In the past 4 years, I’ve went from a sole proprietor, skipped over an LLC and became an S-Corp. But how do you know what entity to become? When’s the right time to switch? I’ve had the pleasure for the past 2+ years of working with an incredible, forward-thinking CPA, Jason Blumer and team, and thanks to him having been doing smarter business and saving money. I’ve asked Jason to guest write an article explaining when’s the right time and why you should be a certain business entity.
I have to say that taxes suck. As someone who runs a CPA firm that prepares taxes for creative professionals all over the country, I pass out a lot of heartache because of the suckiness of taxes. Most of the confusion is centered around what type of entity they are in, and how that affects their personal taxes. Let me try to clear it up.
We try to walk creative professionals through three steps of understanding what entity they should operate in and how that will affect their taxes.
First Step: Sole Proprietor
Operate as a sole proprietor. This is the easiest business to operate in and the easiest to set up. Just wake up one morning and say “I’m in business” and you are a sole proprietor! You don’t even have to keep a separate bank account or accounting system (though you should). This is for someone operating on the side. As a sole proprietor, you will pay the most in taxes (called self employment tax) and will file a Schedule C on your personal tax return.
Second Step: LLC
Next, most creative professionals ask if they should become an LLC (limited liability company). Maybe. If you are still a single owner (meaning you don’t have a partner) then becoming an LLC won’t make any difference to your tax situation. That is, you will still file a Schedule C on your personal tax return and will pay self employment tax. You are still in the highest possible tax bracket. Sucks. So why become an LLC? Because becoming an LLC can limit your liability. But do creative professionals need limited liability? Maybe. Now we are getting into legal advice, which I can not give (because I’m not an attorney). But I can give you some basic advice. As a sole proprietor (from the First Step above), everything is exposed if someone wants to sue you. That is, they can take your business assets and your personal assets. But if you become an LLC, only the assets of the LLC are exposed. Your personal assets (your home and car) are no longer exposed to anyone that may want to sue you. Do you need to limit liability? I’m not sure, but I would say you are potentially in more danger of liability issues if you do development (as opposed to design). You probably won’t get sued because the logo you designed was ugly. But if you screw up building an online proprietary ecommerce cart, then that may affect the sales of your customer. Consider that, and seek out an attorney if you think you need to be an LLC.
Third Step: S-Corp
You may want to consider moving to an S Corporation if you are making more money and are now operating your business full time. As a general rule, if we see your bottom line profit getting to around $75k to $80k per year, then you are a good candidate for becoming an S Corporation and saving a lot of taxes at the same time. But beware, a LOT of requirements go along with operating within an S Corporation. You will need a proactive CPA firm (like us) to help you manage all of the needs of an S Corporation. The ONLY reason to move into an S Corporation is to save taxes. It is a complicated move and is not for the light-hearted. Many requirements (like payroll, operating a corporate set of accounting records, balancing distributions with salary, etc.) will confuse the crap out of you if not careful. So, again, only make this move if you expect to save taxes. As perspective, if you are making $150k in bottom line profit, you could potentially save over $10k per year in taxes. Pretty sweet. You’ll pay some of that to the CPA firm to help you manage this, but it shouldn’t be anywhere near $10k per year. After paying the CPA firm, you’ll net a lot of cash in your pocket you can go buy some burritos with. Now tax savings can be tasty. Wurd.
Let me know in the comments if you have more questions about this complex matter. I’ll try to hook you up, unless it becomes too complicated or too specific to your situation.