There are many different types of business entities and choosing which route to go can be confusing. I’ll talk about the path I generally like to take when starting a new business. Every bootstrapped app business that I’ve created, I’ve followed the general transition from starting as a sole prop, to an LLC, to being an LLC elected to be taxed as an S-corp. Here is my over-simplified explanation of the route I take.
Sole Proprietorship – Stage: New
A sole proprietorship is the simplest form and most common structure to start a business. Your business profits (and losses) is yours. There is no distinction between you and your business. No formal action or paperwork is required to form a sole proprietorship. This is how I always start every new business since it starts out as a “hobby” or “experimental business” until you actually start generating revenue. Signing up for an Apple Developer License is also the easiest and fastest when signing up as a sole prop. If you have an idea you need to get out asap, then this is the fastest way to go. You can always convert it to an LLC later.
Sole Proprietor Taxes
Since you and your business are the same, the business is not taxed separately. You will be taxed under your social security number and your sole prop income is your own.
EASY – Sole prop is the cheapest and easiest business to establish. Taxes are just as easy since your business is not taxed separately. Signing up and getting approved for an Apple Developer account is fastest as a sole prop.
Liability – There is no legal separation between your sole prop and yourself, so you are responsible for everything. You are liable for all obligations of the business and endure all the risk. If someone sues your business, your personal assets are at risk.
Limited Liability Company – Stage: Growing
Once your business starts growing, it’s smart to begin taking precaution to protect your personal wealth. You never know what kind of lawsuit might be around the corner, so you want to separate your business entity from your entity. Applying for the Apple Developer Program takes a bit longer since they have to verify all of your paperwork (e.g. Articles of Organization, etc).
Since an LLC isn’t a separate tax entity, all the income taxes are passed to the LLC’s members (you) and are paid through personal income tax. You can also opt to be an LLC, but taxed as an s-corp as a tax saving strategy. (more below).
Liability – You now have a legal separation between you and your business. Your personal assets are now protected from your business assets. If your business gets sued, your personal assets are safe.
Self Employment Taxes – Now that your are an official business, you must pay self-employment taxes towards Medicare and Social Security. You can avoid some of this through paying distributions when you opt to be taxed as an s-corp (below).
LLC Taxed as S-Corp – Stage: Profitable
Now that you are profitable, you’ll start noticing that you’re being taxed more. Doing taxes after making money from apps for the first time in 2010, I had a taxable income of $500K. Being only an LLC at the time, I had no idea about self-employment tax. I didn’t learn this stuff in my MBA program(or I didn’t remember any of it) and it hurt a ton when having to shell out for tax payments. This was a painful lesson, but I signed up to be taxed as an s-corp the following year. If you’re at this stage in your business, ask your CPA about it and fill out Form 2553.
S-corps avoid double taxation (being taxed at the corporate level and then again as a shareholder). Instead, profits (or losses) are passed down to the shareholders. In addition, S-corp distributions aren’t subject to self-employment taxes for Medicare and Social Security.
Tax Savings – The best feature of an S-corp is the tax savings. Basically, you’ll be paying your self a salary and bonus (distribution). Only your salary gets hit with the self-employment tax. The caveat is that the salary needs to be “reasonable”. So you can’t pay yourself a $10K salary and a $200K bonus. Let’s look at an example:
Sole Prop or LLC – $80,000 net income for the year. You pay 15% or $12,000 in self-employment tax.
S-Corp – $50,000K salary and $30,000 bonus (distributions) for the year. You pay 15% of $30,000, which is $4,500. You just saved $7,500.
Harder To Set Up – Takes more logistics and money to set everything up. This includes paying for a payroll service to receive W2 forms. .
Which business entity do you use and why? What has been your experience?
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