Choosing the right entity structure for your business is a crucial decision that can have a significant impact on your financial well-being. Whether you are a business owner, freelancer, solopreneur, gig economy worker, or 1099 contractor, understanding the various options available to you can help you save money in the long run. I’ll explain the different entity structures and their implications on your finances.
1. Sole Proprietorship:
If your total income falls below the range of $50k-$70k, operating as a sole proprietorship may be sufficient. However, as your income grows beyond this threshold, you may need to consider other entity structures to optimize your tax savings and protect your assets.
2. LLC (Limited Liability Company):
An LLC offers protection against potential lawsuits by separating your personal assets from your business liabilities. While this structure provides asset protection, it may not necessarily help reduce your taxes. However, there are four ways an LLC can elect to pay taxes, including as a sole proprietorship, partnership, S corporation, or C corporation.
3. S Corporation:
An S corporation is a tax designation that allows business owners to save on self-employment taxes by splitting income between salary and distributions. By doing so, you can potentially reduce your tax liability while still enjoying the benefits of limited liability protection. Considerations when electing S corporation status include eligibility requirements, shareholder limitations, and compliance with IRS regulations.
4. C Corporation:
C corporations offer benefits such as Qualified Small Business Stock (QSBS) exclusions and the ability to raise capital through stock offerings. Small business owners considering a C corporation election should weigh the advantages of limited liability protection and potential tax savings against the complexities of corporate governance and compliance requirements.
Hypothetical Example:
Let’s consider a business owner, Sarah, who earns $250,000 in income and falls into the 25% tax bracket as a sole proprietor. As a sole proprietor, Sarah is subject to self-employment taxes, which can significantly impact her tax liability.
As a sole proprietor, Sarah’s total income of $250,000 would be subject to both income tax and self-employment tax. Self-employment tax consists of Social Security and Medicare taxes, totaling 15.3% on the first $142,800 of income in 2021, and 2.9% on income above that threshold.
Calculating Sarah’s taxes as a sole proprietor:
– Income tax on $250,000 at 25%: $62,500
– Self-employment tax on $250,000 at 15.3%: $38,250
Total tax liability as a sole proprietor: $100,750
Now, let’s explore the scenario where Sarah elects to operate her business as an S corporation. By paying herself a reasonable salary of $100,000 and taking ownership distributions of $150,000, Sarah can potentially avoid the self-employment tax on the distribution portion.
Calculating Sarah’s taxes as an S corporation:
– Salary of $100,000 subject to income tax at 25%: $25,000
– Self-employment tax on salary portion at 15.3%: $15,300
– Distributions of $150,000 taxed at ordinary income rates: $37,500
Total tax liability as an S corporation: $77,800
By operating as an S corporation and structuring her income as a combination of salary and distributions, Sarah can potentially save $22,950 in taxes compared to operating as a sole proprietor. This tax-saving strategy allows Sarah to retain more of her hard-earned income and optimize her tax efficiency.
In this hypothetical example, we see the significant impact that choosing the right entity structure can have on a business owner’s tax liability. By working with a certified financial planner and exploring the benefits of different entity structures, business owners like Sarah can make informed decisions to maximize their tax savings and financial well-being.
5. Role of CERTIFIED FINANCIAL PLANNER’s™:
CERTIFIED FINANCIAL PLANNER’s™ play a crucial role in helping business owners strategize the right time to change entity structures for maximum benefit. By analyzing your financial situation, goals, and business needs, a CFP® can provide valuable insights on when to transition to a more tax-efficient entity structure and optimize your overall financial strategy.
In conclusion, choosing the right entity structure for your business is a decision that requires careful consideration and expert guidance. By understanding the implications of each structure and working with a CFP®, you can maximize your tax savings, protect your assets, and set your business up for long-term success.
Disclosures:
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
About the Author
Lifepoint Financial Design is a comprehensive financial planning firm designed for millennial business owners. Mike Metzger, Founder &CFP®, helps business owners, by implementing complex financial and tax strategies at the right time so his clients generate wealth, mitigate taxes, and set up a plan for a work-optional lifestyle on their terms. Contact Mike – Website | Instagram | LinkedIn