One of the first things you need to do when you start your business is to choose a legal entity. But it can be confusing. S-corp, LLC, sole proprietor, how do you choose?
When I was first thinking about how to start a consulting business, I read a lot about the differences between different business entities. However, all the details and technicalities were overwhelming, and my indecision stopped me from actually doing anything. Another problem I ran into was that I had it stuck in my mind that starting a business was something that other people did–not me. I thought that it was unrealistic as well as complicated to start a business. As a result, I wasted time in “analysis paralysis”: researching and reading without taking any action.
Then, my wife wisely suggested that I meet with the CPA at the company where she worked, since he had a fair amount of experience with small companies, and also did taxes for small businesses and entrepreneurs. I took him to lunch, outlined what I was thinking about doing, while at the same time inwardly thinking that I’d get laughed at for being unrealistic. But he was great. He validated my consulting business idea, as well as what I’d already read about legal entities, and gave me advice that was invaluable.
So what route did I go? I’ll go into the details in a bit. But first:
How much does it cost to create a business entity?
Glad you asked!
The cost varies from state to state, and will depend on the legal entity (corporation, LLC, etc.) that you choose. However, don’t get fooled into thinking that you have to pay thousands of dollars to create your legal entity. Technically, I suppose if you had a pile of cash laying around and wanted to do such a thing, you could pay an attorney or company to create the legal entity for you.
But we’re bootstrapping here, doing things on the cheap.
Truth is, you can create a business entity for your consulting business for a small fraction of what an attorney or other online service might charge. You could either research the filing requirements for your state yourself (which is the way I did it), or you could use one of the following reputable legal services providers to walk you through the process:
Does a legal entity protect me from liability?
Sometimes, but it’s always best to also have liability insurance for your business as well. Your business entity–such as a corporation or LLC–can provide protection of your personal (non-business) assets, but your business assets can be protected through liability insurance that you’d purchase for your company. When you become a consultant, make sure you protect yourself.
How do I choose between the different business entities?
This was one of the things I struggled with when I became a consultant. There’s a lot of info available, and it can be tough to figure out which is the best for your situation.
A great article outlining each business entity type, their pros & cons, and situations where each makes the most sense can be found at QuickSprout (it was originally linked from an article on the Inc. Magazine website).
And, of course, you should go take a look at the IRS’s website for their info on business entities.
In the end, I chose to form an S-corp when I started my consulting business. By the time I talked to my CPA friend, I had already narrowed down my choices to either an LLC or an S-corp. However, the main factor that tipped the scales for me deciding to go the S-corp route was that with an S-corp, I was able to make myself an employee (although I sometimes subcontract to others, I have no plans for hiring employees). As an employee:
- I can pay myself a salary,
- reduce the self-employment taxes that I pay compared to being a sole proprietor,
- can have my corporation contribute to a SEP-IRA retirement account for me,
- and have my corporation pay 100% of my family’s health insurance premiums (which, for a family of 4 is like a small mortgage payment every month).
- In addition, the employer-paid social security and Medicare taxes, the SEP-IRA contributions, and the health insurance premiums are all business expenses which lower the net income for the corporation. Why do I care about this? Because the less net income from my consulting business, the less taxes I’ll have to pay.
Things may have changed since I formed my S-corp, and LLC’s may offer those same advantages. In any case, for me, I think that an S-corp has been a good choice.
One last caveat: I’m neither an attorney nor an accountant, so any legal or accounting advice I give is based on my own experience; you should seek the advice of a competent attorney and/or accountant for your situation.