About once a week we form a small business for a new small business owner. An entrepreneur will contact us and form an LLC or an S-Corporation or potentially some other type. I normally sit down with them for about an hour and talk through a variety of legal issues. I am going to condense that down to a short summary version here.
The first issue is which type of business entity should I choose? Most businesses that are being started are going to be one of two types and LLC or S-Corp. When I say S-Corp I mean a Corporation which elects to be taxed as a subchapter S-Corporation. In other words, rather than paying taxes at the corporate level and then again at the owner level, the tax passes through the S-Corporation and are only paid at the owner level. An LLC also has that same approach.
Now you might say, what is the difference between the S-Corp and the LLC? They both provide limited liability equally, however, the S-Corp permits to deduct money, under certain circumstances, from self-employment tax. That will save you about 15%. So let me give you an example. Let’s say you are a business that makes $100,000 in profit per year. So that is you may have $1 million in total sales, but $900,000 in expenses so only $100,000 in profit. In an LLC that entire $100,000 in profits would be subject to regular income tax, as well as self-employment tax, which is 15%. So if you are in a 35% tax bracket, plus 15% self-employment tax. You may be paying close to 50% in taxes. So for $100,000 in profit, $50,000 in taxes. It is a lot of money. In an S-Corp you can avoid some of that self-employment tax. Again that is the 15% portion. Here is how.
In an S-Corp you determine what your fair market salary would be, let’s say it would be $50,000. That means on that first $50,000, you are going to pay self-employment tax at 15%, but on the remaining $50,000, you will not pay a self-employment tax, which means $50,000 will be free of a 15% tax. That’s about a $7,500 actual cash savings in taxes. Now you might be asking yourself, what if I am interested in having an LLC, is there any way to be taxed as an S-Corp? The answer is yes and in fact many small business owners start out as an LLC, and then you can elect to be taxed as an S-Corp in the beginning of the calendar year in which it is to apply.
So you might start out being taxed as a default LLC, the default is sole proprietor, and then two years down the road elect to be taxed as an S-Corp once your profits justify it. The one drawback to an S-Corp is you need to pay and report your taxes quarterly. So essentially you’re paying a payroll service to do payroll withholding and that can be annoying and it also has some costs involved. So an S-Corp can save you money, but it’s not worth doing unless you’re making, as profit, substantially over what you would be paying yourself in wages.
I realize this is a little tricky. A business attorney or CPA can help your through your situation and help you figure out which entity and which election is right for you.
Once you have the right entity set up, you’ll want to look into getting an EIN, that’s a tax ID for a business. It is free. You can call the IRS, you can file online or you can do it by fax or mail. Again it is free. The easiest way and the preferred way is just fill out the form online, you’ll get a PDF right there with your tax ID. You can then go to the bank and open up a bank account in the name of your LLC or Corporation. Don’t get the EIN until after you have gotten your Corporation or LLC because if you get it now you’ll have to get it in your own name. After you form the business, you can get the EIN in the name of the business and that EIN will now be the tax ID, kind of like the social security number for the business.
If you will be charging sales tax when you sell products to your clients, you’ll need to get a sales tax ID number from the state of Minnesota. That is free you get it from the Department of Revenue just go online. You can get it right there by filling out an online form. Then you collect that sales tax and you pay it into the Department of Revenue.
If you have multiple owners in your business, you’ll need an agreement that sets forth a structure for how you make decisions, how profits will be distributed. What if someone wants to get out of the business? How will they be bought out? Can you sell your shares of the business? What if you get divorced? Die? Become incapacitated? File for bankruptcy? What is the impact on the other owner? There are all sorts of scenarios that come and let’s face it, at some point you will leave your business. If it’s not by death it will be sometime sooner. Maybe you just want to get out, maybe you can’t get along with each other. You need a buy sell agreement and by
laws and an operating agreement in place to set forth the structure for dealing that. If you don’t have that, and you can’t come to an agreement later, the only way to get that resolved is to fight about it with a judge, which is going to costs thousands if not tens of thousands of dollars to fight. A buy sell agreement is a great way to save legal fees down the road because you know that you are going to eventually leave the business. Once you get it set up right, you probably won’t use an attorney for awhile.
You might need an attorney when you grow and decide to hire an employee. You might have some questions about that. If you decide to get a trademark to protect a brand name or product name. If you’re going to be utilizing independent contracts, you’ll want an agreement to make sure that you can defend they are an actually independent contract and not an employee and set forth the terms of the arrangement protecting your intellectual property. Making sure that anything prepared by the independent contractor is your intellectual property, not theres. The default rule is the intellectual property is owned by the independent contractor who creates it, not the company that hired them.
If you have questions feel free to give us a call. We typically go through all of this when we set up an LLC or Corporation for people. We typically spend an hour answering all of your questions and making sure your business gets off to a good start and is in compliance with the law. We try to have competitive rates. We charge $450 for any business type as long as there’s one owner. And there is also a state filing fee which right now happens to be $155. For more information, feel free to go to MinnesotaAttorney.com