The important fact is to decide on a business structure that is going to meet your near current needs as well as your future needs at the lowest possible costs to you and the least amount of personal liability to you. Since I reside in Washington State and understand the ins and outs, I would always recommend starting a Limited Liability Company if you are out to make money and are starting out on a tight budget to gets the doors open for business.
Here is why, the initial expenses are more costly, but the benefits of protecting your personal assets from legal claims far outweighs the initial costs.
The Internal Revenue Service (IRS) allows you to make an election of how you desire your new business to be taxed. The election is first made when you apply for your Employers Identification Number (EIN). You can select to be taxed as a “Sole Proprietor” also referenced as a Disregarded Entity. You can choose to be taxed as either a “Partnership”, S-Corp, or C-Corp. Why is the selection critical? It depends on your circumstance and the State you are located. Is it just you and you are the only owner? Are you married? Do you reside in a mutual property State? Are there any other people that own a percentage of the company that is not your wife or reside in a state that does not consider mutual property between husband and wife. If you reside in Washington State and are the only owner and expect to remain that way for some time, or you are married, I would strongly recommend selecting the Sole Proprietor option also known as Disregarded Entity.
Why the strong recommendations you may ask? Because a Partnership, S-Corporation or C-Corporation is going to cost you way more in tax preparation services and or payroll services then you truly need. Single Owner or Married Owners who have selected to be taxed as a Sole Proprietor (Disregarded Entity) can pay themselves without payroll. They only need to have tax preparation services for they individual Federal 1040. In mutual property states such as Washington, the IRS has regulations to allocate year end self-employment taxes between spousal owners based on the operating agreements percentages of ownership or what could be considered participation levels of labor. Why the operating agreement is always at least recommended if not required by law. As you can see without an operating agreement that would break out the percentages of ownership between spouses, you would be liable if you were ever audited by the government. There simply is no legal document that justifies the allocations or how self-employment taxes are to be distributed.
As the company grows, there will become a time to consider when to change the tax elections from Sole Proprietor or Disregarded Entity with the IRS to usually a S-Corporation. When and why change the tax election, When the cost of running payroll, cost of tax preparation services for a business or partnership returns and your individual Federal 1040 return become less than your combined total self-employment taxes you pay. The remainder of any excess profits can be distributed out not as pay, but similar to dividends with preferential tax treatment or much lower tax rate in regards to your personal reportable income.
Author: Fred Pugaczewski, BC&FS