If you are ready to start a business, congratulations, you are on the road to one of the purest forms of American freedom. But you must know it will not be easy. It is fraught with challenges. But it will give you freedom, the freedom to determine how to structure your life.
One of the basic issues you must sort out is how to organize your business. The main options are 1) sole proprietor 2) LLC (limited liability company) or 3) S corporation. Below is a very brief summary of the three options.
1. SOLE PROPRIETORSHIP. This is the best option for most people starting a small or microbusiness. It’s easy to set up. All you need is a tax identification number, a business bank account, a business license (which you can get after you are up and running) and a fictitious business name if you are operating under a name other than your own. The downside of a sole proprietorship is it affords you no asset protection and all of your net income will be subject to payroll tax.
2. LLC. LLCs can be set up as a partnership (more than one owner) or a single member LLC (only one owner, or if in a community property state like California, a husband and wife who can choose to be treated as one owner). LLCs can provide a barrier between business law suits and your personal assets. In most cases, multi-member LLCs are taxed as a partnership and single member LLCs are taxes as a sole proprietorship.
To establish an LLC, you must file Articles of Organization with the state Secretary of State, file a Statement of Information, execute an Operating Agreement, get a tax identification number and an LLC bank account and get a business license. It requires substantially more effort than a sole proprietorship, but if you want to protect your personal assets from business lawsuits or claims, then an LLC can give you the protection you need. Net profits will be subject to payroll taxes.
California makes LLC not so attractive for businesses that gross more than $250,000. An LLC must pay the state a minimum of $800 per year for the privilege of being a California LLC. In addition, California levies a gross receipts tax which is an additional $900 for LLCs that gross $250,000 or more and $2,500 for LLCs that gross more than $500,000, and it goes up from there. Because of the gross receipts tax, we usually don’t recommend our small and microbusiness clients use an LLC if they will gross more than $250,000. In fact, in most cases, we don’t recommend LLCs for operating businesses. But we do recommend LLCs for our clients who want to protect passive investments, like owning rental real estate.
3. S CORPORATION. S corporations are usually the best choice for small and microbusinesses in California. To establish an S corporation, you must file Articles of Incorporation with the Secretary of State, file a Statement of Information, get a tax identification number, execute Bylaws, Organizational Minutes, issue Share Certificates and open a corporate bank account and get a business license. This takes a bit more effort than an LLC. The corporation will have to pay a minimum state tax of $800, but if your business will gross more than $250,000, it will most likely be a better choice than an LLC, as corporations do not have to pay a gross receipts tax. In addition, with an S corporation, you may be able to pay yourself partly in salary, which is subject to the payroll tax, and partly as a shareholder distribution. Shareholder distributions are not subject to payroll taxes, so by separating your W2 payroll income from your shareholder distributions, you may be able to save in payroll taxes.
CONCLUSION. If you are just starting out and your are in a low liability business, then a sole proprietorship may be the best choice until you are up an running. If you need liability protection and you do not expect to ever gross more than $250,000, then an LLC may be the best choice If you need liability protection and expect to gross more than $250,000, then in most cases, an S corporation may be the best choice. And if you need an entity to hold rental properties for liability protection, then an LLC may be the best choice.