WHAT IS RIGHT FOR ME?

One of the many questions I get as a tax and financial advisor is what business structure to choose when you are starting a business. Liability notwithstanding, a big determining factor is the direction of the business and how you want it to be taxed. Now before some of you check out on this topic here is a quick note for the tax year 2018. Early statistics are showing refunds are coming in lower. This does not mean you are paying more taxes(in most cases) just that the withholding calculator was adjusted so many people are having less money taken out. We shall see how things turn out, when all the data is received, however you should re-evaluate your withholding on your W-4 to plan ahead for 2019. I am not a proponent of getting a big refund(basically an interest free loan to the government) but no one likes to pay upon filing.

Now there are two main types of for profit business structures we will call them pass through entities and C Corporations. A pass through simply means all the profits and losses of the business will “pass through” to the tax return of the owners. Meaning for example, if your business has $100K of profit, then as the owner you personally will pay tax on that $100K. As a business owner you are liable to pay federal taxes(up to 37%) and FICA taxes(social security and medicare 15.3%). This reality could mean that you could pay nearly 50% tax on your profits(yikes!) However, with proper planning you can reduce that number and here is a breakdown of your main entities and an example for your review.

Pass Throughs

Sole Proprietorship

This is normally the business everyone starts with. When you start making money directly from people, for a good or service, you have a sole proprietorship. The IRS states your activity reaches to the level of a taxable business when you make over $400. As a sole proprietor you could operate alone indefinitely or bring on contractors or staff—but if your income passes a certain threshold, you’ll want to incorporate.

Sole proprietors have their pros and cons. On the positive: Sole proprietorships are the easiest and most affordable to set up. There’s no legal paperwork involved, outside of local licenses and permits, so you can be open for business immediately. You can deduct most business losses on your personal tax return and tax filing is easy—simply fill out and attach a Schedule C to your tax return.

On the downside: As a sole proprietor, you’re taxed as an individual—which means letting go of a significantly larger percentage of profits than you’d pay as a corporation. You’re also 100% liable for the company’s finances meaning any debts of the business could cause you to lose your personal assets. With these concerns it is much harder to get financing from banks and investors.

Best Candidates

If you want to run a small and simple operation, with few employees, the sole proprietorship could be best for you.

People who are successful in this role are comfortable making 100 percent of the business decisions, while also being accountable for any costs, debts, and legal responsibilities.

Partnership

A partnership is very similar to a sole proprietorship except it is with 2 or more people. They are called your partners(they pay top dollar for this info). There are two types of partnerships: general partnerships (GPs) and limited partnerships (LPs). In a general partnership, all partners actively manage the business and share in the profits and losses. Like the Sole prop all you and your partners have to do is start conducting business to be open.

In the GP, each partner is personally liable for the debts and other liabilities of the business. With that being the case, it is important to choose the right partner and have proper planning in place to resolve disputes and splits from the business. The tax filing is more complex as you file a 1065 form where each partner receives a K-1 form showing their portion of the profits or losses of the business.

A LP is a registered business entity where one set of partners(general) actively run the day to day operations of the business and the other partners(limited) only act as investors. The limited partners are only responsible up to the amount they contributed to the business, as opposed to the entire business, and do not have personal liability. LPs also will not pay FICA taxes as they do not have an active role in the business.

Best Candidates

If you have a business idea that requires you to work with someone else via day to day operations or capital, then a partnership could be a good choice. Simply start working together for profit and you have a partnership.

S Corporations

An S-corporation is a singular or multi owned business that provides liability for the owners but has pass through tax treatment. This means that, like a sole prop or partnership, an S-corp’s profits and losses pass through to the owners’ personal tax returns. There’s no corporate-level taxation for an S-corp.

An S-corp can only have a maximum of 100 shareholders (all of whom must be US citizens or residents) and only one class of stock. Shareholders are paid a set wage which controls the amount of FICA taxes are paid. Because of this tax advantages the IRS constantly monitors the wages of shareholders who are employees to make sure they are being compensated according to market and industry standards and paying the fair amount of taxes.

Best Candidates

If you don’t plan for massive growth and won’t have any foreign partners and don’t mind the extra cost and filing requirements, then the S-Corp can be a good solution for you.

Limited Liability Company

A limited liability company (LLC) is a hybrid business entity. Owners can choose how they are taxed, either individually to each owner(as a Sole Prop, partner or S-corp) or as a corporation. The entity provides the owner personal liability protection with the flexibility to adjust your tax strategy over time.

Best Candidates

An LLC is for those looking for a legal structure that’s relatively easy to set up and you want some flexibility. You will want a clear exit strategy for each partner and a plan for the business, so you can choose the taxability wisely.

C Corporation

C corporations are the most common form of corporation in the U.S. It takes the liability off individuals because it is its own legal entity. The corporation itself can retain profits and incur losses and is taxed separately from its owners.

The owners are compensated with wages and pay additional tax on distributions of profits after the C Corp files its own tax return. Establishing a corporation is complex and expensive and regulations on the state, federal, and local levels can result in large legal bills.

Best Candidates

C corps are a great option for companies expecting high growth and expansion. It can also be suitable for businesses that need to retain money for business operation in the future.

Example

The most frequent question I get is how to have your LLC taxed. One of the main factors here is controlling the amount of FICA taxes. Many entrepreneurs get shocked by the extra 7.65% they have to pay on their earnings. So many like to reduce that by paying themselves wages. Here is an example:

Mr Business owner is a single taxpayer who files a standard deduction and has $100K of business profit. He didn’t withhold any taxes during the year and ended up with the following situation:

Adjusted gross income(AGI): $92,735

QBI deduction: $16,187

Self Employment tax: $14,129

Federal Tax: $10,179

Total tax: $24,308

His counterpart Ms Business owner decided the previous year, by March, to pay herself a wage of $40K. She is also single filing the standard deduction and she paid the following taxes.

Adjusted gross income(AGI): $92,735

QBI deduction: $11,388

Self Employment tax: $6,120

Federal Tax: $12,126

Total tax: $18,246

The Ms in this example was able to save $6,062 through the S-corp election. This can be a powerful planning tool but must be administered correctly. As always let me know if you have any additional thoughts/questions.