So you’ve made the decision to become a contractor – congratulations! That first decision to make the leap and become your own boss can be one of the hardest choices you’ll make, but as a new business owner, it certainly won’t be your last. In fact, the next decision you’ll be faced with is another doozy: choosing a business model.
At first glance, a sole proprietorship may sound appealing because it’s easy to setup with little to no paperwork or fees (you typically just start working and pick up any income/losses on your personal taxes). But that doesn’t mean it’s the best business model for a general contractor. With a sole proprietorship, liability can come back to haunt you. Say someone gets hurt on a worksite or you default on a business loan. If someone comes after you, they can go after not only your business assets, but your personal assets as well, and that’s a situation no business owner would even want to think about.
That’s why so many contractors and home service providers choose a business model that protects them and their personal assets, acting as a shield between their business and their personal lives. In most cases, this divider comes in the form of a Limited Liability Company (LLC) or an S Corporation. Here are the differences to consider between the two, and how to tell which is best for you:
Limited Liability Company (LLC)
As the name implies, the biggest benefit of an LLC is that it shelters you personally from any liability for your business. So in the example above, if your business was sued, only your business assets would be vulnerable, not your personal assets. LLCs also offer the option of having an unlimited number of owners, referred to as “members,” if you don’t want to be the sole decision-maker. Because LLCs are pass-through entities when it comes to taxation, all gains and losses from the business flow through to each members’ individual tax return. This means you’re only paying taxes on the portion of profits you receive as opposed to all of the business’s earnings, as you would with a sole proprietorship.
LLCs do require more extensive paperwork in the setup phase because of the legal protection they offer. You’ll be required to choose and file a unique business name, as well as file Articles of Incorporation with your Secretary of State. Some states also require you to publish your Articles of Incorporation in a newspaper or legal journal at an additional expense. Of course, you can choose to work with a filing company who will take care of this paperwork for you, but that often costs more than doing the work yourself.
Corporations offer the same benefits as LLCs in that they protect owners from personally being held liable for their businesses. There are two main type of corporations: C Corporations and S Corporations. C Corporations tend to be reserved for much larger companies with unlimited shareholders, and their profits are subject to double taxation: once when earned at the business level, and once when passed along to shareholders. However, S Corps are much more attractive to businesses who have several years of experience under their belt and a larger number of shareholders than a startup but don’t want to deal with double taxation. Similar to LLCs, profits and losses from an S Corp pass-through to its stakeholders as dividends, thereby only being taxed once on individual tax returns. Another advantage of this is these dividends are taxed at a lower rate than normal income. However, it is important to note that shareholders must be paid “reasonable compensation” for their work. Unfairly limiting the amount of money given to a shareholder in hopes of reducing taxes won’t hold up legally.
To set up an S Corporation, you must first file your business as a corporation. Once you’ve ensured your corporation meets the criteria for an S Corp (be a domestic corporation, have no more than 100 shareholders, have only one type of stock, etc.), all owners must then sign an IRS Form 2553. Some states also require S Corps to establish their board of directors and issue stock certificates during the registration, so it’s wise to check with your individual Secretary of State for local rules.
Finding the right ownership structure for your general contracting business is a matter of your personal preference and how much experience you have. If this is your first time as a business owner, an LLC may be a better fit as it’s easier to setup than a corporation and still offers the separation needed to shield your personal property from business liability. However, if you’re more experienced and are ready for your business to expand to its fullest potential, an S Corp may be right for you.