By Attorney Steven A. Leahy
I was reading posts in a Facebook Group where this question was posted “I’m setting up an online course. Should I set my business up as an LLC or some sort of corporation?” The question did not surprise me, but the comments certainly did.
So, I thought I would answer this question from my perspective. Here are my top three reasons you should not operate a business as a sole proprietor.
The first, and most obvious, reason is limited liability. Limiting the liability of the owner of a business always makes sense. Even if the owner cannot limit all liability, the protection offered by the proper entity structure can significantly protect the business owner from the debts and obligations of the business. For example, if an employee of the business writes a defamatory article or posts copyright infringing material on the business web site, the owner’s personal liability would be limited to the amounts invested.
Another good example of limited liability goes to taxes in general. Many company taxes would disappear with the dissolution of the company. There are, however, taxes from which a business owner can never by shielded – some payroll taxes, sales taxes, excise taxes, etc.. These are trust taxes. Because the business owner collects these taxes from others and holds them in “trust” for the taxing authority, if those taxes are not handed over, those taxing authorities will collect from the business owner personally. In addition, these taxes are not dischargeable in bankruptcy.
The second reason is to lower your tax obligations. Sole proprietors pay the highest taxes. Why is that? Because, not only do they pay income tax on any profit, they must also pay self-employment taxes on all of that profit. For example, lets make some basic assumptions to make this analysis a little easier to understand. Let’s say the income tax rate is 20%, and the self-employment tax is 15%. Let’s also assume the business makes $100K after expenses – keep the numbers round. As a sole proprietor (and, by the way, a single member LLC) federal taxes would work out like this: Self-employment tax = 15% of $100K or $15k; Income Tax = 20% of 100K or $20k; making the total tax $15K + $20k or $35K.
Now, let’s assume a Sub-chapter S corporation structure and the owner becomes an employee of the corporation. As an employee, the owner collects a wage of $50K. Because the owner is an employee there isn’t a self-employment tax. Instead, the federal government imposes social security and medicare tax of 15% shared by the employee and employer equally. Because the owner is both the employee and the employer it would look like this – the company would pay 7.5% of $50K in payroll taxes, or $3750; the owner/employee would pay the other 7.5% of $50K in payroll taxes or $3750; for a total payroll tax of $7500. The owner would pay the same 20% in income tax, $50K in wages, the other $50K passes through to the owner as income. Here’s the math $7500 in payroll taxes (instead of self-employment taxes) and $20K income taxes. For a total tax obligation of $27,500.00. That’s a savings of $7500.00 or more than 21%!
The third reason is just as important as the other 2, maybe a little more so – deductions. Sub-chapter S corporations file their own tax returns, separate from the business owner. The company’s business expenses are deducted from the business income on that return. Sole proprietors, and single member LLC’s take those business deductions on Schedule C of their personal income tax returns. So what, you say.
Well, having sat through IRS audits and discussing these audits with the IRS auditors – schedule C business deductions are huge red flags, and are closely scrutinized. So, not only are you more likely to get audited, those deductions are much more likely to be denied. If the IRS denies your deductions, your income increases. And, as I explained, sole-proprietors pay the highest taxes. Therefore, artificially increasing income will also increase tax obligations.
So, to answer the question: Do not remain a sole proprietor! Generally, I recommend my clients form a Sub-chapter S corporation and become an employee of that company. I also recommend they engage a payroll company to do the necessary paperwork and pay their payroll taxes. Not only will this help lower tax obligations, but it will help the business owner stay in compliance (pay their taxes) as they come due.
An LLC can work. If the LLC also elects a Sub-chapter S tax designation AND files a separate income tax return.
Steven A. Leahy is a tax attorney in Chicago, Illinois. He is the host of the long-running popular Radio Show “The IRS Radio Hour” heard every Sunday evening on AM 560 The Answer. Attorney Leahy is also the author of the book “Deal With Your IRS Problems Today!” You can get a FREE copy of this important book at FreeIRSBook.com.