The Perfect Entity Choice for Your Dream Business

I associate the “dream business” with the need to scratch an entrepreneurial itch – it seems like a great idea, but you have no idea how successful it will be.  For the reasons set forth below, the best choice of entity for your dream business is probably an LLC.

One of the first steps in starting any business is determining which type of entity to form and organize and operate your business out of: a corporation, an S Corporation, a limited liability company (LLC), a limited partnership, a general partnership, or a sole proprietorship (which is the default when you don’t form and organize an entity).

It should come as no surprise that, by and large, business clients want to form the type of entity that will allow them to keep the most money after taxes.  The 2017 Tax Cuts and Jobs Act introduced the Qualified Business Income (QBI) Deduction.  There are limitations and exemptions, but the QBI Deduction generally allows taxpayers to reduce QBI received by 20%.  Wages paid to a shareholder of a corporation, or guaranteed payments to a partner of a partnership, are not eligible for the QBI Deduction.

For many closely-held small businesses, the choice of entity is between an S Corporation or an LLC, because (i) even though the corporate tax rate is at a low 21%, C Corporations are still subject to double taxation; (ii) sole proprietorships and general partnerships do not offer liability protection to the principals of the business; and (iii) the flexibility of LLCs has largely supplanted limited partnership – except in real estate and other investment projects.

Whether or not you should choose an LLC or an S Corporation for your dream business largely depends on… how much money you anticipate making.  There lies the rub.

If you choose an S Corporation and don’t make much income, most of the income is probably going to be passed through to you in the form of wages. Shareholders of S Corporations must pay themselves “reasonable compensation” when they perform services for the S Corporation.  As a result, much of business income will be subject to self-employment taxes and only the “profit” (taxable income of the business less wages) will qualify for the QBI Deduction.

If you choose an LLC and make too much income (yay dream business!), a greater portion of the income will be subject to self-employment taxes, the net investment income tax, and California’s gross receipts tax.

The good news is that an LLC– even a single-member LLC – can elect to be classified as a corporate entity and taxed as an S Corporation.  This means that you can begin operating your dream business as an LLC and later elect to have it treated as an S Corporation, for tax purposes, if the need arises because of too much income or other factors.  Conversely, you can’t switch your S Corporation to an LLC if the dream business isn’t doing so well.

In conclusion, an LLC is a great fit for many dream businesses. Of course, every business is different and there are exceptions… and exceptions to the exceptions. If you are starting a new business, you should work with your legal and tax advisors to create a structure that suits you.