You’re probably here because tons of people are talking about S-Corps and why it’s a good idea for business owners to move to that tax structure. In truth, they’ve gained traction following the pandemic, especially when everyone was after the PPP loans. However, before you go full-steam ahead on switching to a S-Corp entity, it’s important to understand the implications for your business.
After all, understanding the nuts and bolts of your entity structure isn’t just for your accounting team. It can seriously shape how you grow, evolve, and even sell your business one day, if that’s your goal. And yes, it’s about the bottom line, too!
Understanding S-Corps, C-Corps, Partnerships, and Sole Proprietorships
These are the four most common entity types, so we’re running through them so you have a sense of which might be best for your business.
An S-Corp, or S Corporation, is designed to let income, deductions, and other tax items pass directly to the shareholders, whether there is just one or multiple. Because it reduces individual risk and liability, it’s appealing for small businesses.
While you can absolutely change your entity structure down the road, this can often come with headaches and an elaborate dance with the IRS. With that in mind, it’s important to understand some of the requirements and challenges of S-Corps.
Reasonable Compensation Rule
While it sounds like legalese, it basically means that if you run an S-Corp and actively contribute to it, you need to pay yourself a “reasonable” salary. But “reasonable” is subjective and generally is the amount you would pay someone else to perform your job so it should be both fair and what keeps the tax man happy.
The Selling Challenge
If your goal is to sell your company one day, know that S-Corps come with certain restrictions that might add complications when the time comes to sell. As a result, many S-Corps shift to C-Corps when they’re ready to sell the company.
Every major decision in an S-Corp requires unanimous agreement. If you’re a team of one or two, this might not be a big deal. The more members, the more people you need to get on the same page. While it ensures that all voices are heard, it can also mean longer decision-making times and potential deadlocks.
Simply put, C-Corps are legal entities that are separate from their owners, and it’s a more traditional corporate structure. It’s great for businesses that plan to raise capital or expand on a larger scale.
Like S-Corps, owners are protected from personal liability. C-Corps can also exist if owners—shareholders—change, and can benefit from different tax advantages. However, they’re more complex to set up and require extensive operational processes and documentation with more stringent regulatory oversight. While this shouldn’t stop you from choosing a C-Corp entity if it’s best for your business, it’s worth mentioning.
Running an C-Corp means that stakeholders that work in the business are paid as W2 employees via payroll.
Because the C-Corp is taxed as a separate entity, the stockholders must pay personal income tax on W2 wages and dividends paid from the company profits
Many of our clients, including cannabis businesses, find that C-Corps are ideal structures based on their needs and goals.
Just as the name suggests, partnerships mean shared ownership between two or more people, who share ownership, responsibilities, profits, and losses—though not necessarily equally. These are frequently popular with multiple stakeholders because you can set up custom terms with regard to who gets different shares of profits.
A partnership, may have employees that are paid via payroll, but the partners are paid by distributions of the business profits. They are not paid W2 wages
Unlike S-Corps, it’s often easier to sell a partnership or add partners to the list.
Sole proprietorships, on the other hand, are usually the simplest entity structures. One person operates a business without formal organization and often under their own name.
A Sole Proprietor may have employees that are paid via payroll, but the owner is paid via draws from the business profits. They are not paid W2 wages
Because they’re easy to set up, often requiring just a business license (though this varies by state and type of business), sole proprietorships are a popular choice for small-scale ventures, freelancers, and those testing a business idea.
With only one person, the owner has total control over all decisions, and they report income and losses on personal tax returns.
On the other hand, the owner is personally responsible for all debts and liabilities and it can be difficult to obtain business funding. As a result, as businesses grow, many shift to a more formal entity structure.
Different Entity Types May Require a Mindset Shift
Where sole proprietorships may see their business as an extension of themselves—and, in turn, their personal finances, moving to a more formal entity type is more than a few legal documents and a logo or business card.
You must also think of the business as a separate entity from a financial standpoint, keeping all record keeping and spending separate from your personal finances. That means you must also spend wisely with the best interests of your company in mind. Sure you can splurge on a new computer, desk, or high-end coffee maker. But you need to keep personal spending separate.
Deciding on the Right Model
The best business model and entity type for you depends on your unique situation. This is something we frequently help clients with. So if you’re looking at setting up a new business or changing your entity structure, set up a call with us, we’d love to help you set up your business and finances for success the first time.
The first time?
You might be surprised at some of the weird stuff people do when left to their own devices, no matter how savvy they are in business. Whether that means buying major upgrades for their home or all of their groceries and clothes on the business account, or something else, if you find yourself in a place where you have some of that “weird stuff” to untangle, know this—you’re in good company. We help all the time with this. However, we’d like to help you avoid any of the headaches we can by starting you off on the right foot and give you advice for best practices.
Know When to Bring In Professionals
Accountants, lawyers, business consultants, and tax preppers aren’t just for big corporations. These experts can offer tailored advice based on your business and industry because they understand the various factors and variables.
Whatever business entity you choose, know that it has the power to shift the trajectory of your business. Automated Accounting Services would love to help you choose the right one so you can set yourself up for the success and growth you want. Contact us today to get started.