The following excerpt is from Mark J. Kohler’s book The Tax and Legal Playbook. Buy it now from Amazon | Barnes & Noble | IndieBound | Entrepreneur Books
Your business entity can be the most valuable player on your team. It’s critical to wisely choose the entity that's best for your business, make changes when necessary, and take advantage of the benefits of your business structure.
The following issues could have a major impact on your entity decision:
- The amount of your earnings and deductions
- Tax planning to avoid paying too much self-employment tax
- Liability exposure from your product, services, or location
- Whether you have a partner or investor in the business
- Where you live and are conducting business
- Business goals and marketing plans
- The administrative costs and demands of setting up certain entities
To help you choose the one that's a good fit for you, let's take a look at the four top options.
Sole Proprietorship
A sole proprietorship is the simplest form of doing business. All you need to do is just start selling your product or service. No Tax ID number (EIN) is required. No doing business as (dba) registration is required, although one is recommended for marketing purposes. No business bank account is required, although one is recommended for bookkeeping and audit protection. No extra tax return is required. All your income and expenses are reported on your 1040 Form, Schedule C.
One of the primary disadvantages of a sole proprietorship is the self-employment (SE) tax of 15.3 percent on the ordinary net income generated by your business. Ordinary income includes items such as sales of products or services, commissions, or short-term income in real estate if you are a real estate professional. SE tax doesn’t apply to passive income, such as rent, dividends, interest, or capital gain. When evaluating the possible tax ramifications and planning options of your sole prop, it’s critical to distinguish between ordinary income and passive income
Ordinary income can blindside many new business owners with a big SE tax bill in the spring of the following year. After you write off all your personal conversion expenses and the business still has a profit, the SE tax will kick in. However, if your net income is small, don’t worry about the SE tax and move on to consider the next issue that may impact whether or not you form an entity.
Another primary disadvantage of the sole proprietorship is the owner’s personal responsibility for the liabilities of the business. If you have exposure to risks, you may want to consider setting up an entity even if it's unnecessary for tax purposes or any other reason.
One strategic option is setting up an LLC, but taxing it as a sole proprietorship. This way you get the asset protection of an LLC, but you don’t have the cumbersome tax reporting of an S or C corporation. However, if you're running a low-to-zero liability exposure business, setting up an entity for liability protection purposes probably isn’t necessary. Continue to address any other issues or reasons that would make setting up an entity necessary.
If you have a partner or investor in your business, it’s almost a given that you'll form an entity rather than operate as a sole proprietorship. Simply by definition, having a partner means you need to file a partnership tax return, will be taxed as a partnership, and have personal vicarious liability exposure for your partner’s actions. Additionally, you'll want to legally document your relationship with the individuals you are doing business with and be careful not to open yourself up to a lawsuit with a “handshake deal.”
Setting up an entity is essential to establishing and building business credit. Building business credit takes time, but when done properly, it can be a huge asset to a small-business owner. This alone could be your reason for forgoing a sole proprietorship and setting up an entity right out of the gate.
It’s important to do a cost-benefit analysis during this entity research process to ensure it makes financial sense to set up an entity. Keep in mind that each state’s filing fees and annual reporting procedures and costs will vary dramatically. Moreover, some states impose taxes specific to certain types of entities that you wouldn’t typically realize exist. Typically, there are four costs to consider: 1) filing fees and setup costs, 2) annual maintenance fees and services, 3) any state entity taxes on gross or net income, and 4) tax return preparation and services throughout the year. Your attorney should be able to easily cite the costs to you. You can also visit the various state websites, starting with the tax commission and secretary of state sites, to gather this information.
If you discover after this cost-benefit analysis that the costs of setting up and maintaining an entity far outweigh any benefits it offers you, then a sole proprietorship could be the perfect fit, as long as you don’t also have tax, liability, or partner issues.
I often tell clients that unless there's a major liability, partnership, or tax issue, starting out as a sole proprietorship is a great fit. But if you begin making more money (or believe you will) or have liability exposure, you should consider other options. Following are three more business entities you can choose from.
Limited Liability Corporation (LLC)
An LLC is a fantastic entity for certain reasons, but it can also have some major drawbacks. Some of the benefits of an LLC are:
- Personal protection from the operations of the business (i.e., lawsuits)
- The ability to reserve a business name and create a formal brand
- Documentation of the relationship in a partnership via the LLC operating agreement
However, an LLC may surprise new business owners in the following ways:
- An LLC doesn't save on taxes in any way.
- You could be shocked by self-employment (SE) taxes if you generate ordinary net income.
- Many states have additional operational costs and/or high filing fees or taxes for an LLC.
There are three primary reasons why an LLC might make sense in certain situations for a new business owner.
1. Liability protection with rental property. The number-one reason thousands of LLCs are created and used around the country every year is to hold rental property. The LLC protects the owner and manager of the property from the operations of the business/rental. In order to have this protection, the manager and owner (referred to as the “members”) of the LLC need to act responsibly—without negligence and within the scope of their duties and responsibilities.
The well-established laws and statutes of LLCs across the states will protect the members of the LLC from liabilities that could arise with contractors, tenants, and guests of tenants on the property. If you even own just one rental property, an LLC should be a serious and important consideration.
2. Liability protection in an operational business and ability to convert to an S corporation later. Sometimes an LLC can be a great stepping stone for a new business owner when they have an operational business. Self-employment (SE) tax applies to ordinary net income in an operational business. Just because you form an LLC doesn’t mean you can limit the SE tax on that ordinary income.
SE tax applies to ordinary net income but not passive income. The best way to limit SE tax is to implement an S corporation. However, one of the major benefits of an LLC is that you can obtain asset protection early in the life of your business, while your ordinary net income may still be low or inconsequential, but later retroactively convert to an S corp when the time is right. This is because, under the tax code, an LLC can be converted to an S corp retroactively by filing an IRS Form 2553.
It’s important to note that forming an LLC doesn’t simply mean filing a single piece of paper with the state. It’s crucial that the owner treat the formation and maintenance of an LLC similar to that of a corporation to receive the same type of protection. Many new business owners fall prey to the false belief that an LLC is simpler to set up and maintain.
3. Advantageous for partnerships. An LLC is excellent for partnerships. It protects each partner from the actions of the other partner and allows for more efficient tax planning. Most important, the LLC creates a mechanism to document all the agreements and terms of the partnership. Far too many business owners partner with others based on agreements made by handshake, email, or some scribbles on a paper napkin.
LLCs can be designed so that each partner holds their share in the form of an S corp. This allows each partner to take additional tax write-offs utilizing his own S corporation, receive other sources of revenue, establish his own payroll levels to save on self-employment tax, or even create a 401(k) or health plan tailored to his situation.
An LLC is just as important when investing in rentals on the passive side of the equation. With an LLC, the partners (or members of the LLC) are personally protected from the actions of the other partners. The entity also provides documentation of the terms of the partnership. Moreover, it’s important to integrate the estate planning for each partner with the LLC, just in case one partner passes away. Typically, the ownership of the LLC would be held in the name of each partner’s revocable living trust. Just because a partner has stepped up to the plate in terms of an LLC and asset protection, it does not necessarily mean the partner has considered who will inherit her share of the LLC upon her passing, whether it be her family, loved ones, or charity. The title of any property or assets would be held by the LLC for asset protection purposes, but the ownership of the LLC would be in the respective trusts, which eases the inheritance process should one partner die.
S Corporation
Most small-business owners with operational businesses should at some point consider organizing their ventures as an S corporation. The asset protection could be critical and the tax savings significant, depending on their situation.
There are two major reasons why you may choose to form an S corp. First, shareholders and officers of an S corp aren't personally liable for corporate debts and liabilities. Second, your share of the S corp’s net income will not be subject to self-employment tax. (SE tax is a combination of Social Security and Medicare taxes, also referred to as FICA.)
Many small-business owners already take advantage of the savings that an S corp offers in regards to the SE tax. However, some tax planners advise business owners to stay away from the S corp because the strategy to save on SE tax is subject to abuse by some unscrupulous business owners and sometimes comes under fire by legislators. Please don’t listen to this advice without getting a second opinion. Bottom line, the S corp strategy works when it's used properly and isn't abused.
Related Video: Why Convert to an S-Corporation?
As with the LLC and standard corporation, asset protection is one of the major benefits of the S corp. In fact, the same protection of the corporate veil is afforded to both the S and C corp, provided they are established and maintained properly.
Many small-business owners establish an S corp to start the process of building business credit (sometimes referred to as “corporate credit”). When you create an S corp, you'll obtain a Tax ID number and eventually be able to establish credit and borrow funds solely in your company’s name. It takes time, but when done properly, it can be a huge asset to a small-business owner and is a notable ancillary benefit to operating an S corp.
S corps are designed for small businesses; this election restricts companies to no more than 100 shareholders. The big benefit is that the S corp isn’t subject to corporate tax. As a result, shareholders avoid corporate tax (often referred to as double tax) on their net income. Net income, after all business expenses are deducted, flows through to the shareholders of the S corp and their personal 1040 tax return on a Form K-1.
S corps can save immensely on the dreaded SE tax. If you’re operating as a sole proprietor or an LLC and creating ordinary income from operations (i.e., sales of services or products), all of your net income is subject to FICA/SE tax. In 2014, the tax is 15.3 percent on the first $117,000 of net income (this amount is adjusted for inflation annually), then 2.9 percent on everything above that.
Related Video: When to Set Up an S-Corporation
However, the S corp allows its owners to take a reasonable payroll (i.e., salary) through a W-2 and take a good portion of their profit as net income under the K-1. The beauty of this strategy is that the business owner only pays SE tax on their payroll, and not on the flow-through income from the profit.
In regards to payroll and net-income planning, we consistently encourage our clients to allocate at least one-third of their net income to “wage earnings,” and the remaining amount can flow out as “net income” not subject to SE tax. However, please know this is a starting point; every taxpayer is different. Moreover, it’s important to maintain this procedure through proper payroll planning. When taking the operational costs of maintaining an S corp into account, it typically doesn’t make sense to use an S corp unless you’re making a net income of at least $30,000.
I’m convinced that the S corp has to be the single most influential tax and legal strategy for a growing small business. If you're considering creating ordinary net income, it’s only a matter of time until you take advantage of the S corp structure.
C Corporation
Almost every Fortune 500 company is set up as a C corp, and they have specific reasons for doing so, such as raising capital and abiding by securities laws in order to go public. But for the average small-business owner or startup, this is completely unnecessary. Large corporations have different goals from small-business owners, the least of which is saving money on taxes. A small-business owner’s needs are very different, and most of the time they can skip the complications of corporate double taxation and just use an LLC or an S corporation.
In my opinion, the C corp is one of the greatest pitfalls in tax planning for the small-business owner, and it astonishes me how many lawyers promote it. Essentially, there are three myths used to sell entrepreneurs C corporation packages they don't need:
Myth 1: Extra C corporation tax deductions. Advocates for the C corp will contend that because of all the entity’s extra tax deductions (discussed below), you’ll be able to dramatically reduce your net income far more than you could with any other type of entity. Their point is valid in that owners of S corps cannot take certain write-offs. The rule is that if you own more than 2 percent of an S corp, neither you nor your spouse can take the following write-offs:
- Disability insurance
- Health Reimbursement Arrangement
- Day-care assistance plan
- Educational assistance program
- Cafeteria plan
While these sound like good write-offs you’ll miss out on, consider that: 1) Not everyone can use these write-offs anyway; 2) they don’t add up to enough to make a long-term difference; and 3) if you have other employees, you have to give them the same benefits you receive in order to take the deductions. I'm convinced that promoters who address this topic fluff up the benefits of C corps for small-business owners either because they can’t think of anything else to discuss or they want to sell you a corporate entity setup.
Myth 2: The lower C corporation tax rate. If eliminating all corporate income via deductions doesn’t work (and it won’t), the C corp promoter will try to convince you that because the C corp only has a 15 percent tax rate on the first $50,000 of net profit—and thus typically a lower rate than personal income tax rates—you will somehow experience savings. This is a shell game you can lose quickly if you aren’t very, very careful.
To effectuate this savings, the guru will suggest you pay the corporate tax and leave the money in the C corp so you don’t pay the double tax (your personal income tax) when you pull the money out. The problem with this plan is the ultimate outcome: Your money will be stuck in the corporation. You’ll only be able to loan yourself the money, at best. Someday you’ll want that income, pull it out of the corporation or zero out any loans, and then have to pay individual income tax on the retained earnings or distributions. Leaving the money only delays the inevitable.
Now, before I get C corp promoters so upset they won’t read any further, I’ll admit there have been and may someday be even lower tax rates on dividends from C corps. And in certain situations, if your income is low enough, the C corp won’t pay any tax at the end of the year, and thus you avoid the double tax problem. However, for the average small-business owner, these savings are the exception, not the rule.
Myth 3: The higher payroll solution. Ultimately you plan to make money with this company, right? After all these incredible C corp deductions, how are you going to take that profit out and not pay double tax? More salary? If you take a loan, the taxes will hit like a ton of bricks when you eventually shut the C corp. It’s a ticking time bomb!
Where are you going to hide all the profit you plan on making? Invariably, when the C corp advocate is faced with the corporate income issue, they'll suggest taking a greater payroll to wipe out the income.
Let’s think about the salary strategy. If you take a larger salary to wipe out the net income of the corporation, what do you pay more of? Payroll tax! Remember that 15.3 percent self-employment tax we were trying to minimize by using the S corp strategy? If we're required to take more payroll with a C corp, then what’s the point? In the S corp, we could take a lower salary and not have any corporate tax on the net, so obviously the S corp wins this argument as well.
Before you spend one dollar with someone advising you to start a C corp, make sure they run the numbers. Have them take your last year’s business tax return/operations and your projected business revenue/expenses and calculate the savings as it ultimately “nets” onto your personal tax return. Then make sure you are actually going to undertake the strategies they are suggesting, before the final step of comparing the savings with the administrative costs and headaches of the C corporation. This also includes a comprehensive cost-benefit analysis of any other entities you may need to structure in conjunction with the C corporation to save on SE tax and the double-taxation threat of the C corporation. Have them promise in writing that they will cover any penalties and interest for bad advice after they prepare and sign your tax return.
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, Khareem Sudlow
