one or more rental properties you may want to consider forming an LLC to protect yourself from the inherent risks of renting property, the largest of which is the potential to be sued for damages or injuries that occur on your property. While landlord insurance may mitigate some of these risks, it does not shield your personal assets from any gaps in coverage or payouts in excess of liability limits. By creating an LLC, only the assets held by the entity are exposed and your personal assets are protected.
Depending on your specific situation, you may want to consider forming your business into a corporation and elect to be taxed as an S Corporation. Corporations offer liability protection to its owners, which are also called shareholders. While corporations are typically the most structured of all entities and provide the least flexibility, they offer specific tax benefits which have the potential to generate large tax savings. Unlike a sole proprietorship or LLC, the income earned by an S Corporation is not subject to self-employment taxes, which are 15.3% of the first $118,500 of earnings in 2016. S Corporations are pass through entities that must file federal and state tax returns. This means that the income and deductions generated by the business are allocated to each shareholder and taxed on their individual returns.
While forming an entity has its benefits, it is also more costly and less flexible than operating a sole proprietorship. The costs and benefits are different for every situation and a decision should not be made without the advice of a tax or legal professional. If you own a sole proprietorship or rental properties and would like to discuss the benefits of forming an LLC or S Corporation, please contact your L&B professional.