The Revolution Will Be Taxed. Four Possible Ways to Structure Your Business.

If you are running a small business, or are thinking of starting one, have you wondered if you need to be a corporation? Do you have employees or independent contractors working for you? Are you paying your help in the most tax efficient manner? Do you travel a lot for business and pleasure, or both? If so, are you deducting the correct portion of your trip? Are you maximizing how much money you can put away in retirement savings plans?

These are some of the common questions that most independent workers and business owners ponder over on a regular basis. There are many tax planning ideas regarding these questions, many of which freelancers and small businesses owners may have not even thought about.

This article will attempt to provide you with a basic understanding of the more common types of companies to run your business under, as well as some basic tax concepts regarding these decisions.

Generally, there are four basic ways to set up your business for tax purposes. Corporation, S-corporation, Partnership/LLC/LLP and sole proprietorship.

Corporations

First, a corporation. A corporation is a separate legal entity that stands on its own for tax purposes. It is owned by one or more individuals or entities. A corporation is created in a state (your choice as to where). Contrary to popular myth, incorporating in a state that charges minimal fees to incorporate is not always the best answer since a corporation must pay tax in the state (and often the city) that it does business in regardless of where the corporation is incorporated. So, choose your state of incorporation wisely. It is best to consult with an attorney and your CPA as to the best state to incorporate to attain the best benefits both legally and financially.

Once the legal entity is set up as a corporation, the corporation must file annual tax returns for the IRS (federal) and the required state/city tax returns. These tax returns report the corporation income, expenses and other required information. The corporation pays tax at the corporation level on the corporation's taxable net income (taxable net income = all income minus the allowed expenses and deductions).

A major detriment of a corporation of this type is the concept of double taxation. First, the corporation pays tax on its net income. Then, once the company has profit and decides to "distribute" that profit to its shareholders, the distribution is in the form of a "dividend". This dividend paid by the corporation is then included on the recipient's taxes and taxed again. Hence, double taxation. The dividend paid is NOT deductible by the corporation so it does not result in any tax savings for the corporation. The only other way to "distribute" the corporation's profit is the pay salary to the owners, and though the corporation does get to deduct this, that salary is also subject to income tax and social security tax on the recipient's individual taxes.

S-Corporation

This concept of double taxation brings us to the next commonly used entity known as an S-Corporation. An S-Corporation is created in the same way as a regular corporation (as explained above) and thus files annual tax returns with the IRS and required states (and cities). However, once the corporation is created, the corporation must file "S-corporation" election forms (federal and often state) within 2 1/2 months of creation, and meet some general requirements and restrictions, in order to be treated as an S-Corporation for tax purposes. The main benefit of the S-corporation (over the regular corporation) is that the S-Corporation does NOT pay tax on its net income at the corporation level for Federal taxes (and even most states). Rather, it is a "pass thru" entity and the net income flows through to the shareholders of the company and is included on the shareholder's tax returns. Hence, for federal and most states, only one level of taxation on the profit. Note: be careful with NY City since NY City does not "respect" S-Corporations. You should be sure to discuss this with your CPA.

It is important to note that it is not the total shareholder’s distributions that are taxed, but the S-Corportions net income. This means that if the S-Corporation chooses to leave some of its profit in the bank, the shareholders are taxed on it anyway.

As you may or may not know, most of us pay two types of tax on our earnings. Income tax and social security tax (FICA and Medicare). A kind of loophole in the tax law states that the pass through income from the S-corporation to its shareholders (done via a Form K-1 issued by the corporation) is only subject to income tax and NOT social security tax. This could result in big savings in taxes for profitable corporations. So, many of you may now be saying, "why wouldn’t every company be an S-Corporation and save these taxes?" Well, two answers that somewhat negate this. One: the IRS is not that clueless (contrary to what people may think). The IRS often examines S-Corporations to determine if an adequate and reasonable amount of salary is being paid to the shareholders performing the services for the corporation. So if your small business brings in a profit of $100K, but your “salary” is only $10,000, they’re going to notice. And if an adequate and reasonable salary is not being paid to those shareholders, the IRS may reclassify ALL of the distributions made by the corporation as "salary" and require that social security tax be paid on this full amount as "deemed" salary. This obviously results in the loss of that benefit of only paying income tax on the corporation's net income. Thus, S-Corporations need to be sure they are paying an adequate and reasonable salary to those shareholders performing services for the company. Adequate and reasonable to the IRS is based on many factors including the profit and revenue of the company, the size of the company, the industry of the company, comparable salaries of people performing similar services outside of the company and various other factors. Your CPA should be assisting you in coming up with an adequate and reasonable amount. The second reason why a shareholder may not want to avoid paying social security tax is, by doing so, the amount being paid into the US social security system is limited and thus, upon retirement, the social security benefits received may be limited and/or lower than anticipated.

Partnership

The third type of entity is a partnership. Many of you have possibly also heard of LLCs and LLPs (Limited Liability Companies and Limited Liability Partnerships). All three of these have different legal ramifications so you should be sure to consult with an attorney. However, in general, for tax purposes, all three of these are generally treated the same. As with a corporation, the partnership is created in a state and, instead of having shareholders, it has partners (or "members" if it is classified as an LLC or LLP) and files an annual tax return. Similar to an S-corporation, a partnership is a flow through entity and doesn’t pay tax at the Federal (IRS) level. The partnership issues a Form K-1 to its partners/members and the income is included on the partners' tax returns. Note that in NY City, depending on income levels, the partnership may be subject to the NYC Unincorporated Business Tax ("UBT"). Unlike S-corporations where the income that passes through is only subject to income tax (not social security tax), earnings passing through to the partners of a partnership are subject to both income tax and social security tax.

Also unlike S-corporations, there are no major restrictions or limitations on who can qualify as a partner of the partnership. Additionally, which is beyond the scope of this article, partnerships have more flexibility in the allocation among partners of the profits and losses of the business than do S-corporations.

All the above types of entities have several tax related requirements in common. These include but are not limited to:

• Maintaining an accurate set of books and records (accounting/bookkeeping)
• Maintaining proof of expenses and income via receipts, cancelled checks, credit card bills, invoices etc. (Note: You are required to show proof of payment of an expense AND a receipt/invoice for the expense. Just a receipt is often not sufficient.)
• Filing annual tax returns and, depending in the type of entity, paying quarterly estimated taxes both to the IRS and to states/cities.
• Maintaining separate entity bank accounts and credit card accounts - meaning separate than the shareholder/partner's personal accounts.
• Obtaining an employer identification number ("EIN"). This is similar to a social security number but for a company.

Sole Proprietor

The last common way to structure your business is to not create an actual new business entity, but rather to operate as a sole proprietor (commonly used by freelancers). This basically means that you are running a business solo (under your own name or under a registered business name) but not through a separate legal entity. The income and expenses of your business are reported as part of your personal tax returns via Schedule C (and some other related forms/schedules that may be required). Other than your personal tax returns, no other separate income tax filing is done for a sole proprietorship (unlike the annual tax returns required for actual legal entities). Generally, everything that is deductible for an actual legal entity is also deductible for a sole proprietor. A sole proprietor can have employees, separate bank and/or credit card accounts, an employer ID number, etc. The profit from the sole proprietorship is subject to both income tax and social security tax (note that in NY City, depending on income levels, a sole proprietor may be subject to the NYC UBT - Unincorporated Business Tax) and is all paid with your personal income tax returns, which also means a savings when you visit your CPA in April.

As mentioned above, there are many tax implications (both positive and negative) of these various entities as well as legal implications. You should discuss your options both with your attorney and your CPA to determine the best structure to operate your business. The links below also contain various tax related information you may find useful.

www.IRS.gov - Excellent site and has special section for self-employed
State websites - Usually something like www.nys.gov. check www.sisterstates.com for links to all states

Contact Howard directly for advice specific to your business and needs.