Business Entities and Advantages to Having One

Welcome to Part 1 of the FIRE small business series.

You can see the Introduction and summary of what we are talking about here.  You should also read the disclaimer here:

***Disclaimer ***
This is written for educational purposes.  I am writing to explain my understanding of these principles.  Please, do your own research and talk to a licensed professional before putting this into practice.  The intent of this article is to aid in understanding, point you in the right direction, and to allow you to ask a licensed professional questions that may pertain to your individual situation.  If you see something wrong, please let me know with documentation, so that I can adjust and get all the information as correct as possible.
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Ok, the lawyering is out of the way… on to the fun stuff.

Basic Introduction To Legal Business Entities

There are several reasons why you would want to set up a small business.  Some examples include setting up a side hustle, creating a separate entity to own rental properties or trying to make the next Google or Apple.  What ever your reason, there are 3 main ways to structure your business according to the legal system:
  1. Sole Proprietor – This is very easy to set up.  Any income you make comes straight through to your 1040 income.  You can write your expenses off against this income.  You’ll also owe self employment tax on any profit from this.  But, the key here is that you personally are responsible for any liabilities.
  2. Limited Liability Company – Again the income passes directly to the ownership and you’ll owe self employment tax.  Unlike, the SP there is a legal difference between you and the entity, so the entity carries the liability.  Hence the name … Limited Liability.  One down side to this is: it’s a little difficult to divide up if you need to sell off shares for investing, fund raising, etc.  It can happen, but it’s not as clean.
  3. Corporation – This is what you see traded on the NYSE.  It’s all the big names that you know and love.  There are two versions of a Corporation: a C-Corp and an S-Corp.  A C-Corp which is what you know as a member of the S&P 500. It pays a separate corporate tax on the income of the corporation itself, then the owners pay tax again once they are paid. An S-Corp – which like the SP and LLC passes it’s income to the owners and it goes on the owners’ 1040.

While setting up a legal entity is a huge PITA (Pain In The Ass), it is worth having legal separation in the off chance you get sued.  They can only go after the assets of the company.  Your personal assets are not considered part of the company assets in LLC’s or Corporations.

In all these scenarios, you are subject to a variety of taxes.  Most of these should be fairly familiar to you, mainly your standard income tax.  In each of these situations, other than the C-Corp, the profit from the company becomes income to the owner and is therefore taxed as part of your personal AGI.  You’ll owe self employment tax based on the company income that is passed through to you.  You also may or may not be required to contribute quarterly estimated tax payments (think withholding, but since you don’t have a steady pay check, you don’t have the withholding).

You’ll need to go through a bunch of hoops to get one of these things set up.  I’m not going to go into all that here, but if you’re interested you can ask… or you can go here to start looking at all the legal processes, etc.

Wait… WTF Is Self Employment Tax?

Everyone owes tax for Social Security and tax for Medicare.  (12.4% & 2.9% respectively, at time of writing).  What maybe you don’t realize is that your employer typically pays half of it.  Thanks employers!

So, when you look on your pay stub and you see FICA tax, you only pay 7.65%, the other half is picked up by your employer.

Well… now since you own the company and you are the employer, guess what?  You owe both halves.

That additional half is what we lovingly refer to as Self Employment Tax.

Let’s look at a simple example:

Say we have a W-2 employee and we have a small business owner (any structure).  And let’s make these assumptions:

  • Making $100,000 a year.
  • 25% tax bracket (assume flat tax for simplicity, our graduated system works the same way, but this is easier to understand)
  • Payroll Tax (7.65% for W2 and 15.3% for small business owner)
  • You have expenses of $40,000 (Non-deductible for W-2 and deductible for business)

So what happens?

W-2 Employee:

  1. You take your 25% tax off the Gross Wages ($100,000 * 25%= $25,000).
  2. You take the employee portion of the payroll tax off the top (7.65% * $100,000= $7, 650).
  3. You’re left with $67,350 as your take home pay. ($100,000 – $25,000- $7,650= $67,350)
  4. Then you pay your expenses and you are left with $27,350.  ($67,350 – $40,000 = $27,350)

Small Business Owner:

  1. You take your expenses off the top to get company profit ($100,000 – $40,000= $60,000)
  2. You pay your income tax on the profit of the company ($60,000 * 25% = $15,000)
  3. You pay your self-employment tax on your profit (15.3% * $60,000 = $9,180)
  4. Then you have your take home left at $35,820. ($60,000 – $15,000 – $9,180 = $35,820)

Simply by opening a business and pushing all your expenses against it you’ve upped your take home pay by about 30% ( $35,820 – $27,350 = $8,470  –>  $8,470/$27,350 ~ 30%).

Wow!  That makes quite a difference.

Got it?  Ok, let’s look at more real numbers:

There is some nuance to every single situation.  The graduated tax rates also add some complexity.  Let’s look at our 100% deductible $40,000 expenses against different income levels:

W2 vs SE Tax Brackets & Take Home difference

If you have a small business, you can actually take home quite a bit more money.   It really narrows down during the transition away from the FICA taxes.  You’ll also notice that your tax rates increase faster through a corporation, because of the self-employment tax.

What else you can see is that as you can push more of your expenses against the company, the more advantageous it gets.  Look at the difference it can make given our default numbers:

Take Home Pay Difference by % Deductible Expenses

If you don’t have any expenses to put against your company, there’s no advantage.  It’s actually more expensive since you have that self-employment tax. But, you can find something, your company can pay your phone bill, cable/internet bill, gas, travel, even part of your rent!

This can get really interesting if your company takes a loss (has more expenses than income).  Because, that loss will also pass-through to your personal income and actually reduce the total AGI of your household.

Be careful with this!  Make sure you talk to a tax professional about what is considered acceptable business expenses. Also, you can’t just always run a business at a loss to get tax breaks.  But, you can see that there are considerable benefits to going through the hassle of setting up the company.

Great, so what do we have?

We have an S-Corp for a couple of different reasons.  The main one being: Due to the nature of the business, we were not allowed by CA state law to be an LLC.

While it’s a little more complicated than an LLC, being an S-Corp has some benefits.  It’s easier to take on investors if we need to in the future and we can get around some of the pay roll taxes**.  That and, we are required to have a nice dinner on the company every year as a board meeting :).

Until next time…

This is a super simple example of how getting your revenue through a business entity can save you quite a bit on your taxes.  That’s all fine and good.  But my guess is that my fellow FIRE folks are more interested in how you can use this in conjunction with retirement accounts to accelerate your savings even more.

Tune in next time where I talk about the various small business retirement plans.

** In the process of writing this the Government decided to pass a huge tax reform bill.  This whole mess doesn’t really apply here since this is assumed to be paid out as wages.  We’ll explore pass-through income (draws) in a later post.  Also, LLC’s can file as S-Corps for tax purposes.**

19 Comments

  • Gwen @ Fiery Millennials January 24, 2018 at 4:56 am

    Excellent work, as always. I will re-read this when I’m awake and can process the information efficiently! Can’t wait for the next part in the series!
    Gwen @ Fiery Millennials recently posted…200k at 27

    Reply
    • Mr WoW January 24, 2018 at 5:46 am

      Great! Hopefully it’s helpful! Makes you think huh?

      Reply
  • Dads Dollars debts January 24, 2018 at 5:20 am

    Good recap. I run my business as a sole proprietorship. I wanted to do an LLC but there is a $800 annual fee in California making this a less attractive option.

    Reply
    • Mr WoW January 24, 2018 at 5:45 am

      Yeah that sucks a bit but with the type of business we have we need to have the liability protection. So it’s well worth it.

      Reply
    • Mrs. Groovy January 24, 2018 at 7:01 am

      And I thought NC was expensive at $200/year. You know you can form this in another state right? Delaware, MD, LV are mentioned as being some of the best states for an LLC. The nonprofit I worked for in NY was incorporated in DE.

      Many people say doing an LLC is easy but I think if we form one, I at least want to talk with a lawyer or an accountant. Since we have the Talking Trash vlog and want to sell an e-book, I want to make sure everything is under the LLC umbrella.

      Looking forward to the rest of the series Mr. WoW!
      Mrs. Groovy recently posted…Geoarbitrage Is a Great Way to Reinvent Yourself

      Reply
      • Mr WoW January 24, 2018 at 7:06 am

        California is crazy. That $800 is just for operating in CA. Doesn’t matter if you’re incorporated there or not.

        Reply
      • Mr WoW January 24, 2018 at 3:19 pm

        Also, yes you can roll everything under one. There’s nothing that says you can’t diversify your business. We run everything through ours, Mrs Wow’s business, any tech consulting I do and this blog actually. Its more a matter of book keeping.

        Reply
      • Mr WoW January 24, 2018 at 3:24 pm

        People incorporate in Delaware since it’s super business friendly with laws, etc. https://technical.ly/delaware/2014/09/23/why-delaware-incorporation/

        For us there was no reason to since it’s a super small, and we’re not doing anything in that regard.

        Reply
  • David January 24, 2018 at 7:39 am

    This series is off to a great start! Thanks for writing and looking forward to learning more!

    Reply
    • Mr WoW January 24, 2018 at 3:20 pm

      Yeah of course. Thanks. Hopefully you find it useful!

      Reply
  • Accidental FIRE January 24, 2018 at 4:00 pm

    This is great man… it’s nice to see the hypothetical numbers with the math laid out. Looking forward to your take on the pass-through income and implications with the new law.
    Accidental FIRE recently posted…Stop Being So Cheap

    Reply
    • Mr WoW January 25, 2018 at 5:36 am

      Glad to hear it. It hopefully all be helpful. Certainly was interesting to try to write. Had to read all the new stuff.

      Reply
  • FIRECracker January 27, 2018 at 6:55 am

    Great stuff! I’m bookmarking all this great content if/when we need it later to set up a business.
    FIRECracker recently posted…Friday Reader Case: Would You Rather Have One Million in Debt or One Million in Assets?

    Reply
    • Mr WoW January 27, 2018 at 9:11 am

      Well, I hope it’s helpful. I know it’s only really US stuff, but you know. Same principles.

      Reply
  • Mr. Tako January 29, 2018 at 9:17 am

    Great post Mr. Wow. I’ve been avoiding setting up an LLC for the past year because of the fairly large setup fee. But at some point I’ll need to roll one.

    Thanks for writing this!
    Mr. Tako recently posted…Going Completely To Cash

    Reply
    • Mr WoW January 29, 2018 at 4:17 pm

      The process is pretty easy. Yeah there are some fees but if you don’t need it to be super bullet proof you can just go through legal zoom. I went through an attorney with ours because of the nature of the business.

      Reply
  • Eric February 22, 2018 at 12:41 pm

    Thanks so much for this! One of the most helpful articles I’ve read in a while!

    My wife is a pediatric OT and recently started her own business! She has a sole proprietorship and took out insurance. She pays under $100 annually for a $4 million insurance policy. Do you think that is an appropriate strategy? I saw you mentioned: “the key here is that you personally are responsible for any liabilities.”

    Reply
    • Mr WoW February 22, 2018 at 4:16 pm

      So, I’m not sure about the insurance policy, and quite frankly insurance is my arch enemy.

      I’m also not an attorney, so I’d definitely run it by one of those in your state.

      If I were to guess, should you get sued and the settlement goes above the limit of the policy, or the insurance finds a way to not pay (which I wouldn’t put past them) you are personally liable for that overage given a sole proprietorship.

      With an LLC or a Corp, only the company is liable, you are not personally, so your personal assets are protected. Granted you maintain your corporate duties, board meetings and the like.

      So, I guess it’s a matter of risk tolerance and the complexity of setting up the entity in your state. There are also considerable advantages for taxes on a corporation/llc versus a sole proprietor.

      I would imagine given this you can’t just run around with no insurance commiting malpractice everywhere going “I’m a company, can’t touch me”. I’m guessing you have to be a reasonable person, or “not a shithead” as we like to say around here.

      Reply

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