Starting up a business can be the most rewarding, profitable, and life changing decision anybody can make. Let’s face it, it’s the American Dream to be independent and financially free, right? But why do so many Americas choose to be employees instead of business owners? For many, it’s the lack of “security” (how secure is your life when your manager can decide if you continue to have a job or not) that they feel when they’re employed. Not having the proper education in our school systems on the topic of entrepreneurialism is also to blame. We’re taught to go to school and get good grades so you can get into a good college and get a good job. For most people this might be the best path for them as business ownership is not for them.
For those of us that understand that the odds are stacked against us to become wealthy as an employee, we look for other options. We ask ourselves, “what do I love to do that I can make money at?” This is where dreams begin along with the hundreds of scary questions that pop up in our heads. With the proper knowledge you’ll be able to breeze through these administrative questions of how to start a business and actually focus on your business model and becoming profitable.
Fast Fact: Did you know that 19.4 million nonemployer business(businesses with no employees other than the owner) are sole proprietorships, 1.6 million are partnerships and 1.4 million are corporations
Where do I start? Should I start out as a sole proprietor?
(Let me start off by saying I am NOT an attorney or a CPA and the information provided is based solely on my personal continuing education on the topic. Please consult your attorney and CPA to determine which solution best fits your personal and business needs)
The most common place to start is to become a sole proprietor. For many people, starting out as a sole proprietor may be the perfect fit, but for most it could be a complete disaster. I won’t be focusing on sole proprietorships in this blog post but I do want to help you decide to look into a proper entity that will save you in taxes, protect you from any liability that might arise in your business.
- Simplest form of doing business. All you have to do is start selling your product or providing your service. There are no tax ID’s required, no business registrations needed, and you don’t even need a separate business banking account.
- Self Employment Tax: One of the primary disadvantages of a sole proprietorship is the 15.3% self employment tax on ordinary income (passive income is not subject to SE tax). S-Corps don’t pay this tax but we’ll get into this in a minute. Self employment tax is a combination of Social Security and Medicare taxes
- Liability: The second primary disadvantage, and in my opinion the most important, is that a sole prop does not provide ANY protection of your personal assets for the actions of your business. For example, lets say you open a small bakery out of your home and one of your customers gets sick or even worse dies from E Coli contamination. You personally can be sued, opening up all of your personal assets (bank accounts, home, cars, etc) to litigation judgments. A simple LLC can provide the asset protection you need.
- Business Credit: Businesses require money to get started and to continue to grow. One of the most valuable asset of my company is the ability to receive business credit, which is completely separate from my personal FICO, from banks and other institutions that offer revolving credit or credit lines. You won’t fully understand how important this is until you have a cash crunch and need access to funds quickly.
Limited Liability Companies (LLC)
Limited Liability Companies are a fantastic entity for many reason, but do come with some major drawbacks. Check your state laws on the different types of LLC’s allowed including Series LLC’s
- The number one reason LLC’s are created are to hold rental property. They provide the asset protection that you need from the operational side of the business. LLC’s don’t only protect the owner from tenants but also from contractors and guests of the tenants. These are fantastic entities to use for the investment side of your businesses.
- LLC’s can be retroactively converted to S-Corps once your business is generating large amounts of ordinary income. S-Corps are the best way to limit your Self employment tax where as LLC’s do not provide any tax savings for you.
- LLC’s are great for partnerships as they protect each partner from the actions of the other partner. The LLC operating agreement which is drawn up at the opening of the LLC can document exactly what each partners responsibilities are, how and what share of profits and losses will be distributed, and can be “owned” by each partners S-Corps allowing the individuals to take advantage of S-Corp advantages including limiting self employment tax and setting up seld directed 401k’s and IRA’s which can be used to invest in almost anything you desire (more on this topic in later blog posts)
- An LLC provides no tax savings in any way (you’ll be shocked at how much in SE taxes you pay once your LLC begins to generate ordinary income)
- Some states have very high filing fees and operational costs
S- Corporations (S-Corp)
In my personal opinion, if you are a business owner you should have an S-Corp structured into your business model because the advantages are endless. An S-Corp is critical for the small business owner in terms of asset protection, tax liability, and having the ability to set up retirement plans and health savings accounts for yourself and also your employees if you have any. S-Corps are designed for small businesses where as C-Corps or Corporations are built for large companies that are looking for hundreds or thousands of shareholders to raise capital and even take the company public on the stock exchange.
- Shareholders and officers of an S-Corp are not personally liable for corporate debt and liabilities
- Your share of the corporations net income is not subject to Self Employment tax
- Allow the business to establish Business Credit by using the Tax ID Number where eventually you will be able to borrow funds solely in the companies name which does not affect your personal FICO score.
- Can set up retirement accounts and health savings accounts for you, your family, and your employees. Did you know that your retirement account can hold real estate, for example rentals or fix and flip projects that you manage? How awesome is it that I can flip a house inside my retirement account (or have tenants pay their rent directly into my retirement account) where all of the profits or rental income is either tax free or tax deferred depending if you use a roth or traditional account. What’s even more exciting is you can do the same in your health care accounts…say good bye to needing Obama Care and paying those extremely high premiums. One fix and flip making you a very modest $20k profit could cover your health care expenses for years and years.
- S-Corps do require a larger amount of management. Payroll is required, annual shareholder meetings (even if you are the only shareholder)and documentation need to be kept (later I’ll get into how you can have your shareholder meeting anywhere in the world and have the trip be completely tax deductible). Make sure you have a competent attorney and CPA who can manage these simple administrative tasks so you don’t have to be bothered by them. It is critical to operate the S-Corp with the proper payroll so get your team of professionals on board. If you need an amazing tax and legal representative I’ll be happy to forward you some information.
- Other than that, there are not many disadvantages to an S-corp.
Hopefully after reading this short article you have gained a little more knowledge on the topic of Entity selection for your new business you’re starting. Obviously there’s a ton more information on this topic including another dozen or so entities that you could use and I recommend you take further steps of gaining knowledge by reading books, joining a business development group near you, or taking some educational courses that focus on Entrepreneurship.
If you are interested in learning more about how to build a strong foundation to your business, learn more about the tax and legal strategies or self directed retirement/health plans or have an interest in learning how to get started in real estate investing, please sign up for our newsletter and I’ll send you a short 15 minute video introduction on how our number 1 real estate investment education and business development trainings are changing the lives of thousands of people across the United States.
Good luck in your future endeavors