If you are thinking about going into business for yourself in the United States, there are five primary ways you can do that:
- Sole Proprietorship
- Limited Liability Corporation (LLC)
- Subchapter S Corporation (aka, "S Corp")
- Subchapter C Corporation (aka, "C Corp")
The list above is roughly sorted in order based on how established the business is, with nascent businesses starting as sole proprietorships on one end of the spectrum and Fortune 500 companies organized as C Corps at the other end of the spectrum. But why is that the case? What are the pros and cons of each? And why might your business want to move up the list over time?
I am not an attorney. This is not legal advice.
I am not a certified public accountant. This is not accounting advice.
I am a software developer. But this is not software development advice.
This is simply an overview designed to provide you with some baseline information for you to start a conversation with your attorney and/or CPA.
For more detailed information, I highly recommend this podcast episode with guest CPA, Erica Goode, upon which I'm basing most of the content of this article. That said, if I get anything wrong, it's likely due to my poor translation/paraphrasing/memory and not the expert commentary of Ms. Goode.
A sole proprietorship is a fancy word for ... nothing, basically.
If you wake up one day and decide to start freelancing, to start getting paid to write code (by someone other than your employer), to start a side hustle (as the kids like to say these days), then congratulations, you are now a sole proprietor.
- You just have to ... nope ... never mind ... you literally have to do nothing to be considered a sole proprietorship.
- OK, you do have to claim your additional income on your annual tax returns (if you do more than $600 of work for a company, they are required to provide you–and the IRS–with a 1099 to report that income)
- You do at least ... nope ... never mind ... there are literally no legal or tax benefits to being a sole proprietor.
A partnership is a fancy word for ... a sole proprietorship with two people (nothing, basically).
If you wake up the next day and decide that you bit off more than you can chew with this new side hustle, and so you call your buddy to have him give you a hand in exchange for splitting the revenue with him, then congratulations, you and your buddy are now a partnership.
- A buddy with whom you can split your revenues today and argue with over important aspects of the business some day in the future.
- Moral support.
- Programming support.
- A good answer for your clients when they ask, "What happens if you get hit by a bus?"
When Does It Make Sense to Transition from Sole Proprietor to Partnership?
Under the following conditions:
- You are just starting out.
- You have a buddy with a complementary skill set.
- You have a buddy that you trust.
Limited Liability Corporation
Everything is going great with this new side hustle, until one day you make the tiniest logic error in your code, and it just happens to result in an $86,000 accounting error. In a fit of rage, your client not so subtly hints that you better have good liability coverage by shouting after you as you leave their office, "You better hope you have good liability coverage!"
Later, as you recount the story to your lawyer friend over beers, he laughs at your expense and then says, "Well, at least you're not a sole proprietor or partnership, 'cause then you could really be screwed!" At which point you laugh heartily with him, then go quiet for a few minutes, then stare into your beer, then turn to him and say, "That thing about being screwed, um, if I were a sole proprietorship–hypothetically speaking, of course–what would that mean?"
"Well," he says, wiping his mouth and stifling one final laugh, "it means that your client would be able to sue you and seize your personal assets. You know, your house, your car, your first-born." He laughs one more time at that last bit, stands up, stretches, and says, "I'm gonna go get us a couple more beers."
You're not sure if it's the beer or that last tidbit of information, but you're not feeling so well as you watch your buddy walk away. As he comes back with the beers, he notices the color has drained from your face. "You, OK?" he asks.
"Sure," you say, "but my hypothetical friend...he isn't feeling so well. Have any advice for him?"
"Well, you can tell your 'friend'–are we really still doing this whole 'hypothetical' thing?"
"Humor me," you sigh.
"OK, then. Tell your friend that he should probably form an LLC. That's a Limited Liability Corporation."
"And what's that do?"
"Really, it's right there in the name. It's a corporation–a legal entity–that helps limit your personal liability for actions you take as the corporation."
"What does that require?"
"You file some paperwork with the state. And then you have to do some basic things to act like a business, like keep separate bank accounts for personal and business use. And, like they say in Ghostbusters, 'Don't cross the streams. That would be very bad.' In other words, keep your business stuff separate from your personal stuff."
"Why does that matter?"
"Well, if you ever did get sued–assuming the business itself isn't very valuable–they would go after your personal assets."
"But I thought they couldn't do that? I thought that was the whole idea of an LLC in the first place."
"It is. But their attorneys will try to 'pierce the corporate veil.' In other words, if you are playing all loosey-goosey with your business–mixing personal and business funds, depositing client checks in your personal checking account, that sort of thing–then they'll say you aren't really treating it like a business, so why should the court? And if the court agrees with them, well, then you're back to being screwed all over again."
- File paperwork with your state.
- Maintain a (metaphorical) wall between your business and personal life (separate bank accounts, etc.).
- If you get sued, you won't lose your house and car.
When Does It Make Sense to Transition to an LLC?
- As soon as you commit to your side hustle for the long term.
- Before you do any kind of work that might expose you to large liabilities.
If you are committed to your business and you know you are going to stick with it, then you should likely skip the sole proprietorship/partnership phase (which really only makes sense if you are in "exploratory" mode) and create a legal entity immediately–either an LLC or S Corp.
Subchapter S Corporation
So, you filed your LLC, you learned many lessons from your big mistake, and things are blowing up (in a good way now).
You quit your day job and your side hustle is now your main source of income. In fact, you just closed the biggest deal of your fledgling new career and you're out celebrating with friends on New Year's Eve.
"Hey, how's the business going?" asks your attorney friend.
"Unbelievable! I just closed a hundred-thousand-dollar deal with 50K up front. I'm going to do 200K this year!"
"And what about your friend?" asks the attorney with a sly smile. "Is he still a sole proprietor?"
"Nope," you grin, "I–I mean, 'he'–took your advice and incorporated as an LLC. And 'he' is feeling preeeetty good about that decision right about now."
"'He' won't be feeling so good come tax time," your buddy's girlfriend mutters into her glass of wine.
"Wait, what do you mean?" you ask.
"Well, I don't know your whole situation," she starts, "but it seems to me like you're probably overpaying on your taxes as an LLC."
"Wow, you're basing your opinion just from hearing how much revenue I made this year?"
"She's a CPA," explains your lawyer buddy.
"Of course she is," you roll your eyes. "I feel like I'm in the middle of some kind of bad joke, 'A lawyer, an accountant, and a programmer walk into a bar...'"
"OK, I'll bite," says the CPA. She proceeds to continue the joke,
"'...and the bartender says, "I've got a terrible cockroach infestation behind the bar. Can one of you take care of it for me?"
The accountant replies, "Sure. You have 17 cockroaches among the bottles of liquor, 8 in the sink, and 5 at the end of the bar."
"How does that help?" says the bartender. "All you did was count the cockroaches."
"If I may," says the attorney next, "cockroaches are one of the oldest and lowest forms of life. They can run up to three miles in an hour. The American Cockroach has shown an attraction to alcohol. And a cockroach can live for a week without its head."
"How does that help?" says the bartender. "All you did was recite some obscure facts about cockroaches–most of which also apply to attorneys."
Finally, the programmer grabs a marker and scrawls a message on a piece of cardboard and hangs it over the bar.
"How does that help?" says the bartender. "All you did was hang a sign that says, 'Cockroach races: minimum bet $50.'"
"Easy," smiles the programmer, "I turned all your bugs into a feature."
"All right," you smile. "That's not too bad for making it up on the spot. Now, why do you think I'm overpaying on my taxes as an LLC?"
"Well," she starts, "as a self-employed individual you get 'double-taxed' for your FICA and Medicare taxes."
"Right," you nod, "I'm paying both the employee and employer portion of those taxes for a total of 15.3%."
"Yes," she agrees, "plus your federal income taxes, which vary based on your income level. From a tax perspective, an LLC and an S Corp are both pass-through entities. That means that the net profit of your business is treated as income on your personal taxes. You do not pay a separate business tax."
"OK, so that's how an LLC and S Corp are the same. How are they different?"
"With an S Corp, you can take part of your income as a dividend. A dividend is just like regular pay but without the payroll taxes. You still pay federal income taxes on your distribution, but you save the 15.3% of payroll taxes."
"That sounds great!" you exclaim. "So if I were an S Corp, I could save fifteen percent on the 150K I just banked this year?!?!"
"Only if you want to get audited," she belly laughed. (Apparently, she found my question very amusing. Accountants have weird senses of humor.) "You still need to pay yourself a reasonable salary. And pay the 15.3% payroll taxes on that reasonable salary. But if $75K is a reasonable salary, then you could still save fifteen percent on the other half of your income. Which is more than ten grand in savings."
Suddenly, your initial excitement about your big year recedes as you learn that you could be keeping an extra ten thousand dollars in your pocket.
You can't help yourself. You need to know the exact figure. You open the calculator app on your phone and plug in the numbers. 75,000 times 0.15 equals... "Eleven thousand two hundred fifty dollars!" you shout, catching your barmates off guard.
You turn an angry eye to your lawyer buddy. "This is your fault! You told me to go with an LLC. Why didn't you tell me about this S Corp thing?"
"Whoa, take it easy," he responds. "First of all, I'm not an accountant. From a legal standpoint, the LLC and S Corp offer the same exact protections. Plus, there are fewer requirements to maintain your 'corporate veil' as an LLC. As an S Corp, you need to elect officers, issue stock, hold annual meetings, maintain a corporate minute book, et cetera et cetera. And if you don't do any of those things properly...poof goes the corporate veil! And with it, all those liability protections."
"That does sound like a lot of extra work," you admit.
His girlfriend chimes in again. "That's true, but now your business is at the point where it's worth it. Take a portion of that tax savings and use it to pay an attorney to maintain your records for you. You'll still come out way ahead."
Same as for an LLC, plus:
- Pay yourself a reasonable salary (as a W2 employee).
- Hold (at least) annual meetings.
- Maintain a corporate record book.
- Maintain required business licenses.
- Pay less in payroll taxes (for business owners).
When Does it Make Sense to Transition to an S Corp?
Once the tax savings make it worth the extra work to maintain the more complex corporate status.
In practical terms, this generally means that your annual profit exceeds a reasonable salary that you would pay yourself (and your fellow owners).
Subchapter C Corporation
"Thanks," you say. "I gotta admit, this wedding is a lot more fun than I was expecting out of a lawyer and an accountant."
"Hey! We know how to have a good time," your buddy's new bride retorts.
"You do, you do," you nod along. "Me, too, though. Especially with how well my business is going."
"Dude, again?" your buddy rolls his eyes. "You're about to pump us for more free professional advice at our wedding?! You really have no shame."
You brush off the snark. Of course you're going to make their wedding about you. You didn't just spend 2,500 words as the protagonist in this tale to suddenly give up the spotlight before the big finale.
"I can't seem to hire fast enough," you say. "We've been working fully remote for the past two years, but I think we could generate more synergy if we were working together in person." As your business has grown, you've started referring to yourself as "CEO" instead of "owner." And that means you have to use words like "synergy" because those are the rules and you didn't make them up but you still have to follow them because you have no choice and what were you even saying...
The newlyweds are waiting impatiently as you stare off into the distance reflecting upon your meteoric rise and overall awesomeness.
"Listen, I don't want to interrupt whatever's going on inside your head, but we've got other guests to mingle with. You were saying something inane about 'synergy'?"
"Oh, right. I'm going to build an office building," you say. "I've got a site picked out and I've started working with an architect. I plan on breaking ground sometime in the next two to four years. I'd like to start earlier, but being in this top tax bracket is just killing me. At nearly 40%, I'm only able to save about sixty cents on the dollar to put towards that building. I wish there was something I could do."
Eager to keep moving, your buddy shrugs his shoulders and says in the most empathetic tone he can muster, "Yeah, that's a tough one. I'm sure you'll figure it out, though."
The bride speaks up. "Actually..."
"You don't have to do this," your buddy tells her. "Tell him to make an appointment with you when we get back from the honeymoon."
"It's fine," she says to him.
"What's fine?" you ask, completely unable to read social cues.
"I think you should consider re-organizing as a C Corp," she says.
"No, no, no. You're the one who told me to organize as an S Corp in the first place!"
"Well, your situation has changed," she says. "As an S Corp, your profit passes through to your tax return. That means you avoid paying corporate taxes. But it also means that you have to pay that full tax amount every year. It limits your ability to build up cash for large capital projects.
"If you became a C Corp, you would pay corporate taxes on your business profits. You would also pay taxes when you paid yourself dividends. So you would be paying more in taxes under most circumstances. The one exception would be if you wanted to put aside money over multiple years for a large capital expenditure."
"Like building a new office?" you ask rhetorically.
"Exactly," she says.
- Not all revenue passes through on annual personal tax returns (only a benefit in certain specific situations)
When Does it Make Sense to Transition to a C Corp
If you're reading this blog for business advice...you probably don't have to worry about that right now. 😁