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Small business owners often struggle with the decision regarding which entity form to use for their business activities. Some don’t create any separate business entities others engage in constructing complex corporations. In this paper we will review a specific case in point for a Massachusetts based small business owner who is making about $180K in revenue, has $60K in expenses and produces $120K profit from this business activity. We will compare how different business structures will affect administration costs and tax liabilities.

In general the decision regarding business structure will affect multiple aspects of the business including but not limiting to operations and administration, personal liability and risk, legal protection and taxes, ability to raise capital. The ideas expressed below cannot substitute a tailored tax plan based on specific circumstances and situation of the client. For a comprehensive review of your business please contact us through our contact form.

Hobby: The easiest business activity structure is hobby. It doesn’t require you to register your business with the state. There are no annual filings or specific administration requirement either. When filing your personal taxes we will need to report the business revenue on line 21 of form 1040. After the recent changes under the Tax Cuts and Jobs Act of 2017 we can no longer deduct the expenses for our hobbies. This means we will need to report the full 180K in revenue as income. Below is a short illustration what this will mean for federal income tax for a married couple relying solely on this income.

 

 

 

 

 

 

 

The tax liability in this scenario will be $26,199 for the IRS and 8,731 for the state of MA giving the owner $85K in net cash inflow.

Sole Proprietorship (DBA): The second level of business organization is sole proprietorship. It can have the name of its owner or a DBA giving another identity to the business. Most towns and states will require a business certificate issued by secretary of state or local government. You should expect to pay probably about $50 to register and you need to renew it every 4 years. The biggest advantage is that all business related expenses can be deducted when calculating tax liabilities. The illustration below will be different from the first one we did because we will have less income to report and we can include the 50 dollars license fees into the deductible expenses of the company.

With the DBA or sole proprietorship we can deduct expenses before calculating tax. However we will need to calculate and pay the self-employment tax. These are the Social Security and Medicare contributions. These contributions will be counted towards our government pensions when we retire. So they are not lost forever. In general it is a better structure to have, the total cash inflow is larger by about 4K and we are also contributing towards Social Security and Medicare benefits for our retirement.

The next level of business organization is a limited liability company. This stricture is governed on the state level by the secretary of state. The LLC structure creates a new entity form that is separate from its owner. This allows the owner to separate his personal assets from the business assets and create more flexibility when working with creditors and investors. It also creates a layer of protection to the personal assets of its owner. The annual fee to the state is $500 per year but if filing online there is an additional 20 dollars convenience fee. Tax filings will not be any different from the DBA scenario. The benefit of the LLC is really the additional protection created through separating the business activity from personal assets so in event of a lawsuit personal assets are protected. Illustration below is integrating the higher cost to the state for the LLC registration.

The difference in the net cash inflow is immaterial. Given the benefit of limited liability this structure is much more beneficial to the owner and at the same time the net money effect is about 300 dollars.

The last business form we will discuss here is the S-Corporation. It is the most advanced and requires the most administration in order to stay in full legal and tax compliance. S-Corporations are pass through entities so we pay only personal taxes with them by transferring our profit from the corporation into the personal 1040 filing. Corporations should register with the state they operate in and file Articles of Organization. The registration fee is $265 and then the annual renewal fee is $109. Internally the corporation should keep corporate bylaws and shareholder meeting minutes for each meeting. Also Massachusetts has a minimum tax for corporations which is $456.

Having an S-Corporation we should not forget that we need to run payroll for even the owners. So we will include a fee for the payroll service, payroll tax paid by the employer and payroll tax paid by the owner/employee getting the salary.

The S-Corporation for people within this income range looks the best option of them all. The after tax net cash inflow is almost 10K higher than the previous scenarios.

If you’d like to see how much money and/or efforts you can save managing your business finances, feel free to give us a call at (617) 515-6163 for a free 15-minute consultation!