How To Choose The Right Business Structure
Welcome to part 3 of our 10 part series, Idea to Income, where I speak with business attorney, Nikki Semanchik about business structure and its impact on your company.
Many new entrepreneurs start their business as sole proprietorships. As your business grows and you recognize it will no longer be just a hobby or project, there are numerous benefits to changing from a sole proprietor to one of the many entity options available. These options are filled with legalese and can often be intimidating and confusing. Fortunately, Nikki breaks it down in plain english so that you can make an informed decision on which option to consider further.
In our discussion we review:
- The differences between a corporation and an LLC
- Benefits of the S-corp taxation
- Helpful insight into B-Corps
- Whether you should incorporate in Delaware or California
- Typical state filing requirements
- The process for changing your entity
- Important information on professional corporations
We cover a lot and hope you enjoy our discussion!
Our video provides all of the information. For those of you who prefer to read, please find the most pertinent material below:
Nikki has also been kind enough to make this helpful guide she created available to viewers.
Does business structure matter?
Do I even need an entity? Why not just operate as a sole proprietorship?
It’s not always a bad decision to start as a sole proprietor. Your business may start as a side hustle and you’re deciding if you’re going to make this full time or not. You probably don’t want to jump into a formal business structure like an LLC or a corporation before you know exactly where you’re heading. So actually, a sole proprietorship is often a great place to start.
As your business gains traction and you realize this may be more than a hobby, establishing an entity can be highly beneficial.
Protecting your business from liability becomes a major reason. Nikki says many people hear liability protection and it causes concern. We think, is someone going to sue me? It can be scary. In reality, Nikki says the liability protection that comes from establishing an entity compares to creating a shield for your business. You want to ensure that any liability in your business, stays in your business. By creating the entity, you protect your personal assets from being at risk from any mistakes that are made from the business. This way someone can’t come after your home, the assets in your bank account, or even your family member’s assets. Instead, this shield protects your personal assets. If somebody sues the business, they can only go after the assets in the business – so the business bank account, tangible assets the business owns, property, etc.
Of course we hope you are never sued. But even if you are operating the business to the best of your ability and doing your best to avoid mistakes, we must acknowledge that we live in a highly litigious society. Especially those of us in California. Therefore it is important to take appropriate steps to protect yourself if anything were to ever go wrong accidentally. After all, part of why you have a business is to build up your personal wealth. You want to be able to build that up and not risk losing it later because of a honest mistake made in the business. Proper business structure creates peace of mind in this respect.
The two most popular entities are a corporation and a limited liability company (LLC). They’re similar in that they provide liability protection.
Corporations have been around forever.
Corporate code outlines the rules for a corporation which means there is more formality. You have to have an annual meeting every year. This can be a bit awkward when your running the entire corporation yourself as a solo owner. However, corporate formalities are items a business lawyer can actually help the owner with. Nikki does this work regularly for clients.
A lawyer like Nikki will remind you about your requirements. These include an annual meeting, filing a statement of information with the secretary of state, keeping minutes (transcribed notes) from your annual meeting, and noting who you elected as your officers and directors. That’s another formality that will feel weird. You need a president, a secretary, treasurer, directors and shareholders. All of these titles which can feel strange when it’s really just you wearing all the hats. But it is necessary and it’s that corporate formality that in fact provides the liability protection. We have to do those things to preserve that all important liability protection.
The LLC is a newer entity type.
And since the laws are more recent, we have a little bit less formality with the LLC. Nikki describes LLCs as an entity made up of contract. You kind of create the rules for your LLC, which Nikki talks about more further below.
Notably, you don’t need to hold the annual meeting and all of the various titles. You just have the members of the LLC.
Business structure taxation
Both the corporation and an LLC can be taxed in different ways. This can cause a lot of confusion.
Many owners think an S-Corp and a C-Corp are two different business structures. When in reality, it’s one entity type. It’s just a corporation. The difference between an S and a C corp is how we’re notifying the IRS that we want that entity to be taxed.
So first step – determine the entity, either an LLC or a corporation as the most typical. Second step – determine how we want to be taxed.
As Nikki mentioned before, LLCs are a creature of contract which means they can essentially be taxed in whatever form they want. Nikki describes them like a legal tax chameleon. LLC’s can be taxed as a regular corporation, a S corporation, a partnership, or a disregarded entity. A disregarded entity means they aren’t taxed at all, and the tax just flows onto your individual income tax return and the IRS doesn’t even see it as an entity. There are pros and cons to each tax structure depending on what type of business you want to have and what stage you are in.
Nikki is a huge fan of the S Corp taxation.
The reason is you end up saving a lot on self employment tax when you’re an S corporation. She notices what scares people early on about the S corporation are the steps needed to qualify. The biggest hurdle being that you have to actually payroll yourself. This can confuse owners especially when it is just themselves they’d be payrolling. That can feel overwhelming. Rest assured there are a lot of different payroll companies that can make this easy. One popular do it yourself option is Gusto. Thanks to technology, it’s easy to run payroll for yourself.
What amount should you pay yourself? Have a conversation with your CPA and ask them, what is a reasonable compensation?
This is the rule that the IRS has – the IRS will give you the tax benefit of savings on self-employment taxes as an S corporation. But, in order to do that, you have to pay yourself a reasonable compensation. You can’t just pay yourself a dollar and avoid taxes altogether. Keep in mind, when you’re just getting started, maybe reasonable does mean nothing if you aren’t making anything yet.
Recall back in episode one in our financial projections guide, we talked about that ramp up time – it’s not uncommon. Then, as you ramp up, Nikki encourages having a midyear planning session with your CPA. Figure out where you’re at. You can change your payroll, it can evolve. Importantly, the pay must be reasonable depending on the stage of business you are in.
How you do get that tax savings?
What happens is, in California we pay self employment taxes when we’re self-employed. Normally, if you’re an employee you’ll see there are a bunch of taxes taken out of each pay stub. What you might not realize is that your employer is actually paying taxes on your behalf too. Specifically, the employer pays half of the social security as well as the Medicare tax, which is automatically taken out of your paycheck. The figure comes to 7.65% that the employer pays on your behalf. When you are self-employed, you have the luxury of paying the entire tax, which is 15.3%. Yeah, pretty high.
Importantly, with an S-corp you can pay yourself a reasonable salary and then take any excess as an owner distribution. Why is this so valuable? With this process, you’ll only owe the self-employment tax on the salary, not the distribution. Often when you have the CPA run the numbers, once your making over $30,000-$50,000 you’ll save significantly on self employment taxes by being an S corporation.
As an example, imagine that we’re making $100,000. Our expenses are $20,000, so we have $80,000 of taxable income. That’s where we’re going to be taxed: 15.3% of $80,000 is going to be taxed for self employment tax, if we are a sole proprietor.
Instead, we’re going to have a conversation with our CPA and say, okay, of this 80,000 what is a reasonable amount to payroll myself as an employee of my business? What will the IRS think is reasonable? I’m going to payroll myself that amount. For the example, let’s say the CPA says $30,000 is a reasonable salary. Now, that $30,000 is where we take the 15.3% self employment tax out of, instead of the full $80,000.
What happens to the extra $50,000?
The extra can be taken as an owner distribution. This distribution will be subject to income tax, but not self employment tax. So it leads to huge savings.
When Nikki was deciding how to be taxed she had her CPA run her taxes both ways. They ran it as a sole proprietor and then again as an S-corp. The accountant’s software makes this comparison easy, fyi. Nikki saw about 50% less in tax from choosing the S-corp election!
With these tax savings why wouldn’t the S-corp be the default option? You want to be sure your business is at a point where the tax benefits are worth the costs. Remember, you’ll need to hire a payroll company. You have incorporation fees (California has an $800 annual requirement). It’s better to be at a point where you feel comfortable with that before you move forward. Also, C-corporation have benefits to owners seeking outside investors which we will touch on later.
The do good business structure – B Corps
Another entity Nikki works with a lot is benefit corporations (B corps). There are social purpose corporations and benefit corporations in California, which are especially popular amongst millennials these days. When you have a benefit corporation, in addition to maximizing shareholder value, the business has an important goal of giving back in some way to society. Maybe it’s environmental, maybe it’s to individuals through social work, whatever it is there is some societal impact.
Toms and their shoe giveaway program may come to mind when you hear this.
The B corporation really becomes a powerful marketing platform. A lot of companies will do a version of when you buy something, we give something back. That’s what Toms did for awhile you may recall. From a real perspective on the business owner, it doesn’t change anything. We can still be an S Corp or a C Corp as a benefit corporation. It’s just that when we file our articles with the secretary of state, we’re saying we’re a benefit corporation, and we’re saying to the secretary of state, we have an additional benefit. So that our shareholders, they don’t have to just maximize shareholder value. They also think about this other thing, which again could be a number of different societal benefits.
Importantly, oftentimes the benefit is for the employees.
It could actually be that the company cares about valuing their employees and giving back to them in some way, imagine that!. Important to know is when you have that benefit corporation, you actually have to do a b impact assessment on an annual basis. This is an assessment from a third party and there are a lot of companies now that will do them for you. It’s an internal assessment that you do on your business to evaluate if you’re actually making the impact that you said you were going to. Think of it as a way of being held accountable. If you pass, you get your B certification and you can put that emblem all over your branding and website. People now know that you were evaluated as being a true B Corp.
Importantly there are no tax benefits with the B corporation, it’s not like a non-profit. Instead it’s more about formalizing a structure for the company’s DNA. Recall back at the end of episode one we talked about the importance of creating core values. When you’re building a team, you can’t bring someone in if they don’t have the same values as you. You can’t train values. It has to be really inherent and new members have to get onboard knowing that’s important. What’s interesting then about the B corporation structure is that by business structure design you have internal accountability to those values.
Does business structure have to start in Delaware?
Nikki meets a lot of new owners under the impression their business needs to be a Delaware entity. It’s kind of misinformation. A Delaware entity is not for everybody. Typically it is going to be appropriate for owners interested in bringing on investors. Investors feel comfortable with Delaware entities. They know the laws, and Delaware does have a lot of laws that are favorable to corporation. Additionally, if an owner has ambition to raise money, they may be interested in a C-corp as most investors will also prefer to see that business structure.
However if you are in California, or whichever state you operate in and entering into contracts in, you’re – what the secretary of state and the franchise tax board define as transacting business here. In that case, you’re going to have to register in California anyway. You still have to pay the minimum franchise tax fee in California. You are still subject to California laws. Nikki finds most new owners don’t realize this. They end up paying fees to setup in Delaware but then are subject to all the local laws and fees anyways. Technically, you would be a Delaware corporation qualified to do business in California. So it’s a foreign qualification.
For the average person who’s providing services or selling something here in California, and they’re not looking to bring on investors or go through traditional startup funding rounds – probably just stick to California.
Business structure filings
Sticking with the state, your business must make regular filings. Using California as an example. What exactly do I need to file? When do I need to file? What are some of the common filing forms that people might not be familiar with?
Nikki says almost every state has an annual filing with the secretary of state. In California, we call it a statement of information. You file that and basically what you’re doing is updating the secretary of state on your most recent address. This allows them to always be able to contact you. Additionally, you let the state know who your officers and directors are, or who the manager of your LLC is. The statement of information is their way of having that touch point with you so that they can find out where you are and also so that they can send your tax statements.
The annual filing is also the way that other people can look up your business. They’ll see where you’re officially registered. Also, if they’re going to sue you they can find your agent to service a process.
If you don’t submit your filings, the Secretary of State suspends you.
When you’re suspended and you’re not in good standing with your Secretary of State, then you can’t defend contracts. So, if you are sued, the lawsuit would be ruled against you just by nature of the fact that you’re not in good standing and you don’t have that protection anymore. Things could quickly spiral out of control. Make sure you file!
California also requires a franchise tax fee of $800 for LLCs. You have to pay it pretty quickly after establishing your LLC business structure – typically with the third or fourth month after you form. For corporations, that’s not the case, but you do have to pay a minimum fee. Once your revenue goes up, the fee goes up.
These initial fees can turn off new business owners, but it is important to recognize that the legal protection they provide should be well worth the cost. Additionally, the S corporation savings on self employment taxes alone would likely be much more than the cost if your business is generating decent returns.
A lawyer’s help with business structure
Why would someone who’s starting a business work with a lawyer? What is the value early on versus working through an online option, like Legal Zoom?
Nikki says the relationship your building will be very valuable. When we have a business, we can’t do it all on our own. We’re too busy. You really have to choose a couple of people that are going to be there to guide you. Nikki recommends having a financial person, a CPA, and a lawyer. (I’d also recommend having a good commercial insurance agent on the team.) That way, when things happen, you know you’re protected and can make the right decisions. Part of the benefit is establishing that relationship early on. Secondly, because the internet is a big place and information is at our fingertips, it can also be confusing to figure out which actions will be best for the business. Nikki finds a lot of clients that will form their business structure on Legal Zoom and they won’t have the S-corp selection, they won’t be in the right entity type, or they won’t even know why they chose the business structure they did. They can’t remember because nobody helped them decide and the choice they did make often doesn’t suit the business.
Importantly, working with an attorney early allows you to be more intentional about business decisions instead of just jumping right in and not knowing. You don’t know what you don’t know. Plus, rules constantly change with businesses. For example, are you going to hire an employee? California laws just changed with employees and independent contractors. Are you offering services? You need to have a service contract. A lawyer can spot issues for you and help you navigate.
Nikki enjoys working with owners early on. Yes, working with a lawyer may be more expensive, but making business mistakes early will be so much more costly later.
Can you change the business structure later?
The process to change your business structure depends on which entity you chose to begin with.
What if you’re an LLC and you’re taxed as a disregarded entity or a partnership and you want to become an S corporation? Then you would need to file the S election form with the IRS and it’d be effective for that coming year. That’s a fairly easy and straight forward transition.
If you’re an LLC and you want to become a corporation, then you’ll have to do a conversion with the secretary of state. It’s still doable, but more involved. This is why it’s important to consider the goals for your business early on. If you’re in a situation where you know you’re going to want investors, remember a C-corporation may be the best choice. Another benefit of a C-corporation is you can have multiple types of shares that you offer people. You may have certain type of shares as the founder and somebody else has different type of shares with different rights.
Sometimes Nikki has clients approach her with an LLC and they’re trying to add investors and trying to create different types of membership structure. They can do it because LLCs are flexible, it can just be trickier. Shares aren’t interchangeable or sellable with an LLC. Instead, they have membership units. Also an S-corp can only have one hundred investors allowed in the entity. Another important rule is that an S corporation can’t have different types of share ownership structure. They can have one share type that doesn’t vote. Other than that, the rules say that you can’t have common and preferred shares like a regular C corporation can have.
For a lot of viewers/readers it’s likely going to be common to go from the sole proprietorship, to the LLC. Then if you have ambitions of bringing on investors, you have the opportunity to transition to a corporation, and likely a C Corp at that point.
An important note, is that some professions, can’t be an LLC. Professionals like lawyers, dentists, veterinarians, accountants, cannot be an LLC in California. They have to form a special type of corporation called a professional corporation. That professional corporation can then be taxed as an S corporation or a C corporation. Kind of similar, but it does have a different name and different requirements.
A special thank you to Nikki Semanchik of Semanchik Law Group for providing this helpful information and helping owners navigate through these options.
- Clarified the differences between a corporation and an LLC
- Provided insight around the taxation of different business structures
- Gave insight into the benefits of B-Corps
- Helped us understand the pros and cons of incorporating in Delaware
- Reviewed state filing requirements with us
- Explained how to make an entity change later
- Described the difference with professional corporations
Remember, this course is all about taking action.
Be sure to contact Nikki or an attorney in your area if you are interested in learning more about these options. And feel free to contact us if you’d like help evaluating the financial implications of your decision.