SHOULD YOU BE A SOLE PROP, LLC, OR S CORP?
Most of this blog post comes from the book Unf*ck Your Biz.
BEFORE YOU READ THIS…
I highly recommend you checkout our other blog all about legal basics where I discuss how an LLC legally protects you in business. To quickly recap:
Sole props and general partnerships are the “default entities” and provide no liability protection.
LLCs are the most popular option to get liability protection as they’re easier to form an manage than corporations.
S Corps are a type of tax status, not an actual entity. You form an LLC and then elect for it to be taxed as an S Corp if/when it makes sense.
The rest of this post will focus more on (1) the tax side of things and (2) how to actually form the entities.
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Read the post on legal basics so you have a better idea of the legal reasons behind different entities..
BUSINESS ENTITY TAX
Get this. I have a master’s degree in tax law. It still took me a few years to really understand the nuances of the buzzwords we’re about to cover. That’s because I’d never really found a source that thoroughly explained them. So I’m writing about it in this book. The terms disregarded entity and pass-through entity are often used interchangeably and incorrectly.
Honestly, you’ll be A-okay if you don’t understand these terms, but how cool would it be if you totally get it!? So stick with me, friend. You’re doing great and you got this.
A disregarded entity is an entity that is not recognized for tax purposes and therefore (for tax purposes) is not separate from its owner. Sole props and single-member LLCs are disregarded entities.
To explain this a different way, disregarded entities are a function of state laws. You form an LLC under the laws of your state. They have nothing to do with IRS laws and regulations. So the IRS disregards them.
You know that Mariah Carey “I don’t know her” GIF that’s now used as one of the ultimate forms of shade? When asked about Jennifer Lopez back in the early 2000s, Mariah simply responded, “I don’t know her.”
First of all, sure, Jan. But second, I’m kind of here for it. Was it petty? Was it her honest reaction? Who knows. The IRS, while way less fun and dramatic, is basically the same. You form an LLC, and the IRS is like, “I don’t know her. They’re disregarding your LLC.
Let’s think about our tax forms. Here’s the best technical description I have for disregarded entities: If an entity is disregarded, the income and expenses go straight onto the owner’s tax return (on a Schedule C). If an entity is not disregarded, the business must first file its own return. From there, the method of tax on the owners is determined by whether the entity is a “pass-through.”
Let’s contrast the sole proprietorship with a single-member S corporation. Your personal tax return binder is due on April 15th each year. The Schedule C is one of the forms due with that return. S corps have their own, separate return, and C corps have a separate one as well. Those tax return are due on March 15th each year. They’re entirely separate from the personal return since they’re not disregarded. This leads up to understanding the difference between a disregarded entity and a pass-through entity.
PASS-THROUGH ENTITIES
In a pass-through entity, the profit of the business passes through the business entity and to the owner(s). All disregarded entities are pass-throughs since the profit goes directly onto the personal tax return. But not all pass-throughs are disregarded. It’s like the square and rectangle thing.
From there, the question is: Which other entities pass profit directly to the owner? The answer: S corp, partnerships, and multi-member LLCs. Here’s how that works.
First, the business files its own tax return (because it's not a disregarded entity). A partnership would file a form 1065 and an S corp an 1120s. Those forms report income, expenses, and profit of the business. In order for the profit to pass through to the owners, the business files K-1s along with the business returns. (A K-1 is comparable to a W-2 or a 1099. It’s a tax form that shows a taxpayer’s receipt of income.)
The owners input the info from the K-1 onto their personal tax return. This is how they’re taxed for the profits of the business. When a pass-through files their initial return (the 1065 or the 1120s), it’s for informational purposes. The business doesn’t pay the taxes. The owners do once the income passes through.
S corps and partnerships file their returns on March 15th each year. In the binder/tax return, they complete and include their K-1s. They also send copies of those K-1s to the individual owner, who then reports and includes them in their personal tax return. The K-1s are the tool that passes through the income from the business to the owners.
Let’s look at an example. Lucy and Ethel are business partners in a multi-member LLC, a disregarded entity. They’re budding chocolatiers. The business makes $100,000 and has $40,000 in expenses. They file an IRS Form 1065 showing the income and expenses.
Along with the 1065, they also file two K-1s. Lucy and Ethel each show they are 50/50 partners, and that their shares from the partnership are $50,000 in income and $20,000 in expenses for a profit of $30,000.
Lucy and Ethel take the K-1s and input them on their personal tax returns, which effectively adds $30,000 of income to whatever other income they might have.
SALARIES AND S CORPORATIONS
Owners of S corps take salaries via payroll. Assume you have an S corp that earns $100,000. You have expenses of $10,000, and you pay yourself a $60,000 salary.
The salary goes through payroll. Your payroll provider issues you a W-2 to report your $60,000 salary on your tax return.
At tax time, you file your 1120s and K-1 showing $100,000 in gross revenue. On these forms, your salary will appear as an expense. Thus expenses are $70,000, and profit is $30,000. That $30,000 passes through the business to your return via the K-1.
So you can see that you’re still reporting all the business’s net income (before salary) on your personal return in some manner. The business truly made $90,000, as that was your personal financial gain. Remember we call that owner profit. That’s what makes an S corp a pass-through. All of the business’s net income before salary is reflected on the owner’s tax return.
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ALL ABOUT S CORPORATIONS (S CORPS)
At some point, most of us are told about the magical S corporation. It’s like the unicorn of business entities. It’s unique and mysterious. Everyone thinks it’s super cool, but how do you really know? This section breaks down the intricacies of S corps, debunks some myths, and provides an actionable way to determine if S corps are worth looking into further. To start, we need to discuss some basics.
WHAT IS AN S CORP?
Repeat after me: An S corp is not a type of entity. Did you repeat it? Let’s try one more time. An S corp is not a type of entity. You may be thinking, The fuck, Braden? You just listed S corps under the different types of entities like a billion times in the last section.
And you’re right: I did, but I’ll explain. Entities are formed with the state. Remember that sole props and partnerships are our defaults, so they don’t require forms to file. Formal entities do. You file articles of incorporation with the state to form either an LLC or a corp (or one of those other less-common entities).
After forming an LLC or a C corp, you make an election for your LLC or C corp to be taxed under special regulations provided by subchapter s of our tax code. Once you do that, you’re operating under what we call an S corp. I know. It’s quite bizarre.
This is why we call an S corporation a tax status or designation rather than a type of entity. I almost always recommend forming an LLC and, when the time is right, electing for that LLC to be taxed as an S corp. This allows you to obtain an LLC sooner rather than later for the liability protection. When you’re ready, you can form an S corp.
I really dislike the name S corp because it really implies that you have a corporation, which is confusing. I’d prefer that we call them S LLCs when “S status” is elected on the LLC, but—alas—we must pick and choose our battles. Instead, I’m here to tell you why the name sucks as we continue to roll with it.
For now, I want you to really cement the concept that when I or anyone else uses the phrase form an S corp, we really mean elect S corp tax status. I call your initial entity—the one you form before electing S corp status—your underlying entity. I already explained why I typically like LLCs as underlying entities. Due to issues of double taxation, you wouldn’t want to form a C corp as the underlying entity unless you’re ready to make the S election at the same time. I also find C corps a bit more difficult to form and manage. I’m not a fan.
SALARY VERSUS DISTRIBUTIONS
The first step to understanding S corps is to realize you will start to pay yourself differently. As a sole proprietor, you can really do whatever you like when you get paid by clients.
When you form an S corp, you’re effectively making yourself the sole shareholder and sole officer (employee) in your business. Think about it this way. You can own stock in a corporation and receive dividends as a shareholder. You could also be an employee of a corporation and receive a salary and paychecks from the business. You could also be an employee who owns stock in the company and who receives dividends and a salary. This last scenario is what happens in an S corp except that, if you are a solopreneur, you are the only shareholder and likely the only employee.
Once you form the S corp, you become an employee of the business and pay yourself a monthly salary in exchange for the services you perform for the business. You may then pay yourself a distribution as the sole shareholder.
Salary is your compensation for working in the business. Distributions are your reward for being the owner of the business.
Only the salary is subject to self-employment tax. Remember our super fun 15.3% self-employment tax? (I explain that in this blog post) This is how the S corp saves tax dollars. A sole proprietor pays this percentage on top of normal income taxes. In an S corp, the distribution portion is not subject to this tax.
Sounds awesome, right!? Real quick, let’s do a conceptual understanding check-in. Ask yourself what the trick is to saving taxes in an S corp. Assume you’re profiting $100,000 in your business. You decide to pay yourself salary payments every other week and profit distributions once per quarter. In order to save taxes, do you want higher salary payments or higher profit? Profit, right? Because you don’t pay self-employment taxes on the profit. But can you pay yourself a $0 salary? Nope.
Many new business owners get super excited when they learn how the S corp works and are ready to pay themselves a low salary to save taxes on the high distributions. Obviously, the IRS wants to prevent that, so the salary must be “reasonable.”
REASONABLE SALARY
Initially, the process of determining a salary for yourself seems super arbitrary. After all, if we’re the only one running our business, all the money we bring in is our own money. This is the part where we have to realize that our business is its own being. We perform work for our business, which needs to be compensated at a reasonable rate. Our business brings in its own money via things like reputation, good will, and the like.
Once you have determined that an S corp is the right way to go, you must determine what your salary will be. You can determine your “reasonable salary” by looking at the market rate of pay to someone providing your services, in your geographic area, with your level of expertise. Alternatively, consider how much you would have to pay someone else to do what you do. What would be a reasonable amount of pay to find someone qualified to fill your role?
The importance of this is that S corps are subject to fraud and abuse, so the IRS may look at the salary through a critical lens. Taking time to research and document your salary can help prevent some risk.
THE “MANY HATS” APPROACH
An alternative, and often better, approach for small business owners in determining reasonable salary is the “many hats” approach. As a solopreneur, you wear all the hats. Maybe you start your day as a secretary doing your own calendaring and email management. Then you put on your social media manager hat before you step into what you’d consider your core role. Think of your time spent in terms of a pie chart. Each slice is a different hat and is sized according to your time spent wearing that hat. The many hats approach allows us to consider time spent on these various tasks. I write about this more in the S Corp Bonus Guide in Unf*ck Your Biz.
How many slices are there? And what would a reasonable salary be for each of those different roles? This is what the many hats approach considers. You can balance and weigh your time spent in each area to come up with a reasonable salary based on your actual tasks rather than just what you’d earn as a tax attorney, interior designer, photographer, life coach, or whatever your industry is.
A CAUTIONARY TALE
When I first began assisting with business formations, S corps always made me a bit nervous. It almost felt like cheating—and you can so easily cheat by underestimating reasonable salary. It’s kind of like hiking up a mountain when there’s prize money waiting at the top for you. It’s a race, except you’ve gotta carry supplies up with you. So you grab a few things and rush to the top. The judge is there and says, “Well you won, but I don’t think you carried enough.”
Be wary of anyone who tells you that you can mountain climb without many supplies. In other words, be cautious of anyone who suggests you can make your salary super low. Some tax and legal pros are very conservative and will give you high estimations of reasonable salary. Others—and I have seen this often—say that $20,000 is fine for just about everyone. It’s not.
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I want to wrap up this section by telling you how reasonable salary makes sense to me. This will help you wrap your head around it a bit more. Generally, companies pay salary as compensation for services.
If you work for another company, they should pay you a salary based on your time and effort in addition to your geographical location, expertise, experience, and skill. Makes sense, right? You begin all your duties and receive your salary. Now, let’s say that you, along with all your coworkers, make some smart and strategic decisions in the company. The company sees record growth and decides to pay everyone a $10,000 stockholder distribution.
Did you work harder that year? Maybe you did; maybe you didn’t. Maybe you and all your coworkers are the embodiment of “work smarter, not harder.” Your salary is the compensation for your labor and expertise. The distribution is your reward for the company’s success.
Self-employment tax is only levied on the salary. Our tax code subjects only our earned income to Medicare and social security taxes. Earned income is income we have earned through our labor. Stockholder distributions are not earned income. They’re more like passive income or rewards.
S corps allow small business owners to treat themselves and their own companies the same way you were treated in that hypothetical. It only makes sense. If the fair market value of Simone’s labor and expertise is $70,000 when she works for Gymnastics Inc., it should be the same if she then starts her own business doing the same work. In both roles, compensation paid through dividends is a sign of company health and is taxed in the same manner, sans Medicare and social security contributions.
PAYROLL: WHAT IS IT AND WHEN DO YOU NEED IT?
As an officer of the S corp taking a salary, your business is now subject to the same rules as any other corporation with employees. You must not only pay taxes, but you must also have tax withholdings. Think about the last time you had an employer from which you got regular paychecks from a payroll company. They usually have all those perforated edges and look more legit than a handwritten check. Those checks have line items for federal and state taxes withheld from the amount paid to you. Once you have an S corp, you’re obligated to withhold taxes like those checks did.
You could handle these tax withholdings on your own, but the calculations for withholding are complex, and the penalties are a huge pain. Instead, pay a monthly fee for payroll services. The payroll service connects to your business bank account and withdraws funds to issue your paychecks. The checks take out the withholdings, and the payroll company sends the taxes where they need to go. You simply deposit that check into your personal bank account. In reality, you set up direct deposit. It’s all quite streamlined.
S CORPS AND BENEFITS
Running your medical insurance through the business can be a great strategy to reduce self-employment taxes even further. The insurance must be in the name of the business and paid by the business or, if in the name of the individual, the premium must still be paid or properly reimbursed by the business. Ideally, you have the business take care of the premium. This makes things much simpler.
The payments are then included on your W-2 as income. However, if classified correctly, the payments should not be subject to self-employment taxes, only income taxes. If you, as the owner of an S corp, determine that your reasonable salary needs to be $50,000, you’d run that through your payroll. You decide to have your S corp pay your health insurance premiums. Let’s say that’s $5,000 per year. That also goes on the W-2 as income, for income tax purposes. Your W-2 would show income $55,000, of which $5,000 would not be subject to income tax.
But this is not the best way to do it. With our example of $50,000 being a reasonable salary, you’d be better off paying a $45,000 salary plus the $5,000 premium. That nets you the $50,000 total as required and helps you save more in self-employment taxes. In short, that additional $5,000 you are no longer running as salary is taxed more like distribution, saving you (probably) 15.3%, or $765, in self-employment taxes while still meeting your reasonable salary threshold.
If done correctly, you can earn deductions that save you the income tax portion on your premiums as well. For more info, read my full blog post on medical expense deductions.
COST OF FORMING AN S CORP
In addition to reasonable salary” we should also look at the cost/benefit. You have already learned about the benefits. Let’s shift and take a look at the costs.
The primary expense is payroll. Some bookkeepers and accountants can run payroll. Many do not. I recommend using an established payroll company. This will typically cost you $40–$80 per month ($480–$960 annually).
In addition to payroll, you may choose to outsource your books once you form an S corp. Since S corps complicate things a tad, I recommend focusing on tightening up all your systems when you form one. If you don’t do a stellar job with your booking on your own, it’s time to outsource. A qualified bookkeeper will keep accurate books and records as well as create balance sheets. (I offer recommendations on how and who to hire in Chapter 12.) Costs range from $100 to $500 a month ($1,200–$6,000 annually).
One way you can analyze these expenses is through a cost benefit analysis. How much will the cost to form the S corp, annual payroll, and bookkeeping cost you? Do you still save taxes when you contrast that with the anticipated savings you’d get from the S corp? This is our default analysis.
However, I encourage you to think about this another way: Hiring a bookkeeper and getting on payroll will streamline your business. You’ll have taxes on autopilot. You’ll also have access to completed financial reports for your business on a monthly basis. This will not only free up your time, but it’ll also give you a greater sense of confidence in your business and help you step further into the CEO role by giving you better numbers to consider.
With that in mind, consider the breakeven point—the point at which the savings of the S corp will be equal to the additional costs. With the benefits I just noted, this is the ideal time to form an S corp.
HOW TO KNOW IF YOU’RE READY FOR AN S CORP
This is the big-ticket question. People tend to toss around a magic number with regard to what your income should be when it’s time to form an S corp. I often hear $100,000. Other professionals say $60,000. However, the number really depends on your business and industry.
If a reasonable salary for you would be $40,000 and your business is netting $60,000, you might be a great candidate. In other industries, $40,000 might not be reasonable, so the right time may not be until you hit six figures.
I have my own shortcut to help business owners like you determine if and when they’re ready to form an S corp. The key is determining your net business income after reasonable salary, or, remember, we also call this business profit when you have an S Corp.
Let’s break down net business income after reasonable salary. First, pause for a minute and work out in your head, based on what you’ve learned so far, what this could be. Do you have it?
First, consider net business income. We know what that is: the profit. Net business income is gross business income less cost of goods and less deductible business expenses. From there, there’s just one more step: deduct from that the reasonable salary. This is where we can have a large range in our estimated S corp savings. One tax pro may give you a reasonable salary that is $30,000 less than another. Ultimately, as the business owner, it’s your call to determine reasonable salary. Once you have that, deduct it from your net income to get net income after reasonable salary.
Assume your gross business income is $100,000. You have deductible business expenses of $20,000. Your net business income is $80,000. After some research, you determine that your reasonable salary should be $60,000. Therefore, your net income after reasonable salary is $20,000. This final amount is the total on which you save self-employment tax. Thus, if you calculate the self-employment tax you would have paid on that chunk of money, that is how much you’d be saving with an S corp.
Remember: If income is less than $137,000, self-employment tax is 15.3%. In our example, we can calculate 15.3% of $20,000, which is $3,060. This is a rough approximation of how much you’d save with an S corp if those were your numbers. You’d want to compare that savings to any additional costs to find true savings.
Note there are additional tax considerations that complicate this math. This is a good starting point.
We’ve got more posts
Dive into this post to learn more about tax basics
And read more about the medical insurance deductions here.
THE SMALL BUSINESS BLUEPRINT
The Small Biz Blueprint is framework I teach inside of my signature program and book. The goal of the Blueprint is simply to take inventory of what you need to do to form your sole prop, LLC, and/or S corp, and provide a rough outline of each step. In the Unf*ck Your Biz program, we’ve begun creating a Blueprint for each and every state 🤯. If you join, you can get specifics there for your state along with hyperlinks to hop to each license, application, etc. Here we give a general outline mostly using my home state, California, as an example.
Here’s a video excerpt from the Unf*ck Your Biz course on the first few steps of the Blueprint.
STEP 1: GET A REGISTERED AGENT
Your registered agent is responsible for receiving service of process if you are ever sued.
The first step in filing a lawsuit is submitting paperwork to the court. We call that a complaint. It lays out some basic facts and what you're suing for. Example: Client signs a contract on April 5, 2023, to pay $4,000 for photography services. I provide the services. She doesn’t pay. I sue for breach of contract and request $4,000 plus the costs associated with the suit. I state these facts in a complaint and file it with my local court.
After filing, it’s my responsibility to notify the defendant so they can timely respond to the complaint. The defendant must file an “answer,” which asserts whatever defense they want to claim. When we deliver the complaint, that’s called service of process. You’ll typically hire a process server to execute the service of process.
The registered agent is the specified recipient for service of process. Every LLC and corporation is required to have a registered agent, and that agent must have an address in the state where you form your LLC. You state in your articles of organization who the registered agent is. In doing so, you’re basically saying, “If someone wants to sue me, they must notify this person.”
STEP 2: CHOOSE BIZ NAME AND CHECK AVAILABILITY
LLC filings are rarely denied. However, one common reason for denial is using an already-taken name. If that happens, that’s not a huge deal. You pick a new name and refile.
You can avoid that possibility by doing a name search before filing. Google “[state] LLC search.” Find your way to the link from the secretary of state or your state’s agency in charge of biz entities.
STEP 3: DETERMINE ENTITY AND FILE ARTICLES
Almost every state now allows online LLC filing. Search for your state’s online filing system and file through that system. You can typically find this by searching something like “[state] online LLC filing.” Look for the state’s website, which will typically be through the secretary of state at a “.gov” address.
Watch out for third-party filing programs that charge additional fees. Most states allow you to file directly on their site and pay the associated filing fee. Don’t fall for the trap of applying through a different website and paying their fee on top of the filing fee. It’s unnecessary and typically provides no added benefit.
The state should send you a confirmation in the mail when your LLC has been approved and filed. Some may notify by email. Others don’t. In California, LLCs are typically approved within a week. It used to take three to five weeks to get confirmation by mail. They now send email notifications upon approval. If you don’t hear from the state, you can do your own status check. Redo that LLC name search a few days after filing. Search your own LLC name. If it shows no results, your LLC hasn’t been approved (yet). This trick can save you waiting a few weeks before moving to the next step.
STEP 4: OBTAIN EMPLOYER IDENTIFICATION NUMBER
An employer identification number (EIN) is essentially a social security number for your business. EINs serve a few key purposes. You are required to have an EIN when you have employees or if your business is a partnership or a corporation. Remember: When you form an S corp, you put yourself on payroll, making you an employee.
If we really think about this requirement, we can see that EINs are really required for any entity that is not a disregarded entity. (Side note: I know that “any entity that’s not a disregarded entity” is a bit clunky, but I don’t think “a regarded entity” really makes sense. That’s a brain twister.)
Although sole proprietorships and single-member LLCs may not be required by the IRS to get an EIN, most banks require an EIN to open business bank accounts. This is why almost every new business gets an EIN.
STEP 5: FILE FOR SELLER’S PERMIT
Seller’s permits are required when you have sales subject to sales tax. Some states have different names for seller’s permits. Make sure to check the requirements in your state.
STEP 6: GET FICTITIOUS BUSINESS NAME LICENSE
After the EIN, it’s time to file your fictitious business license (FBL). Typically, this application is done through your county.
If you need multiple DBAs, I have a couple helpful tips. Many FBL applications allow you to obtain multiple DBAs on one application. For example, in San Diego, the county charges $5 per DBA in addition to the filing fee. Make sure to add any and all you want. You also want to put each of these on your business license.
STEP 7: OBTAIN BUSINESS LICENSE OR TAX CERTIFICATE
Business licenses are sometimes called tax certificates. These terms are interchangeable. Business licenses are required by most cities. Check your city’s requirements. They typically require a business license anytime you operate a business in the city. The definition of “operate a business” may vary city-to-city, but generally it’s based on your physical location, which would be where your office or storefront is.
STEP 8: DRAFT OPERATING AGREEMENT
If you have two or more individuals coming together to form a partnership, you need a partnership agreement. Since a general partnership doesn’t have a separate existence in the eyes of the law, the partners will be held jointly and severally liable for any debts or liabilities of the business. Also, in California, and in many other states, state default rules apply in absence of a partnership agreement. In short, if you don’t have an agreement, a court can make and infer particular rules. I highly recommend working with an attorney to get one drafted.
Generally, a partnership agreement will include the following:
Nature of the business,
Initial capital contributions of each partner,
Expectations for future capital contributions,
Distributions of capital and cash receipts/profit,
Meeting and voting requirements,
Business interest transfer,
Restrictions,
What should happen in the case of business dissolution,
Rights and responsibilities of each partner, and
Tax allocations between the partners.
It’s not uncommon for business partners to get into disputes. In fact, it’s totally normal. Partners have differing ideas on how to market and where to invest money. Sometimes there’s a discrepancy in the hours worked by each partner in relation to how the partners are being paid. All of these issues can be considered and possibly prevented in a partnership agreement.
Once a partnership uplevels into an LLC, the partnership agreementt gets tossed out for an operating agreement. If, however, the partners form a C corp, they’ll instead draft corporate bylaws. All these documents serve the same purpose but for different entities.
Obviously, if you’re the sole owner of your business, you won’t need a partnership agreement. However, once you decide to form an LLC or corporation, you need an operating agreement or bylaws. Seems silly, right? You’re creating an agreement with yourself.
The main reason to form an LLC is for liability protection. To maintain your liability protection, you must meet particular requirements that prove you’re keeping yourself separate from your business. One way to do that is through an operating agreement.
The agreement places rules on you. For example, you can state the method and manner by which you will pay yourself. This shows that you are treating your biz like a business and yourself like an employee of the business. Many of the provisions in an operating agreement will be similar to those in a partnership agreement.
We also have operating agreements in the Contract Club (www.notavglaw.com/club). Yay! You will find a template for your first meeting minutes in the Club as well.
STEP 9: DRAFT MEETING MINUTES
The operating agreement and meeting minutes are internal documents, meaning they don’t get filed with the city, county, state, or IRS. Remember our corporate formalities? Our internal documents are part of those formalities when we form formal entities. Their purpose is to show we’re operating like a legit business if we were ever to get sued.
As business owners, we have meetings with ourselves every day, but we don’t usually document them. I know it’s weird. But here we are.
Recording meeting minutes is one of those formalities to maintain your magical liability bubble. They don’t have to be complicated; you don’t need to record minutes for every minor decision, like offering a promotion, for example. Instead, record major business changes in meeting minutes like salary raises, opening and closing bank accounts, buying physical property, and the like. If you have one or more business partners, you need a more regular habit of taking meeting minutes, as they document what you have jointly agreed to do. If you operate as anything other than a default entity, you at a minimum need to record annual minutes.
Get the operating agreement and meeting minutes templates in the Contract Club…
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STEP 10: FILE S CORP ELECTION
If you want an S corp in your entity’s first year (meaning in the first year you form your LLC), you must file for s status within two months and fifteen days from the date of forming your business. For existing entities, you can change to an S corp by filing the IRS Form 2553 by March 15th.
If you’re filing your LLC later in the year, note that you’re only getting the tax benefits for those months.
If your S election is not effective on the 1st of the year, you file what’s called a part-year tax return. For the one part of the year you don't have S corp status you file taxes as a pass-through. For the other part, you file as an S corp.
This makes filing a little bit more complicated. Due to this and the lowered savings, you may want to consider filing your S election at the beginning of the following year if you're either otherwise forming the LLC late in the year or filing earlier but do not yet have a lot of savings from the S election.
STEP 11: PAY ANNUAL FRANCHISE TAX
The franchise tax is your annual fee for operating an LLC or corporation in the state. Some states may call it an annual fee. The California franchise tax is $800 a year. Most states are between $100 and $300.
In California, the franchise tax is due on the 15th day of the fourth month after the LLC is formed and by April 15th each year thereafter. Make sure to check your state's requirements and filing deadlines before forming your LLC. Try Googling:
[State name] LLC annual franchise tax, or
[State name] LLC annual fee.
And note that most states have an initial filing fee along with an annual or recurring time fee. Make sure you have clarity on if your state has one or both, when they are, and how much.
STEP 12: FILE STATEMENT OF INFORMATION
The statement of information (SOI) is an informational report required for LLCs and corporations in some states. Some states call this an annual report. States with simple articles of organization (the document or online filing that forms the entity) tend to require an SOI. Other states don't, but their articles might require a lot more info.
In California, LLCs file statements of information bi-annually. The statement is first due within 60 days from filing your LLC and bi-annually thereafter. The questions are basic and repetitive. It asks for the business address, owners' addresses, and registered agent's address. Often, all of these are the same address.
Like most other filings, you can do this online through your state. Don’t pay an online service for it.
STEP 13: OPEN BANK ACCOUNTS
After you get the previous steps done, you’re ready to open your business bank account. Opening the account falls here in the Blueprint because most banks require LLCs to provide copies of the operating agreement, meeting minutes, and articles of organization. (You learn more on banking specifics in Chapter 18.) Circle back to this step once you finish the book.
STEP 14: SET UP PAYROLL
Payroll is specifically for employees. When you form an S corp, you’re an employee of your own business, and you put yourself on payroll. Contractors are not paid through payroll.
Payroll is really pretty simple. You determine your annual salary and how often you wish to get paid. I typically recommend a twice-per-month payroll. I run payroll on the 15th and last day of each month. That’s 24 payrolls per year. Take your salary and divide by 24 to get your payments.
If your salary were $60,000, you’d have payments of $2,500. Your payroll provider will withdraw that amount from your business account, send the required taxes to the state and IRS, and then deposit the remainder automatically into your personal bank account.
My recommendation for a payroll service is Gusto.
Choosing your "reasonable salary" is a tricky process. Some factors to consider are:
Training and experience,
Duties and responsibilities,
Time and effort devoted to the business,
Payments to non-shareholder employees,
Timing and manner of paying bonuses to key people,
What comparable businesses pay for similar services,
Compensation agreements, and
The use of a formula to determine compensation.
Also, make sure to reflect back to our conversation on the many-hats approach.
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“I never thought I would say I enjoyed reading a book on taxes, but I definitely did. Braden’s wit and spunk made this, often times, traumatic topic of taxes, actually really fun and enjoyable. He put into perspective the proper ways of filing your taxes, as well as covering if you should become an LLC, S Corp or sole proprietor, for small business owners. It was jam packed with knowledge and key tips that I have already put into effect in my own business! I’m so thankful that Braden has decided to share his knowledge and help us small business owners. Highly, highly recommend reading this book and getting your legal stuff figured out!”
- Kelsey, Owner of Kelsey Rae Designs
