If you’re about to go out on your own and create a business, congratulations. Becoming an entrepreneur, especially an online entrepreneur is a good idea in this environment. When the government can't shut you down due to a pandemic or whatever reason, having an online business becomes more valuable.
Before you start on your entrepreneurial journey, it's important to understand the difference between three types of corporations.
Once you cross over to the side entrepreneurs and others who make the economic engine run, you’ll wonder why you didn’t start sooner. Salaried employment is great for some people, less so for others.
But if you’re going to be an entrepreneur, do it right. There’s more to creating a business than buying a license (you do know you have to buy a license, right?) and creating a website
A Business' Legal Entity Is Important
Most general contractors, plumbers, electricians, gardeners and graphic designers who set up shop don’t even think about what legal form their new business is going to take.
That’s legal “form” as in “organization or arrangement.” We’re not talking about a piece of paper you have to fill out, at least not directly.
Making the wrong decision about legal form can cost you serious money even before the first sale. You might have learned the terms “sole proprietorship” and “corporation” back in high school. They probably meant nothing to you then.
But now it's important to understand what they mean. Every entrepreneur should know the pros and cons of the three types of corporations specific to your situation.
Avoid The Sole Proprietorship Default Route
Unless you specify otherwise, your new business will operate as what’s called a “sole proprietorship.” This means there’s no practical distinction between you and the business itself.
The “advantage” to a sole proprietorship is that it costs nothing to start. That is, aside from the aforementioned business license and related fees. Kind of like how it’s an “advantage” to not have auto insurance, because of all that money you’ll save by not paying a premium.
I don't recommend running a business as a sole proprietor, unless it's a casual side hustle. Maybe 150 years ago you might, if you made horseshoes and paid your apprentice under the table.
However, since there’s no legal difference between you and the business under a sole proprietorship, you’re on the hook for everything. Everything. If a customer sues an employee, whether it’s justified or not, you could be legally responsible for far more money than your company’s worth.
You'll want to spend a little money before opening and incorporate. Why? You may hesitate at incurring upfront out-of-pocket expenses. However, understand that it’s forward thinking like this that separates the successful from the merely busy.
And once you incorporate, you’re not just a business owner. With the three types of corporations you become a corporate shareholder with all the rights that affords.
Incorporate Your Business
To incorporate, you have to spend money filing with a state. Not “your” state”, but “a” state. Just because you’re headquartered in New Hampshire, that doesn’t mean you can’t incorporate in Montana.
Ever wonder why the catchphrase “a Delaware limited liability company” found its way into the vernacular? Most American publicly traded corporations are incorporated in The First State.
There’s a good reason for this. Under U.S. law, your corporation operates under the laws of the state in which you’re incorporated. This makes sense, otherwise you could be subject to 50 different sets of state laws. That wouldn't be efficient.
Advantages Of Incorporating In Delaware
Delaware protects shareholders (you’re a shareholder, remember?) more than other states do. Some states require the three types of corporations to have multiple officers and directors.
However, Delaware lets you get by with just one. You don’t even have to be a citizen. Actually, you don’t even have to live in the U.S. In addition, you don’t even have to publicly disclose your name.
Other Popular States For Incorporation
For a small corporation whose sole shareholder is also its manager, incorporating in Nevada might make more sense. Should a director of a Delaware corporation commit “gross negligence”, that can still lead to personal liability.
Maybe that’s morally sound, pending a trial, but from a financial perspective it tilts the scales toward incorporating in Nevada if you want to avoid legal hassles that can derive from baseless accusations.
Wyoming and Alaska are also popular states for incorporating, too.
The Worst States To Incorporate
On the other hand, incorporating in California or New York sucks on wheels.
California’s laws are tilted disproportionately in favor of employees, customers, people who slip and fall on the sidewalk outside your retail location. Basically anyone but you!
New York’s laws aren’t much better. The diaspora of businesses from each of those states is purely coincidental to this, by the way.
But there’s so much paperwork. Oh, stop it. Yes, paperwork sucks. It’s tiresome, and counterproductive. And it exists largely to satisfy the government bureaucrats who make their living by creating byzantine regulations and getting people to adhere to them.
But if you’re sufficiently disposed, paperwork still beats the hell out of working for someone else.
Three Types Of Corporations
In the United States, there are three types of corporations.
- C corporation (C corp)
- S corporation (S corp)
- Limited liability company (LLC)
LLCs are technically not corporations, but consider them close enough for our discussion. C and S corporations are named after the particular subchapter of Chapter 1 of the Internal Revenue Code.
Main Difference Between C Corp And S Corp
Most major corporations are C corps, most smaller firms are S corps. The big difference between the two is that C corporation shareholders are subject to double taxation.
That means the government taxes the C company’s income at corporate rates, and taxes the dividends after the corporation distributes them to the shareholders. Ouch.
Dividends For Corporate Shareholders
What are dividends you may ask? That’s what you call the money that filters through to the shareholders in a corporation. Dividends in this case serve the same purpose that wages and salaries do for ordinary employees in ordinary jobs.
But if you’re an S corporation, that’s not an issue. Also, you can pay yourself a salary and the government won’t subject it to self-employment tax. S corporations are designed for small companies, which yours will presumably start out as.
Difference Between LLCs And S Corps
Finally, there are LLCs. The most important difference between them and S corporations is how the IRS treats excess profits. Or in IRS jargon, “distributions.”
Let's say you own and operate an S Corporation and pay yourself a “reasonable” salary out of the profits. The remaining profit is “distributed” to you at the end of the year and isn’t subject to self-employment tax. Be sure to read my post on What’s The Right Ratio Between Salary And Distribution To Save On Taxes And Avoid An Audit?
This isn't so with an LLC. However, you can tell the IRS you want your LLC to be treated like an S Corporation for tax purposes. Just file Form 2553 before “the 16th day of the 3rd month of the tax year.”
LLCs require less paperwork than S corporations. But there's one big tradeoff. Your LLC has to issue you a K-1 statement. The K-1 lists your share of the LLC’s income and expenses, to be transferred to your 1040. It’s not that different than paying regular old income taxes.
S Corps Are Great For Small Businesses
For a typical one-person S corporation, the paperwork consists of little more than this:
- Every month, return a form to the state department of taxation. Takes about 30 seconds, costs the price of a stamp.
- Each quarter, pay estimated taxes. It's a lot easier when you save receipts as a matter of course. If you want, hire an accountant.
- Elect a board of directors, have an annual board meeting and keep minutes for your records.
And I also want to mention, if you have an S-corp or another type of pass-through entity structure like an LLC, be sure to check out the PTE tax election. It's not available in every state, but it can be a great way to save on taxes. You can discuss the options and benefits with your accountant.
A board of directors? My head is spinning.
You know who your directors and officers are? You, and whomever you want to appoint, assuming you want to appoint someone.
In Delaware, remember (and in Nevada), you don’t even have to do that. You do have to hold an annual meeting, though. You can do this in your bedroom, and maybe one day, in your pool. (One point in favor of LLCs is that they don’t have directors’ meetings, or even directors.)
And we haven’t even gotten to the best part: tax writeoffs, which deserve a post of their own. As wonderful as they are, they are yet another indication of how our tax code, flawed and labyrinthine as it is, exists to punish employees at the expense of business owners.
While you might not like the system, the opportunity is there to take advantage of it. Here's a helpful list of business expenses to reference.
Start An Online Business
Out of the three types of corporations, I decided to start an S-Corp for my online business. It's been around six years since I started Financial Samurai and I'm actually earning a good passive and active income stream online now.
I never thought I'd be able to quit my job in 2012 just three years after starting Financial Samurai. But by starting one financial crisis day in 2009, Financial Samurai actually makes more than my entire passive income total that took 15 years to build.
If you enjoy writing, creating, connecting with people online, and enjoying more freedom, see how you can set up a WordPress blog in 15 minutes with Bluehost. You never know where the journey will take you!
Not a day goes by where I'm not happy I started this website in 2009. Financial Samurai has given me something to do in “retirement.” It's been a joy to run this site and learn from all of you as well.
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