4 Step Process – What “Business Entity”?

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Tax and, to a lesser extent, Personal Liability, concerns often create a maze of confusion for those trying to decide what business entity should I choose?

I hope this blog reduces or resolves any confusion, creates clarity, and provides a solution for you.

This blog is intended to provide you a good “Birds Eye View” of your options and a systematic and analytical process to help you discover:

  • What “Business Entity” you may want
  • Why you want it, and
  • How much it will cost

As someone with both an accounting/tax and risk management background, I look at choices from two perspectives:

  1. The number side of me wants to find out if there is a way to save money.
  2. The risk management part of me wants to make sure we are protecting the money we have.

I also look at the “Cost VS Benefit” or the Risk/Return for decision alternatives.

Is the money spent worth the benefit received?

 This same process can work for you as you evaluate the pros and cons of your alternatives.

Before we look at the 4 Steps, it is helpful to see the “big picture” before diving into the details. “First, see the forest, and then see the trees”

Choosing a “Business Entity” involves choosing both a legal entity and also choosing the way you want your business entity to be taxed.

  • Legal Entities are created by state statues
  • Tax Classifications are created by the IRS

Legal Entities:

  • Sole Proprietor
  • General Partnership
  • Corporation
  • Limited Liability Company
  • Limited Partnership
  • Limited Liability Partnership

IRS Federal Tax Classifications are:

  • Sole Proprietor
  • Partnership
  • C Corporation
  • S Corporation

A cursory review of the two (2) lists clearly shows a mismatch; i.e. they are not “apples to apples”.

Hopefully, showing this to you “up front” will help you develop a discerning eye for the difference in terminology. Examples:

  • Corporations and Limited Liability Company’s are legal entities and not tax classifications.
  • A corporation has two tax classifications available to it, the C Corporation and S Corporation.
  • The Corporation is the legal entity and the C Corporation and the S Corporation are tax classifications.

If you get confused as you read through the details below, come back to the two lists to see which term fits where.

 Now, Back to the

Systematic and Analytical Process to Help You Decide:

  • What “Business Entity” you may want
  • Why you want it, and
  • How much it will cost

4 Step Process

  1. Take a Personal Inventory of your Business Needs
  2. Research & Understand your options
  3. Review the Cost VS Benefit of your possible choices
  4. Meet with a Certified Public Accountant (CPA) and an Attorney to help you finalize your decision

Factors to consider in your decision may include:

  • Your Objective
  • Your Industry
  • Short and Long term goals
  • Tax Implications
  • State law treatment
  • Protection for Personal Assets
  • Formation cost
  • Recordkeeping and ongoing maintenance requirements
  • Capitalization
  • Compensation
  • Allocation of Profits, Losses, and Distributions
  • Fringe Benefits
  • Rights and Duties of Business Owners
  • Management and Control
  • Transfer, Conversion, and Merger
  • Termination/Dissolution

Step 1:

Personal Inventory of your Business Needs:

  • What Do I have to Protect?
  • Liability exposure from your product, services, or location?
  • Am I operating this business by myself or do I have partners, shareholders or members?
  • What are my short and long- term goals?
  • Do I want to retain capital to pay for inventory or to fund growth?
  • Do I want to raise capital?
  • Do I want to establish business credit?

 

Step 2:

Research & Understand Your Options:

Broad Perspective:

Taxes and Personal Liability should both be considered as primary factors in your decision.

  • This blog will focus upon federal taxes; your state statues should also be reviewed. Don’t assume that your state law will follow the IRS. Do the research.
  • Personal Liability and the protection of personal assets, will be addressed within each entity type

The two types of federal taxation that are often considered in entity selection are income tax and self-employment tax.

Income Tax obligations vary depending on the legal structure and tax classification.

The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation.

A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute; it is not an IRS filing status.

  • With pass-through taxation, generally, no income taxes are paid at the business level. Business profit or loss is passed-through to the owners’ personal tax returns.
  • Corporations, on the other hand, are separate tax entities and are taxed independently from owners.

 

Self-Employment tax is required if your annual net earnings is more than $400.

As an employee, you know that money is withheld from your paycheck for social security and Medicare tax; you and your employer split this 50/50.

Self-Employed individuals must pay both the employer and the employee side of Social Security and Medicare tax.

The self-employment tax rate for 2017 is 15.3% of the first $ 127,200 of income and 2.9% of everything above that amount.

There is an income cap for the Social Security tax; the Medicare tax is not capped.

The Social Security tax rate is 12.4%; the Medicare tax is 2.9% (15.3% combined).

  • Self-Employment taxes are reported on Federal Form Schedule SE
  • Taxpayers can deduct 50% of their self-employment tax in determining their Adjusted Gross Income on Form 1040; the adjustment does not affect the amount of self-employment tax owed.

 

Detail Perspective:

Sole Proprietor: Flying Solo

Sole Proprietorships are an unincorporated business that is owned by one person.

Owner Liability?

  • Unlimited; A Sole Proprietor is always personally liable for the debts, obligations, and liabilities of the business

How Are Income Taxes Paid? :

  • Report business income or losses on your personal income tax return; the business itself is not taxed separately. File form 1040 and use Schedule C- Profit or Loss from Business.

Will I pay Self Employment Tax? –

  • Yes; file Schedule SE with your federal form 1040

Other Entity options for a Single Owner Entity?

  • Corporation
  • Limited Liability Company- Single Member LLC

 

Partnership: Two or More:

A Partnership is a relationship formed by 2 or more persons or entities that join together to carry on a trade or business.

Two primary choices:

  1. General Partnership – By definition, at least 2 General Partners each of whom manage the partnership
  2. Limited Partnership – A Limited Partnership has 1 or more General Partners and 1 or more Limited Partners. The General Partner manages the partnership; Limited Partners are typically passive investors.

 

Owner Liability?

  • General Partners, in a Partnership, are “jointly and severally” liable for the debts, obligations, and liabilities of the business
  • Limited Partners, in a Limited Partnership, have limited liability unless they take an active role in management; General Partners remain personally liable

How Are Income Taxes Paid?

  • Partnerships file an annual information return; file federal form 1065 and Schedule K-1 is used for the individual member’s profit and loss; Individual Partners file their personal tax information on Federal Form 1040 and Schedule E, Supplemental Income and Loss

Will I pay Self-Employment Tax?

  • Yes, if general partner
  • Generally, No, if limited partner

 

C-Corporation:

A corporation is a separate legal entity with a life beyond that of its owner.

For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.

Double-Taxation applies: the profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends

Owner Liability?

  • Corporations (C or S) – Shareholders are not personally liable for debts, obligations, or liabilities of the business

 

How are income taxes paid?

  • The C Corporation pays taxes on the annual net earnings and files federal form 1120

Will I pay Self-Employment Tax?

  • No, Self Employment Tax does not apply because payment for services is in the form of wages, which is subject to withholding for social security and Medicare tax

 

S-Corporation

  • An S corporation combines the limited liability of a C corporation with the tax treatment similar to a partnership.
  • You “elect” to become an S Corp by filing Form 2553 with the IRS within the 1st 75 days of the tax year that you want to operate as an S Corp.
  • The S status is only to elect to have all income /losses pass-through to the owners/stockholders and you must qualify to elect.
  • Failure to comply with IRS requirements will cause the S-Corp to lose its status.
  • State taxation of S-Corps vary – see your state rules. Some states treat S corporations, like C corporations, and impose an income or franchise tax.

 

Owner Liability?

  • S Corps limit liability to the same extent as C Corporations
  • Corporations (C or S) – Shareholders are not personally liable for debts, obligations, or liabilities of the business

How is Income Taxes Paid?

  • S Corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes
  • S Corporations are responsible for tax on certain built-in gains and passive income at the entity level
  • File S-Corp informational return on Federal Form 1120-S and use Schedule K-1 for the individual shareholder’s profit and loss
  • Shareholder-Employees are taxed on their salary income and on any profits distributed by the S-Corporation
  • Shareholder-Employees file Federal Form 1040 and Schedule E – Supplemental Income and Loss

 

Will I pay Self Employment tax?

  • Generally, no, this is why many Small Business Owners elect to be an S-Corp, if they qualify

 

Limited Liability Company (LLC)

State statues create a Limited Liability Company; owners are called members.

There are 2 primary types:

  • Single Member
  • Multi-Member

Owner Liability?

  • LLCs are state entities; the level of legal protection given to a company’s owners depends upon the rules of the state in which the LLC was formed

 

How are Income Taxes paid?

The tax classifications available to an LLC vary based on the number of members

  • All income, gain, loss, and deduction flow through to members unless the LLC is taxed as C-Corp
  • A Single Member LLC, by default, is a disregarded entity
  • A Single Member LLC can choose to be taxed as a “Corporation” *
  • A Multi Member LLC, by default is a Partnership
  • A Multi Member LLC can choose to be taxed as a “Corporation” *

 

Generally, when an LLC only has one member, the fact that it is an LLC, is ignored or “disregarded”, for the purpose of filing a federal tax return, and is treated the same as a Sole Proprietor.

 

If the only member is an individual, LLC income and expenses are reported on federal form 1040 and Schedule C, E, or F unless it files Form 8832 and elects to be treated as a C Corporation. *

 

A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Federal Form 8832 and elects to be treated as a C Corporation *

An LLC can also elect to be an S Corporation, if they qualify*

The type of legal entity remains the same—only the tax classification changes to impact how the entity reports and pays taxes.

 

Will I pay Self Employment Tax?

  • Yes, Self-Employment Tax applies except if the LLC operates as C-Corp or S-Corp
  • Sole Proprietor and Partners both pay this tax. File Schedule SE with your federal form 1040

Step 3:

Determine the Cost VS The Benefit:

  • Each Option has it’s own “cost” and “benefit”. Understanding this helps you make an educated decision before you spend any money.
  • The options available to you vary by state and by profession. There is no one size fits all rule, for everyone, across the United States.
  • Visit your local SBDC, Service Corp of Retired Executives (SCORE), and Secretary of State website to find specifics for your area
  • Consider Tax (monetary) and Non-Tax benefits

Costs Include:

  • Filing Fees and Set-Up Costs
  • Annual Maintenance Fees & Services
  • Any State Entity Taxes on Gross or Net Income
  • Tax Return Preparation and Services through out the year
  • Cost, in terms of Time & Money: the amount of paperwork required, Board Meetings, Shareholder meetings, minutes, etc.,

For your state entity taxes, you could use an estimated amount of gross or net income for perhaps, 1, 3, and 5 years and then determine you estimated tax for each year. No, this is not a “real number”, but it does provide a useful illustration to help quantify your cost for alternatives

Benefits Include:

  • Potential Tax Savings
  • Peace of Mind because your personal assets are protected from business liability
  • Other intangibles 

 

Step 4: Meet with an Attorney/CPA to help finalize your choice:

Although a lot of information is included here, it does not cover everything that is important to understand.

Your preliminary research has probably increased your understanding, narrowed your choices, and also created new questions for you.

You could consider this 4 Step process as a good preliminary foundation for your discussions with your attorney and CPA; they can provide more details about income tax and legalities for your situation.

 

Wrapping Up

The entity selection process can seem like a maze of confusing options. I hope this information helped to remove some confusion and perhaps, make a small difference for you? If so, please let me know; I’d appreciate it. Thanks.

 

Thanks for reading.

To your success,

Deb

 

 

Deborah Ann Fox, CPA helps Small Business Owners & Individuals build and protect their financial wealth though education, strategy, and proactive tax planning. She is passionate about helping others. She teaches and also blogs to provide helpful information for individuals, independent contractors entrepreneurs, and small business owners.

Debbie offers free 30 minute no obligation consultations. We can discuss/resolve via a mix of phone, e-mail, virtual, and in-person communications.

 

http://www.DeborahFoxCPA.com

 Call 619-549-2717

E-Mail me @ debfoxfinancial@gmail.com 

Twitter: @debfoxfinancial

Facebook: Deborah Ann Fox, CPA

The blog is provided as general information only and should not be considered a substitute for the advice and services of an attorney or Certified Public Accountant.

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What you don’t know can hurt you

RiskIgnorance may be bliss, but what you don’t know, can also hurt you.

You work hard for your money. You want to enjoy it, stretch it, and protect it.  Personal Risk Management is a way to protect your money. It is a systematic process of evaluating the chance of loss and then taking steps to combat the potential risk by practicing risk avoidance, using contractual indemnification, or by purchasing insurance.

One example of risk avoidance is if a sole-proprietor choses to incorporate and thus limits their personal liability exposure.

Contractual indemnification is a common clause in many contracts. Black’s Law Dictionary defines indemnity as a ““a duty to make good any loss, damage, or liability incurred by another.” Indemnity has a general meaning of holding one harmless; that is to say, that one party holds the other harmless for some loss or damage. Indemnification protects you against personal liability.

Insurance helps to stop an insured “loss” from being a financially life-changing event.

Most people probably find insurance boring and reading insurance contracts even more so. As a CPA, with the Associate in Risk Management (ARM) designation, I enjoy looking for the “devil in the details”. It is one way I provide value to others.

The goal of this blog is to plant some seeds of thought, initiate action, and provide you some “sleep insurance” because you took the time to evaluate, know, and feel comfortable with your financial position.  Factors to consider include:

Limits and Exposure:

  • Know what you have to protect:  What is your net worth; i.e. how much could you lose?
  • What type of losses are you covered for?
  • What percentage of your net-worth is protected by insurance and what amount is left “self-insured” in the event of a loss?

Property:

  • Do you know that if you do not buy the correct property insurance limit that you could be held financially responsible, for a portion of the loss? This is called the co-insurance requirement; read your policy
  • What does your insurance cover you for?
  • Do you have a property “named peril” or an “all-risk” policy? A Named Peril policy only provides coverage for the peril specifically named. An All Risk policy provides coverage for all losses not specifically excluded from coverage
  • If you do not have an All Risk policy, your fire policy might include “extended coverage”. Rev Shaw is an easy acronym to see what might be covered other than loss caused by a fire. R=Riot, E=explosion, V=Vehicle; S=smoke; H=hail; A=aircraft; W=Wind

Liability:

  • How do you determine the policy limit that you buy on your auto, homeowners, or Business Owners Policy? Do you buy the minimum limit or do you also have an Umbrella policy that responds in the event that a loss exceeds your primary limit?
  • In a Money magazine 2/5/14 article, Ed Charlebois of Travelers Insurance said “More than 80% of umbrella losses are auto-related,” If you remodel, does your general contractor make sure that the subcontractors are covered for worker’s compensation and general liability? Do you own a swimming pool, hot tub, or boat that increases your risk/exposure for a loss?
  • If you are a business owner, do your contracts require you to name others as an Additional Insured on your policy? Do you know that this means you are sharing your policy limit (s) with others? Is your defense coverage included in your policy limit?

Your insurance agent can help you review the type of coverage you buy. From a risk management perspective, insurance agents/brokers generally will not tell you how much insurance to buy; this increases their liability.  Likewise, I would not suggest limits either. I could, however, help you determine your exposed net worth and help you review how well you are covered from a property/casualty (liability) perspective.

Warren Buffet said, “Risk comes from not knowing what you are doing”.  Take the time to know and sleep well tonight.

Deb Fox is working to “make a difference in peoples lives, hearts, and wallets”. Although she earned her CPA designation in 1997, she is not currently practicing as a CPA. She does use her knowledge to help others protect their financial health and is available for side –by- side, remote, or mobile appointments.

Website: www.debfoxfinancial.com

E-mail: debfoxfinancial@gmail.com

Twitter: @debfoxfinancial

Have you reviewed your legal business structure for tax savings and/or liability?

Tax Time is a great time to review your business financial life and determine if there are changes you can make to help you keep more of the money your earn in your pocket. One way to do this is to see if your legal business structure provides you the best opportunity for tax savings and/ or more limited liability.

In the U.S., there are four major legal choices to chose from when deciding how to operate your business: sole proprietorship, partnership, corporation, and the limited liability company. There are also variations within these categories, such as the S-corporation.

Making this decision is complicated and both an attorney and an accountant should be consulted to provide information to help you decide which form may be best for your business. Factors to consider include:

  • Legal Liability
  • Tax implications
  • Cost of formation and record keeping
  • Flexibility
  • Future needs

As someone with both an accounting and risk management background, I look at choices from both perspectives. The number side of me wants to find out if there is a way to save money. The risk management part of me wants to make sure we are protecting the money we have. The following business entity review focuses upon these two aspects.

Liability can arise from negligence, statutory law, and assumption by contract. The risk of potential liability varies by business entity form.

Sole Proprietor: Flying Solo

  • Taxpayer is the owner; the business is not separate
  • Unlimited exposure to liability
  • All debts or claims against the business can be filed against the owners’ personal property
  • If the owner is sued, insurance is the only form of protection
  • The business itself is not taxed separately; The IRS calls this “pass-through” taxation, because the business Profit and Loss passes through the business to be taxed on your personal tax return
  • Tax is based on your personal income level and is taxed at graduated rates
  • File your personal income tax on Federal Form 1040 and all business information on Schedule C or Schedule F, Profit or Loss from the business
  • Sole Proprietors must pay both the employer and the employee side of Social Security and Medicare taxes; this is called Self-Employment tax
  • Self-Employment tax is required if your annual net-earnings is more than $400
  • The self-employment tax rate for 2014 is 15.3% of the first $117,000 of income and 2.9% of everything above that amount
  • Self-Employment taxes are reported on Federal Form Schedule SE
  • Sole Proprietors can deduct ½ of this cost on 1040-Line 27, the deductible part of self-employment tax 

Partnership: Two or More

  • General Partnerships: Partners are exposed to unlimited liability for business expenses
  • Limited Partnerships: General Partner is personally liable; Limited Partners have limited liability unless they are participating in management
  • Depending on the form, Partners may lose their investment and/or personal assets as well
  • Partners are not employees and should not be issued a W-2
  • Partnerships file an annual information return on Federal Form 1065; Schedule K1 form is used for the individual member’s profit and loss allocations
  • Individual Partners file their personal tax information on Federal Form 1040 and Schedule E, Supplemental Income and Loss
  • Taxable at the personal income level and at the graduated rates
  • File Self-Employment tax on Schedule SE; see Sole Proprietor for additional information

C-Corporation: Double-Taxation applies

  • Separate legal entity that exists, separately and is distinct from its owners
  • Owners’ personal assets are protected from claims against the corporation
  • Generally, the owners of a corporation cannot lose any more than they have invested in the corporation
  • The corporation is taxed and can be held legally liable for its actions
  • Double-Taxation applies: the profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends
  • Owners do not pay tax on corporate earnings unless they receive money as compensation for services or as dividends
  • The corporation pays taxes on the annual net earnings and files Federal Form 1120
  • Corporate owners, who want to leave some profit in the business, may benefit from lower corporate rates
  • For example, 2013 corporate tax rates are 15% for taxable income below $50K, plus 25% for taxable income between $50K-$75K; perhaps, lower than individual rates
  • Corporate taxation is more complicated than the pass-through taxation
  • Self-Employment tax does not apply; FICA payroll taxes are shared 50/50 between the corporation and the employee

Limited Liability Company (LLC) – Single Member

  • An LLC is an entity created by state statute
  • LLCs are state entities, so the level of legal protection given to a company’s owners depends upon the rules of the state in which the LLC was formed
  • Tax reporting depends on the status of the LLC
  • Depending on elections made by the LLC and the number of members, the IRS will treat an LLC either as a corporation, partnership, or as part of the owner’s tax return; i.e. a disregarded entity
  • An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes unless it files Form 8832 and elects to be treated as a corporation
  • If a single-member LLC does not elect to be treated as a corporation, the LLC is a “disregarded entity,” and the LLC’s activities should be reflected on its owner’s federal tax return on Federal Form 1040 and Schedule C, Schedule E, or Schedule F
  • An individual owner of a single-member LLC that operates a trade or business is subject to the tax on net earnings from self employment in the same manner as a sole proprietorship
  • A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Federal Form 8832 and elects to be treated as a corporation
  • All income, gain, loss, and deduction flow through to members unless the LLC is taxed as C-Corp
  • No double taxation unless the LLC choses to file as a corporation
  • Taxable at the personal income level and at the graduated rates
  • Self-Employment Tax applies except if the LLC operates as C-Corp
  • File Self-Employment tax on Schedule SE; see Sole Proprietor for additional information

Subchapter S-Corporation (S-Corp): Double Taxation does not apply

  • Separate legal entity
  • Limited liability for shareholders, officers, and directors
  • Generally, a corporation’s shareholders are not personally liable for the corporations debts just because they have ownership in the business; the same is true for the members of an LLC
  • S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes
  • Generally, the S-Corp does not pay Income Tax at the Corporate level; they can be responsible for tax on certain built-in gains and passive income at the entity level
  • Self-Employment tax does not apply
  • Many small business owners use S-Corps because they can save a business owner Social Security and Medicare taxes
  • Owners receive a salary and normal payroll taxes apply
  • As an owner-employee, the corporation pays ½ of the payroll tax which can be a substantial tax savings to the owner-employee
  • An S corporation must pay reasonable employee compensation to a shareholder-employee in return for the services the employee provides before a distribution
  • File S-Corp informational return on Federal Form 1120-S
  • Income, gain, loss, and deduction is passed through to share holders
  • Shareholder-employees will receive two tax documents from the S-Corporation: a W-2 wage statement and a Schedule K-1 statement
  • Shareholders report the flow-through of income and losses on their personal tax returns; taxed are based upon the individual income tax rates
  • Double-Taxation does not apply
  • Shareholder-employees are taxed on their salary income and on any profits distributed by the S-Corporation
  • Profit distribution is not subject to FICA payroll taxes; salaries paid must be reasonable for services provided
  • Shareholder-Employees file Federal Form 1040 and Schedule E – Supplemental Income and Loss
  • Under California law, the S corporation is subject to a 1.5 percent tax on its net income
  • See if special tax rules apply in your state

Understandably, reading about tax implications and legal liability might seem a bit boring. Most would agree. Think about it this way:

  • Money saved is money you do not need to earn
  • Knowing you are protected is a good form of “sleep insurance”

Chinese Proverb: To open a shop is easy; to keep it open is an art.

Deb Fox can be reached via twitter @ debfoxfinancial or via e-mail @ debfoxfinancial@gmail.com.

http://www.debfoxfinancial.com/