Choosing the Right Business Entity Type

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Business entity? Really? Don’t I have more urgent and important things to deal with? That would have been my response when I started my first small business. The problem with that response is that when you start a business, you don’t get to not choose a business entity type. Either you choose it yourself, or it’s chosen for you by default.

When my wife started her private practice, like most therapists, she didn’t give much thought to the type of business entity she should set up. She just rented an office space, put up some online listings, and was “off to the races.” As a result, she defaulted into the so-called “sole proprietorship” or “sole prop” entity. While very typical, this is not necessarily the best one for a practice, and even if it is reasonably good at first, you may soon outgrow it.

A full description of all possible business entity types and all their requirements, costs, benefits, drawbacks, etc. would fill a book. Worse, a majority of those details are irrelevant to any specific practice (it’s just that which details are relevant will differ from one case to another). Instead, what I’ll do here is give you a very minimal primer so you can listen and ask questions intelligently when you talk with your tax and/or legal pro.

Warning: If you’re like my wife, you may find this dry and boring, leading to glazed-over eyes and checked-out mind (and yes, she totally gave me permission to say that  !) Still, it’s just a couple of pages, so just use toothpicks if needed to keep your eyes open.

What’s Wrong with a Practice Being a Sole Prop?

Depending on your specific situation, there may be nothing wrong with setting up your practice as a sole prop. However, there are some consequences. First, if you stop making payments on e.g. a business loan or business credit card, the credito can go after your personal checking accounts, savings accounts, investment accounts, etc., not just your business accounts. In some cases, they may even be able to go after your family home. Another consequence is that each business entity is taxed differently, so using a sole prop may be costing you thousands of dollars more in taxes than you could be paying if you used a different entity type.

As a Solo Practitioner, What Other Options Do I Have?

The most popular alternatives to sole props are the limited liability company (LLC) and S Corporation (S Corp), each with its own pros and cons. Which is best for you? That depends. Yeah, I know that sounds like a cop-out, but it’s still true.

The Single-Member LLC

You can set up your LLC with you as sole owner, making it a “single-member LLC,” which for better or worse the IRS disregards just as it does sole props. The LLC offers protection against personal liability, so in most cases business creditors can only go after your LLC assets (such as your business checking account). Important note: this will not protect you against claims of personal negligence, though your malpractice and liability insurance policies may help with that.

The main advantages:

  • Limited personal liability.
  • The same tax reporting through your personal tax returns as a sole prop. This is the simplest way to report business income, but given complexity of the US internal revenue code, it’s still about as simple as tying your shoelaces while wearing mittens.
  • Fewer start-up costs, filings, forms, formal meetings, and record-keeping requirements than an S Corp.

The main drawbacks:

  • More start-up costs, filings, forms, and record keeping than a sole prop.
  • All profits pass through to owner as self-employment income, so no tax reduction compared to a sole prop.

The S Corp

This offers similar protection against business liabilities as an LLC. Different than an LLC, the S Corp pays you a salary, distributing remaining profits as dividends. Between your employer hat and your employee hat, you’ll pay the same 15.3% on your salary as you would on all sole-prop profits. However, dividends aren’t subject to payroll or self-employment taxes, which could save you thousands. You have to be careful that your salary/dividend split is defensible to the IRS, so talk about that with your CPA. In general, if you can answer “yes” to the following, you should be safe: “Would someone with similar background and qualifications expect to earn this salary at another practice of similar size?”

As an S Corp, your practice has to file its own tax returns, and since it pays you a salary, it must run payroll. This means your CPA will charge you more, so you need to weigh the added costs against the potential tax savings.

The main advantages:

  • Limited personal liability for owners.
  • May reduce payroll/self-employment taxes, potentially by a lot.

The main drawbacks:

  • More complex than sole prop or LLC – more start-up costs, filings, forms, formal meetings, and record-keeping requirements, translating to higher costs.
  • Have to pay federal and state unemployment insurance, and in some states have to pay certain minimum filing fees and corporate taxes.

An LLC Taxed as an S Corp

If you set up an LLC, your CPA can request that the IRS treat is as if it was an S Corp.

The main advantages:

  • Retains limited personal liability of LLC.
  • May reduce payroll/self-employment taxes similar to S Corp.
  • Fewer start-up costs, filings, forms, formal meetings, and record-keeping requirements than an S Corp.

The main drawbacks:

  • More complex than sole prop, so more CPA expenses.
  • Have to pay federal and state unemployment insurance, and in some states have to pay certain minimum filing fees and corporate taxes.

The Bottom Line

Going from sole prop to LLC to S Corp, the requirements are more complex and expensive. However, the level of legal protections and potential tax savings also increase. Your specific situation will determine which provides the best mix of benefits vs. costs.

We’ve reached the end of the primer and you’re still here - hurray! I know it was painful, sort of like ripping off a Band-Aid, but sometimes you just have to grit your teeth and bear it. Once you give me your email address, you’ll receive a lot of free content, including a worksheet on this topic. In that worksheet you’ll find a list of questions your CPA and/or attorney should ask you, and another list of questions you should ask them.

What business entity are you using? Are you confident it’s the best one for your situation? Have you discussed it with your CPA? What do you think about this post and/or my free business entity type worksheet? Please leave your feedback below. I promise to respond to all (relevant :)) comments and questions.

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Comments (3)

  • M
    • 2019-03-26 06:27:28

    This is so helpful! Thank you!

  • C
    • 2019-09-16 15:21:30

    Hi, Just listened to your interview on Selling the Couch. Very clear description of the differences and pros and cons. One question, if you do the S-corp to save $, the bulk of the savings are from not paying medicare and social security taxes, correct? So those savings will lower your income for calculating your social security income at retirement, right? The benefit is based on the highest paying years of your employment. So unless you're taking those savings as profit and putting them into retirement savings, you will be getting $ now and getting a smaller social security check in retirement? Is that right?

  • O
    • 2019-09-16 15:48:48

    Hi Carol, and thanks for the excellent question. Reiterating that I'm not a tax or legal pro, my understanding is that the answer is yes and no :). First the "yes" part. Indeed, if the defensible salary you choose to take from your S-corp (or LLC taxed as S-corp) is lower than the maximum taxable salary as determined by the SSA (per this is $132,900 for the 2019 tax year), your ultimate Social Security benefit will indeed likely be lower since as you say, your SS benefit is determined by your 35 highest annual salaries. The "no" part is that if you do take a salary that's at least the maximum SS-taxable wage, you still save by not paying the 3.3% Medicare taxes on the rest of your income that's taken as profit distribution, and that doesn't affect your SS benefit at all. Beyond those facts, SS benefits aren't intended to replace your entire salary, and the fraction of salary they replace is smaller at mid- to high-income levels than at lower salary levels. Keep in mind also that the current average SS benefit is about $17.5k/year, and that unless Congress acts to increase payroll taxes and/or increase the full retirement age for SS, benefits will need to be cut by 20%. If that happened today, that would cut the average benefit to $14k/year, so these benefits are not anywhere near enough to count on for funding a decent retirement. Also relevant is that if you have a spouse with much higher earnings than yours, you may get higher benefits anyway by claiming the spousal benefit of 50% of his/her SS benefit. Bottom line, yes, you will likely get lower SS benefits by reducing your current payroll taxes, but I'd rather have a lot more money now at the cost of a little less money later. Still, your point is well taken that we all need to plan for retirement and set money aside each year to that end. That's an important factor that I work on with my financial strategy clients.

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