Sole proprietor, LLC, or S corp: Which structure is right for your IT business?
When you own a small IT business, your focus is usually on your work and on your clients. However, it's worth taking time to consider what kind of legal structure you need and whether your needs will change as your business grows.
What does it mean to be a sole proprietor?
Many people who work for themselves don’t even realize they’re sole proprietors. This could be partly because you don’t have to file any special paperwork with your state to gain sole proprietor status.
Basically, any time you perform “work for hire” (meaning you get a 1099 instead of a W2 at tax time), you’re a sole proprietor in the eyes of the IRS. If you’re running a solo IT business, you’re probably a sole proprietor.
Sole proprietorships are known as “pass-through” entities. This means all business income goes straight to you, the business owner. You then report profits, losses, and business expenses on your individual tax return.
This structure cuts down on paperwork and lets you pay taxes as an individual rather than as a corporation – two of the tax advantages of sole proprietorship. This setup may save you money, but legally, it also means that you and your business are one and the same.
Business liability is probably the biggest drawback to a sole proprietorship. Since there is no legal line drawn between the assets of the owner and the business, collectors can come after your personal income and property if there are any losses or debts. If a lawsuit is involved, the stakes can get even higher.
While IT is a relatively low-risk field overall, all businesses face some risk. It’s important to be aware of the risk you take on as a sole proprietor.
Reduce your risk with a limited liability company
A limited liability company (LLC) has a slightly more complicated structure than a sole proprietorship. You need to file paperwork and pay fees to get it up and running. But the paperwork is usually pretty straightforward, and the fees are often a few hundred dollars or less.
A major benefit is that an LLC separates the liability for the business from you, the individual. This means your personal assets are kept separate. If your business is facing debt collectors or a legal judgment, your personal assets are protected and can’t be seized to pay off your business debts.
Like sole proprietorships, LLCs are also “pass-through” entities. You'll report any income and expenses from the business on your personal income tax return.
“I recommend the LLC for most companies and clients, simply because it has the best tax treatment,” says Bob Zeglarski, founder of Cutwater Law, PLLC. “The LLC is really the best of both worlds, both the liability protection of a C corporation, but the tax treatment of a partnership.”
What is an S corporation?
The S corporation (also known as an S corp) is another popular choice for small tech companies. According to the IRS, an S corp "elects to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes." Technically, you elect S corp status at the federal level for a business already formed at the state level.
If your business elects S corp status, you pay yourself a salary on payroll. You'll be responsible for deducting and remitting payroll taxes, such as federal and state taxes and FICA-required employee and employer contributions.
Any profits left over can be distributed to the owner(s) as dividends. The government taxes these at a lower rate than it does the regular income of a sole proprietorship or LLC.
You might be thinking that this sounds like double taxation. But S corps can avoid that by allowing only one tax report to be filed from personal shareholders of the business. This is one of the advantages of forming an S corporation vs. a sole proprietorship.
The S corp also has some downsides for small IT business owners. For one, it costs more to set up. There is also more paperwork and stricter guidelines you must stick to or risk losing your S corp status.
“I usually recommend an S corp to somebody who has a small business that won’t have a lot of owners, be taking on investments down the road, and really be growing very much,” says Zeglarski. “An S corp could be a good fit for a small business that is planned to be operated as a family business, because you get partnership tax treatment just like an LLC, but also get the same liability protection as a C corporation.”
Limit your liability exposure with IT insurance
No matter which structure you choose, business insurance can limit your risk exposure. Tech companies of all sizes and structures benefit from errors and omissions insurance (E&O), which protects against work mistakes. General liability insurance protects against the most common lawsuits filed against small businesses.
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