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How to know whether setting up an LLC is the right decision for your business

Posted by Carol Mahamedi

June 23, 2021    |     7-minute read (1215 words)

As a business owner, you must select a business entity that is right for you. Whether a sole proprietorship, limited liability corporation (LLC) or corporation, the business structure you choose can impact everything. It will influence your day-to-day operations, the taxes you pay the government, and whether your personal assets are at risk. Additionally, there are several legal protections that entrepreneurs receive by structuring their businesses in specific ways. Here is a look at common business structures to help you decide whether an LLC is right for your business.

What are the common business structures?

If you are considering starting your own business, then it is essential to understand the diverse ways you can structure your business. So, let's cover these business entities so that you can determine which structure is ideal for you.

The sole proprietorship

According to the latest U.S. Census data, sole proprietorships are the most common business entity in America. There is a good reason for this. Whenever someone conducts business activities without registering their business entity, they automatically become a sole proprietorship. Therefore, it is simple to start, and there are few, if any, sole proprietorship startup costs in most states.

However, the fact that it is easy to start a sole proprietorship business does not mean it's the correct entity for you. That is because sole proprietorships (and a similar business structure known as a partnership) are not separate business entities. Instead, the business owner's personal assets and liabilities are the same as their business assets and liabilities. And it is this fact that makes the most popular business structure in existence incredibly risky. 

As a business owner that operates a sole proprietorship, there is no difference between your personal and business assets and liabilities. Therefore, you will be personally responsible for the debts of your company in a lawsuit. If you operate a low-risk business, then it offers an affordable way to create a business. However, you will miss the financial and legal protections that business owners receive from forming a different business structure, like an LLC.

C corporation, S corporation and other corporation entities

On the other end of the business entity spectrum are corporations. There are several distinct types of corporations, which always include one or more people. The most common corporation type is a C corporation, more often simply referred to as a C corp. Whenever business owners form C corps, they protect their individual assets by creating a separate legal entity. Whereas the owner of a sole proprietorship is legally liable for the debts and actions of a business, the corporation owners are not legally responsible for C corp debts. Instead, the corporation itself is liable to pay debts and taxes from their business profits.

Corporations pay taxes differently than sole proprietorships and partnerships

Now, when it comes to paying taxes, there is a significant difference between how sole proprietors and corporations pay taxes. When a business owner operates a sole proprietorship, they pay personal taxes on their business income. Partnerships, which automatically form whenever two or more people conduct business transactions, also require business owners to pay personal taxes on business profits. Additionally, some owners pay self-employment taxes if they are in a limited liability partnership. However, as a C corp owner, your business will pay corporate taxes. And this has profound implications that can impact how much a business and the business owners pay in taxes.

Double taxation? Why corporations may or may not be right for you

There are many benefits to corporations. First, they protect business owners from personal liability. So, if a corporation has debts and a collection agency demands repayment, the agency has no right to demand personal assets from the business owners. Second, corporations have an easier time raising capital than sole proprietorships. That is because changes in ownership rarely impact a corporation but can mean the end of a sole proprietorship.

However, there are several downsides to corporations. As a corporation owner, you must keep extensive records, complete periodic reports and follow the specific operational process. However, another frequent problem occurs with C corporations specifically, known as double taxation.

How double taxation works

As you now know, corporations pay income taxes whenever they earn profits. However, in certain situations, the income a corporation earns is taxed twice. Double taxation occurs when a corporation earns a profit, pays taxes, and then pays dividends to shareholders. With privately owned corporations, shareholders are typically business owners. Therefore, whenever business owners receive dividend payments, those dividend payments count as personal income. And personal income is taxed by the government based on your personal tax liability. Thus, businesses and their owners can pay taxes twice on their corporate profits.

Fortunately, there is a solution for business owners who want protection from a corporation without dealing with a corporation's additional requirements.

What is a limited liability company? (LLC)

For most small business owners, an LLC provides the best of both worlds. An LLC is a business structure that provides the benefits of a corporation without the stringent requirements of owning a corporation.

In most cases, an LLC protects its owners from personal liability. Therefore, if your LLC goes through a bankruptcy process or faces a lawsuit, the business owner's personal assets will not be at risk. Sole proprietorships do not offer these same protections since personal assets like homes, vehicles, and even bank accounts can pay for business debts. LLCs stop this from occurring when the business owner structures and operates their LLC properly.

LLCs and taxation

Like a sole proprietorship or partnership, LLC profits and losses impact an owner's personal income. Therefore, LLC owners pay personal income taxes on business profits instead of paying taxes like a corporation. And being taxed as an individual instead of as a corporation is a good thing since tax rates for corporations are typically higher than individual tax rates. However, that does not always mean that LLC owners pay less in taxes.

LLC and self-employment tax

Now, owners of an LLC often go by the term "member." Each member of an LLC is self-employed and therefore must pay self-employment taxes. Typically, employers pay half the Medicare and Social Security taxes for their employees, and the employees pay the other half. 

Those who are self-employed or considered independent contractors must pay the complete 15.3% self-employment tax rate. However, the chances are that you will receive personal benefits from the Medicare and Social Security programs in the future, so in a sense, it's a tax that goes toward your future health and well-being. Plus, you only pay these taxes on earnings, so you will never owe more in taxes than your LLC makes.

Is An LLC Right for You?

As you can tell, there is a ton of information to know about business entities. While everyone's situation, business and goals are different, LLCs are an excellent choice for business owners who want to protect their personal assets. If you are going to form a business structure but are not sure which one to go with, it is best to speak with an attorney or tax professional. They can explain which business entities would work best to ensure that you are aware of the rules, taxes,and filing requirements for each specific business entity.

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