S Corp (example: Doctor, Financial Planner, Consultants)

Taxation is usually one of the driving factors in setting up a corporate entity. Asset protection comes in a close second when determining if you should remain simply self-employed versus setting up an S corp. As a pass-through entity, an S corp does not have to pay taxes on its corporate income. All profits flow through to the owners.

The S corp also does not have a legal responsibility to pay taxes on its corporate income. From there, the owners pay taxes on their personal tax returns.

C Corp (example: IBM, Start-Ups, any big corporation)

Pretty much any company that has gone public, or plans to go public, will likely be a C corp. With a C corp, the corporate entity is taxed separately from the shareholders.

There are no restrictions on ownership for C corporations. Conversely, S corporations are limited to a maximum of 100 shareholders. The potential for “double taxation” is the biggest drawback to a C corp. First, the corporation is taxed on profits. Shareholders are then taxed again when profits are distributed as dividends. The kicker is the C corp can’t deduct the distributions via dividends.

With the new lower top corporate tax rate (21%), new startups may want to consider being taxed as a C corporation. Another big win, Section 1202 of the new tax law allows shareholders of startups to sell their stock after five years, with no tax on the first $5 million of gain. That is pretty generous if you ask me. I will assume the goal here is to encourage the next wave of innovative companies that create well-paying jobs.

LLC (example: Landlords, Professionals)

A Limited Liability Company (LLC) has some flexibility built into it. LLC owners can file as a partnership, S corporation or even sole proprietor. The LLC is a legal designation rather than a tax designation. An LLC is a pass-through entity, and the owners will report profits and losses on their personal federal tax returns.

The LLC will not pay federal income taxes. Keep in mind that some states do charge an annual tax on LLCs. California imposes an $800 minimum fee while other states have nominal fees, like $35 per year. If the owners elect to tax the LLC as a pass-through entity, the 20% qualified business income (QBI) deduction may apply.

Corporate entity impact on asset protection

Tax savings are often the motivator to set up a corporate entity. Your asset protection will also be impacted by which entity (if any) you choose for your business. Ask any attorney: If you are in business long enough, you will get sued. Having an LLC, or corporation, between you and your actual business will reduce the likelihood that you will be sued as an individual.

If you are set up as a corporation or LLC, are sued and lose, the winner will only be able to go after money within the corporation. Put more plainly, this means they can’t go after your personal accounts.

You must have an operating agreement or bylaws in place, maintain books and record and track the minutes to maintain your asset protection and tax-preferred status. While this may sound like a bit of an ongoing hassle every year, it sure beats being sued for your personal assets.

Self-employed (example: Freelancers)

This includes nearly everyone who receives income via a 1099 form or runs their own small business. Think freelancers, independent contractors, business owners and so on. They must pay self-employment taxes in addition to regular income. By doing so, they are essentially doubling their contributions to Social Security and Medicare Taxes because they are paying as both the employee and employer.

You don’t have to set up any type of entity to be self-employed. Your new top income tax bracket will be 29.6% if you qualify for the 20% pass-through deduction. If you are earning enough to be in the top income tax bracket, you will likely benefit from tax savings and asset protection by forming one of the following corporate entities described below.