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Choosing a business entity structure for your webdev company is just as difficult as it is confusing. Unless you’re a tax expert, the difference between each business type can be difficult to understand, but your choices narrow down significantly if you’re a solo startup owner.
Sole Proprietorship vs. LLC (Limited Liability Company)
Sole proprietorships are the least expensive and simplest business structure to run because you don’t have to incorporate to form one. As long as you’re an individual who operates a business, you’re automatically a sole proprietor and must declare self-employment taxes.
While sole proprietorships are straightforward, they provide no protection between the business and business owner, which makes the owner personally responsible for the business’s debts.
On the other hand, an LLC (limited liability company) separates your business debts, meaning if you go bankrupt, your personal credit isn’t affected. While forming an LLC is expensive and comes with paperwork, you’ll benefit from more flexibility and, usually, a lower tax rate.
Why Sole Proprietors Should Incorporate to Pay Themselves
Since sole proprietors are taxed (income and self-employment) regardless of how much they earn, there are several benefits to incorporating when choosing to pay yourself.
Owner’s Draws (Single-Member LLCs)
Single-member LLCs are taxed similarly to sole proprietors, meaning you pay income taxes regardless of how much you draw. As a single-member LLC, you can withdraw as much as you want, but you’ll want to keep some money held up in your business for tax purposes.
The IRS won’t charge self-employment taxes until you make an “Owner’s Draw.” An Owner’s Draw requires you to write yourself a check from your business account to “pay yourself.
Sole proprietors and LLC owners can use a paystub creator to pay themselves, but there are other uses for creating your own paychecks. For example, you could use pay stubs as proof of income, as a way to track your expenses, and as a pseudo-invoice when you’re starting out.
Owner’s Draws (Multi-Member LLCs)
Multi-member LLCs are treated as partnerships by default, regardless of whether they have employees or not. Instead of paying the whole income tax amount, like in a single-member LLC, multi-member LLCs can separate their tax burden based on the number of partners in the agreement.
For example, if you have 4 partners, you may only pay 25% of the income tax burden. Plus, you won’t need to pay income tax again when you withdraw your income via an Owner’s Draw. However, you will still need to pay self-employment taxes whenever you make a draw.
Pass-Through Tax Status (S/C-Corporations)
Shareholders (LLC members) in an S or C corporation can pay in dividends or as a salary because they’re considered “employees.” If the owner pays themselves with dividends, they are taxed at a lower rate. Dividends are also exempt from income taxes on earnings.
However, S and C Corp owners can’t only pay themselves in dividends, or the IRS is likely to audit you. You’ll have to pay yourself a salary (with payroll taxes and income taxes automatically withheld) before taking an extra percentage of the corporation’s income as dividends.
Corporate Tax Status (C-Corporations)
LLCs have the option to be taxed as a C-corporation, which pays corporate income taxes at the federal level. Corporate income taxes are taxed at a lower rate than personal income taxes. Plus, as a C-Corp, you can pay yourself in dividends, lowering your tax burden further.
However, C-corporations are taxed twice. The IRS charges all C-corps income tax, meaning everyone who earns a salary and dividends from your corporation pays personal income tax on their earnings. Still, it’s doubtful you’ll pay more in taxes than a sole proprietor.
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