If you’re running an online business, one of the best things you can do to protect it is to create an entity. But don't worry, it's not as difficult as it sounds. This post covers what you need to know.
If you’re running an online business, one of the best things you can do to protect it is to create an entity. Don’t worry. I’m not gonna start spouting legalese. Instead, I’m going to help you know your options.
Choosing how to structure your business is an important decision. It will affect how you run your business and could have some big implications for your personal finances. But don’t let that stop you from taking action.
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Why Form a Corporate Entity
Why do you need to bother forming some kind of business entity? There are many reasons to do so, and they don’t have to do with tax benefits. That’s actually a myth you shouldn’t believe.
Whether you’re a sole proprietor or you’ve formed an LLC, you will be taxed the same way. You may enjoy tax benefits along the way, like when you have hired a certain number of employees, but tax advantages don’t have anything to do with you forming a business entity.
Limit Your Personal Liability
When you form a corporation or any kind of entity under the law, it will be considered a separate entity from you. For example, if you form an entity of Joe Blow LLC, there will be two entities. There’s you and there’s Joe Blow LLC. When bad things happen to your business, having a corporate entity prevents these negative consequences from affecting your personal finances and personal life.
When you sign a contract on behalf of your business, you’re not signing it personally as yourself but as the manager of your business. That means any liability, such as failing to perform on a contract, will prevent others from going after your personal assets.
Forming a corporate entity can also protect you from having to pay a lot of money. But there’s an exception. Other people may not be able to come after you for business debts, contracts, or leases, but they can sue you for your own actions.
Always remember that you will be liable for your own actions when you do something wrong. Having an LLC or any kind of business entity won’t protect you from that.
The law recognizes a partnership when you have a joint business venture with another individual. You have to form a corporate entity so that you’ll be protected from the liability of the partnership.
So when your partner commits a mistake, having a corporate entity protects you from the consequences of your partner’s wrongdoings. You can choose to have a Limited Liability Company, Limited Liability Partnership, or Limited Partnership.
5 Business Structures and Their Pros and Cons
There are five different kinds of corporations, and each entity has its own pros and cons. For an online entrepreneur, most of the time the best option is going to be an LLC. But I want to mention the different kinds so you know and you understand why you would generally want an LLC.
You have a sole proprietorship if you do nothing. If you just start doing business and don’t form a corporation, the law will treat you as a sole proprietor.
You’ll have no protection from liability. It may be acceptable to have a sole proprietorship at first when you’re just testing something out as a hobby. But this isn’t the way to go if you’re serious about your business.
You have a partnership if you have co-owners. If you don’t form a business entity, you’ll have a de facto partnership, which means you’ll be treated as partners under the law. It’ll just be like having a sole proprietorship except you will not only be liable for your actions but for the actions of your partner too.
In a Limited Partnership, another person will come into your business and provide the money you need. That other individual will be considered a limited partner, which means they don’t have any decision-making authority and can’t be held liable. Instead, you’re who makes all the decisions and will be held liable.
Big companies such as Coca-Cola are C corporations. They have shareholders, who are owners, an executive team that makes daily decisions for the business, and a board of directors that approves important decisions, is responsible for firing the executive team, and makes strategic decisions.
Aside from having these three different groups, you also need to have bylaws. Establishing a C corporation involves complicated processes.
A C corporation also gets taxed. You need to file tax returns, pay taxes on your profits, and pay dividend payments on the profits you disperse to the owners. A C corporation isn’t the right choice for most online entrepreneurs because of the complexities, formalities, and double taxation.
Limited Liability Company
A Limited Liability Company is a form of corporation that’s created at the state level. It’s a more streamlined version of a C corporation that offers liability protection but without double taxation issues.
A basic LLC doesn’t need to file tax returns or pay taxes. Another advantage to forming an LLC is that you’ll get to write off 20% of the income, including what you pay yourself before you pay taxes on it, under the recent tax reform bill.
If you’re the sole owner, you will have a Single Manager LLC. If several people own and manage the business, then you need to have a Member Managed LLC.
You form an S corporation at the federal level, as the taxation process involves the IRS. Under this business entity, you have to pay the people in the business a reasonable salary through payroll.
If you’re the owner, you also have to pay yourself a salary and pay taxes just like any other employee. In addition, if your income is above your reasonable salary, you don’t have to pay the self-employment tax, which includes your Medicare and Social Security. If you’re thinking of forming an S corporation, you need to work with a CPA.
These are the five types of business structure. If you’re forming something at the state level, the best option is an LLC. Meanwhile, you need to talk to a tax professional if you’re thinking of tax issues, whether it involves an LLC or an S corporation.
How to Set Up Your Business Entity
In many ways, the location where you set up your entity doesn’t matter because you will still pay taxes based on your state of residence. If you’re from Washington, DC, and you form the LLC in Nevada, you still have to pay DC income taxes on all of your earnings that come from the LLC. You won’t save money on taxes by forming your LLC in a different location.
The best thing you can do is to form your LLC in your home state because it’s simple and will save you money in most cases. It gets rid of the complexities of hiring a registered agent or filing in multiple places.
Here are the steps to forming an LLC
- In most states, you can form an LLC online. You just need to answer a few questions including the name of your company, the address, and the Registered Agent’s name and address. There may be special requirements in some states, such as the publication requirement in New York. You have to do your research before you set up your LLC and make sure that you meet all the requirements. You can do it yourself or pay a company like LegalZoom to help you.
- Search for the Secretary of State’s website for your state to find the steps you need to follow for filing your LLC.
- Pay the fee. The cost of filing an LLC varies from one state to another.
- Go to the IRS and get your EIN number, which is the formal number that will identify your business.
- Go to your preferred bank and open a bank account.
After setting up your business, you need to have an Operating Agreement or a Partnership Agreement, if it’s a partnership. It’s an agreement that explains how to operate and manage your business. It sets clear and concise protocols, policies, and processes for the business. Of course, you need to follow everything that’s stipulated in the operating agreement.
Keep Your Personal and Business Accounts Separate
It’s also important to keep your personal and business money separate if you want to keep protection for your business. You must have a personal bank account and a separate business bank account. The law won’t treat your business as a different entity if you don’t. You won’t get liability protection, which is the primary reason you created your company.
So pay for your personal expenses using the cash from your personal account and settle your business expenses using the money from your business account. Don’t forget to talk to a trusted CPA because there may be personal expenses that can be paid for by your business. This could also help you save on taxes.
Keeping your personal and business accounts separate will prevent you from getting in trouble with the IRS. Just be sure to have a procedure where you’ll have documentation of all expenses. So if the IRS comes, you can present them with an accurate expense report.
Get Your Contracts Under Your Company Name
You also want to get all contracts that are on behalf of your business under the name of the LLC you’ve formed. Whether it’s a lease or something else, sign it on behalf of the company by having the contract in the company’s name.
Track Your Expenses
Talk to your CPA about your expenses and how to track them. They will help you structure things and get the maximum tax advantages for your business and personal returns.
Run Your Business the Right Way
So these are the basics of structuring your business and how to keep it protected. Again, if you’re serious about your business and if it’s more than just a hobby for you, you need to form a corporation. For an online business, this usually means an LLC, which will help you avoid personal liability and run the business the right way.
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