You have a great idea for a business, and you can’t wait to get started! Knowing where to start, however, is tricky. Choosing a business entity can be complex and confusing. There are reasons and restrictions to each one. If you are starting a business, or have a business and are trying to decide if you should change the status of your business, professional Mitch Heifler of Miami, Florida is here to help guide you to the right decision.
Businesses do not need to have a separate legal entity. You can operate as a sole proprietor, as long as you have a “D.B.A.”, or Doing Business As document if your business is under a different name than your own. For example if you are simply handing out cards that say “John Smith, Construction” you can carry on without any paperwork (until tax season). However, if you are calling yourself “The Construction King”, you must file for a DBA. The DBA simply puts on public record who you are. It protects the consumer and allows them to have information, if they seek it out, to connect you to any unfinished jobs, illegal activities, or major debts in the past. It does not offer you, as the business owner, any protection.
If you are a sole proprietor, you are personally responsible for taxes associated with your business. You can deduct your business expenses to balance the taxable income and pay less for your business taxes. When you file as a sole proprietor, you are going to file your income and loss on both your Federal return and Arizona state return.
You can also operate as a partnership without forming an entity. When you do this, you will be taxed as a partnership, with your income and loss reported individually by each partner. You can deduct the same expenses as you would if you were a sole proprietorship.
Choosing an entity, however, provides you with some level of personal and business protection. The most basic form of this is the LLC, or Limited Liability Corporation. The company can survive changes of ownership and can be invested in. An LLC can be taxed like a sole proprietorship, or a partnership. If there are multiple members, they are taxed on their share of the income based on how much of the company they own, not how much they personally receive.
When considering how to file your taxes, corporations are divided into two classifications by the IRS, the C Corporation or the S Corporation. C Corporations pay tax on their income, and can write off losses and deductions. An S corporation is not taxed separately, and the owners pay on a percentage of the income from the company. They can use the losses from the business to offset other income. Distributions are not taxable.
C corporations are taxed on business income earned by the corporation, and then again when the income is distributed as a dividend to the shareholders. So, essentially, they are taxed twice on their income. S Corporations are taxed to the owners/shareholders only one time when income is made. An S Corporation can have up to 100 shareholders, and each family member (if applicable) can be treated as a separate shareholder. However, a shareholder cannot be a C Corporation. An LLC is taxed only to the owner or partners one time when income taxes are filed. It is not a separate entity.
There are also restrictions occasionally on the type of business, or owner of the business, when considering different business entities. A C Corporation has no restrictions, but an S Corporation must be domestic. Some insurance companies and financial institutions cannot be classified as an S Corporation. A C corporation can use a calendar or fiscal year to pay taxes and file information, and must use the accrual method of accounting, with few exceptions related to service corporations. An S Corporation is held to the calendar year, with few exceptions, and the cash or accrual method of accounting is allowed. With an LLC, you must use the accrual method of accounting if the business is a tax shelter, or if a C Corporation is a member. The accrual method of accounting means that all expenses are matched specifically with the corresponding income, and are reported when the purchase or expense occurs and not when the cash is paid.
The income tax rate of a C Corporation can be up to 35%, while shareholders are taxed 20% on distributions. Shareholders of S corporations are taxed up to 39.6% on income and 20% on capital gains. LLC members are subject to the same rates as S corporations.
There are other tax related considerations when choosing a business entity. Social Security taxes are placed on income made for services. In the case of a C Corporation, all employees must pay employment taxes. Half of the Social Security and Medicare taxes are paid by the C Corporation, and half are paid by the employee. As a C Corporation, you can deduct a portion of the Social Security tax that is paid from your company’s funds. The S Corporation has similar guidelines. Non-wage distributions to employees are not subject to employment tax. If you plan appropriately with the help of Mitch Heifler, he can help you reduce the employment tax due on owner distributions. Attempting to report your wages as an owner as non-wage distributions in order to reduce your employment tax liability is fruitless, however, since the IRS will analyze your wages and reclassify your income based on a reasonable wage. The reasonable wage factors in your company’s income, employees income, and portion of ownership in the Corporation. An LLC is different in that the owner is subject to self-employment tax, and can deduct half of the self-employment taxes paid against their total taxable income.
Determining what type of business you have and how you want to classify your entity is crucial for financial planning. If you live or do business in the Miami, Florida area and own a business, call Mitch Heifler by clicking the link below for help with your important business and tax decisions.
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