Very few people get rich working for someone else. Those who do are:
- The tiny fraction of actors who star in movies;
- Pro athletes in their twenties and thirties; and
- Partners in law firms, assuming you don’t count their divorces and cocaine habits.
Even United States senators don’t get rich off their $174,000 annual salaries. Oh sure, they get rich, but not directly via their salaries, if you know what I mean. They find all kinds of ways to create passive income.
So what about the remaining 99.999% of us? Are we all destined to nibble at the boss’ table, cross our fingers for incremental raises and hope that Social Security’s still there when we’re old and doddering?
If you have no ambition, then probably. For the rest of us, entrepreneurial ideas and investing are the only way to make it while enjoying self-determination.
Before you complain about this, you should be rejoicing. In most parts of the world, the only way to get rich is to stage a military coup and impoverish the peasants even further. This sounds like fun until you remember that doing so puts you in the crosshairs of the next coup-stager.
This bears repeating – the list of America’s richest people consists of nothing but entrepreneurs and their heirs. There isn’t a salaried employee in the top 50,000. Fortunately, starting a business in this country remains relatively free of red tape. Relatively.
But if you’re going to start a business, do it right. Millions of aspiring entrepreneurs make the mistake of merely securing an operating license from whichever local jurisdiction they plan to do business in and not going any further. (Read “How to Start Being Self-Employed in Six Months.”)
Unless you specify otherwise, your business will run as what’s called a sole proprietorship (or if you’ve got partners, the cleverly named “partnership.”) Madness this is, because under it you (and your partners, if any) are the business. For tax, credit and legal purposes there’s no difference between the business and yourself. Which means there’s nothing to stop a motivated litigant from suing you for more than you’re worth.
Instead, the first thing any nascent entrepreneur should do – before buying a coffee mug or even writing a business plan – is figuring out the right way to structure her new enterprise. For most people, that’s going to be as either an LLC (limited liability company), professional LLC or an S corporation.
Limited liability means a company’s owner(s) can’t be sued for more than what the company’s worth. No one can come after your personal assets, that is. It sounds like an unusually defensive way to get started – testing the alarm system before building the house – but that’s the society we live in.
An LLC doesn’t pay taxes. Instead, the LLC distributes profits among its owners, which then get taxed at the same rate that the wages and salaries of regular people do. Your LLC issues you an IRS K-1 statement, easy enough to do if you own the LLC, on which you list your share of the company’s income and expenses. These then get transferred to the good old 1040 form you know and loathe.
An S corporation (it takes its name from Section S of the Internal Revenue Code) also doesn’t pay income taxes. And, it also divides profits and losses among the shareholders. The biggest difference between an LLC and an S corporation is how the IRS treats profits. If your S Corporation pays you a “reasonable” salary, the remaining profit is “distributed” to you at the end of the year and isn’t subject to self-employment tax. Not so with an LLC. The tradeoff is that an S corporation requires a little more paperwork and filing.
Excuse me, self-employment tax? The hell is that?
Seriously? Thanks, I’ll just keep working for the man, then.
Fine, but you’re paying that 15.3% as it is. If you make under $106,800, the feds deduct 6.2% of that in Social Security taxes and another 1.45% in Medicare taxes (government programs that just keep on giving.) Furthermore, by law your employer’s on the hook for the same amount – 6.2% and 1.45% respectively. Go ahead, add those all up. And remember that taxes, all taxes, aren’t paid by overweight industrialists chomping cigars behind oak desks. They’re paid by you and me.
With an LLC or an S corporation, you pay yourself a salary and deduct from your taxable income everything that’s directly related to the maintenance of your business – your phone bill, car expenses, health insurance premium, etc. A smart entrepreneur distinguishes between Form W-2 income, which is the kind hourly workers and salaried employees earn, and Form 1099 income. The IRS defines the latter as everything other than wages and salaries.
But there isn’t only one Form 1099. There are dozens. One for dividends and distributions, one for real estate transactions…you want as much income as possible to come from these and as little as possible to come from W-2s. When it comes time to file your taxes, and include all those deductions, you’ll appreciate the difference.
Greg McFarlane runs ControlYourCash.com and wrote Control Your Cash: Making Money Make Sense, a financial primer for people in their twenties and thirties who know nothing about money. Get the physical or Kindle edition and reach Greg at greg at ControlYourCash.com.