|Why Form An Entity?|
Advantages of Forming an Entity
By setting up your own Corporation or Limited Liability Company (LLC), you can enjoy the same protections and advantages as companies such as Microsoft and Google. A Corporation or a Limited Liability Company is a legal entity that has a separate existence from its owners. This means protection for the owner’s personal assets as well as saving thousands of dollars in taxes.
Find more information on the differences between Corporations and LLCs here.
Protection from Personal Liability
Forming a legal entity, either a Limited Liability Company or a Corporation, is one of the best ways to protect a business owner from personal liability. Shareholders of a Corporation and members of an LLC are generally not liable for the obligations of the company. Creditors of a Corporation or LLC may seek payment from the assets of the entity, but not the assets of the shareholders or members. This means that business owners who operate through an entity may engage in business while protecting their homes, vehicles or other personal property.
Self-Employment Tax Savings
Corporate profits are not subject to Social Security and medicare taxes (referred to as “Self-Employment taxes”) which is a combined rate of 15.3%. A Sole Proprietor and partners in a Partnership are required to pay Self-Employment Taxes on all wages they pay themselves that is earned from the business. In a Corporation or LLC that is taxed as a corporation, only salaries are subject to these taxes; dividend payments are not subject to Self-Employment taxes.
Scenario: If a Sole Proprietor paid herself $60,000 in wages from her business, a 15.3% tax would be paid on the entire $60,000.
* Note: Sole Proprietors are taxed 15.3% on the profit the business. This occurs regardless of whether the Sole Proprietor paid themselves a salary or not. This also occurs regardless of the amount of the profit.
If that Sole Proprietor formed either a Corporation or an LLC taxed as a Corporation, she can still pay herself $60,000 in total compensation. The owner is required to pay herself a “reasonable salary”; in our example, the business owner and her accountant determined a reasonable salary for her job was $40,000 a year. She also paid herself a company dividend of $20,000 based on the profitability of her business. She would withhold the normal W-2 withholdings on her salary ($40,000). However, she only has to pay state and federal taxes on the dividend payment ($20,000). The owner does NOT pay Self-Employment taxes (15.3%) on dividend payments.
Filing as a Corporation or an LLC taxed as a Corporation gives the owner a total tax savings of $3,060 on the $60,000 compensation package.
**Reasonable Salary: Please note that a shareholder who is also an employee of the company must pay himself or herself a reasonable salary, or else the IRS could re-characterize some or all of the corporate profits as salary. It is important to work with your accountant to determine what constitutes a reasonable salary for your particular profession. You can also check out the Department of Labor’s website which provides statistics from the Bureau of Labor Statistics and provides wages by area (i.e. Phoenix, AZ) and occupation.