Do you know which business legal structure you fall under? Do you know the benefits and differences?

We see many business owners make the same mistakes over and over when starting a business. They quit their day job before proving the market, they believe they’ll make a great salary or even profit in Year 1, and often ignore their marketing funnel until it’s already too late. 

But their first mistake is always ignoring their business legal structure options. In fact, most entrepreneurs tend to select the first option someone else recommends without understanding the implications.

Here we highlight the three most common business legal structures for small businesses, and our most common recommendation!

GOOD FOR: When you’re not ready for a business, when you don’t want to do this long-term, when you’re just working on one project, the first month or two of your business (maybe).

BAD FOR: Any situation where you want to grow a business, pay yourself a real paycheck, when you have more than one client.

Sole Proprietors are pretty common when a business is just starting, in fact many people will tell you to go this route until you “prove the business is there”. However, a Sole Proprietorship can easily get you into the most tax trouble if you aren’t careful. A sole proprietor is literally just the equivalent of earning income as an individual. You have no business protections, and you, by yourself, are the business. This can be dangerous, as the IRS also demands that you pay taxes on all income you make. But, unlike a paycheck that comes with payroll taxes and a W2, you typically don’t pay those taxes until they appear at year-end, which can be an unwelcome surprise to anyone.

GOOD FOR: Small ventures, sole proprietors that want some protections, owning equity in other companies, owning a property

BAD FOR: A growing business, if you want investors, if you aren’t good at bookkeeping and business separation 

Limited Liability Corporations (LLCs) are used quite often for new small businesses. The legal upkeep is less of a burden, the cost to start one is lower, and you can be more flexible with money – which can also be a big negative if you aren’t careful. Many LLC owners get into trouble with the flexibility of the corporate structure, especially if you are the sole owner. We always recommend you keep separate business bank accounts and pay yourself correctly. That said, you can wait to pay taxes until the end of the year and freely move money between the business and yourself. This can cause issues, though, at tax time and if there is ever a legal issue with your business. LLCs don’t alway protect your personal assets in these cases, especially when there is not a clear separation of the business and the owner. LLCs also require that any money you pay yourself be subject to normal payroll taxes.

In most cases, as a small business owner, we recommend the S-Corporation instead.

Our recommendation in most (not all) small business situations.

GOOD FOR: People who want to grow a business, multiple owners, tax savings!

BAD FOR: If you want the business to hold equity in others, if you aren’t committed to growth, for non-resident ownership.

S-Corporations are the best of both worlds. They avoid the famed “double tax” of the C-Corporation, while also benefiting from the tax savings you can get out of dividends. S-Corporations are a subset of Corporations. They require a few extra legal steps and more rigid pay structures for owners that work in the business, but they also protect you personally more than an LLC. The biggest benefit for the small business owner is that as long as you pay yourself a “reasonable salary” with associated payroll taxes, you can then pay our profits in the form of a dividend, which is taxed at a lesser rate than the payroll taxes are. This means that the more your business grows, the more money you can save by paying less tax and paying more in dividends. This can really add up as your business grows.

It’s never easy trying to navigate the world of small business legalities. Most entrepreneurs or small business owners make a guess, follows the flow of a fellow business owner, or settles with the first answer Google gives.

That’s where we come in. Pathfinder can help ensure that you are on the right track and that you are getting and doing the best and most for your business.