Disclaimer: This content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Consumers spent $601.75 billion online with U.S. merchants in 2019, up 14.9% from the year before, according to the U.S. Department of Commerce. With online sales sure to increase in the coming years, it’s prime time to get moving on the ecommerce idea you’ve been itching to start. However, just like brick-and-mortar businesses, ecommerce companies also have legal and tax issues to consider when choosing a business entity type. Which business structure will offer the most advantages depends on a number of factors.
Which business entity is best for an ecommerce company?
Here are the options available to you and what to think about when structuring your new ecommerce business. There are also some insights on where to turn for help when making that all-important decision.
- Sole proprietor.
- S Corps.
- Limited liability companies (LLCs).
The least expensive and easiest entity to form is a sole proprietorship — therefore, it’s also the most prevalent legal structure in the U.S. With less fees and paperwork, the proprietor is completely in control of the business and all profits and losses pass directly through to the owner.
When it comes to taxes, business income and expenses are reported on the sole proprietor’s personal tax return and income tax rates are based on personal tax brackets. Sole proprietors still pay Social Security and contribute to Medicaid.
The biggest thing to consider when setting up your ecommerce business as a sole proprietorship is the personal liability the owner has — including incurred debts and lawsuits brought from employees and/or customers.
There is no legal separation between the owner of the business and the business itself.
Therefore the owner is at risk when the business is at risk. It’s also more difficult to secure funding as a sole proprietor.
With at least two owners you can form a partnership, but like sole proprietorships owners are wholly responsible for the business’s liabilities and debts and retain pass-through taxation.
It’s recommended that partners have a written legal agreement stating each owners’ responsibilities, decision-making rights and how the business survives if one partner wants out.
The Tax Cuts and Jobs Act of 2017 reduced the corporate tax rate from 35% to 21%, which makes the C Corp legal structure more attractive to ecommerce entrepreneurs.
The most appealing reason entrepreneurs choose the C Corp is because the business is considered a separate legal entity from the owner. The personal assets of the owner or owners are protected from all actions of the corporation.
For an ecommerce business, the personal protection offered by setting up a corporation is an enormous benefit.
If you plan to someday sell shares in your ecommerce business, you’ll need to structure as a corporation. The downside includes required filing fees, deadlines, bylaws and annual corporate meetings, but the personal protection from lawsuits and more can be worth it.
Another option for your ecommerce business is to elect S Corp status. The S Corp is not a separate legal structure in and of itself, but instead an option for the LLC or C Corp to have pass-through taxation, while still retaining limited liability protection.
An S Corp has the potential to income split, meaning owners can decide on a smaller salary and then pay income taxes, Social Security and Medicare taxes on the smaller salary.
Then owners can take dividend distributions on the remainder and only pay income taxes. Something to consider: high-earning companies might not benefit from an S Corp because the profits are passed through. A startup, however, would likely benefit from the losses incurred in the early years.
Limited liability companies (LLCs)
Like corporations, LLCs offer protection from personal liability but have less rigorous filing requirements than corporations. Owners are called “members” and have the benefit of choosing whether they want to be taxed as a sole proprietorship, partnership, S Corp or C Corp.
LLCs that choose to be taxed as an S Corp do so to be taxed as a pass-through tax structure and to avoid the double taxation of a C Corp.
If you don’t intend to seek investment money for your ecommerce business but do want asset protection, flexible management requirements and tax choices, an LLC can be a strong choice.
You can change your mind
There are a few reasons for switching entities once you’ve started your ecommerce business.
Sometimes entrepreneurs start an ecommerce business while still holding a full-time job and don't have the time or money to get the appropriate legal structure.
Or you might discover you want more protection than that offered by a sole proprietorship, or you want to take your business public.
Whatever your reason, it is possible to switch entities by taking the proper steps.
To switch from a sole proprietorship/partnership to a corporation/LLC means doing a name search for the new entity’s name and then filing the required documents with your Secretary of State office. You’ll also need to apply for a Federal Tax ID or Employer Identification Number (EIN) from the IRS and set up a separate business bank account with the new entity’s name.
Changing from an LLC to a C Corp can be done, but all members must officially agree to the structure change. Next, file a “statutory” conversion document with the state which shifts your business from one entity to another.
If your state doesn’t allow a conversion document, you’ll need to create a new C Corp, sell the assets of the LLC to the new corporation, pay taxes on appreciated assets, and then make the original LLC a subsidiary or a DBA (Doing Business As).
Depending on the industry of your ecommerce business, you’ll be faced with a number of legal rules and regulations. That’s why choosing the right legal structure is paramount to protecting both your business and your personal assets.
Make sure you consult with legal and finance experts before you make decisions for the future of your business.
Related: How to change your business entity