Tuesday, November 23, 2010

Advice from the Experts - Tax & Entity Formation

This week I have information for all of you who are wondering about the type of entity you should operate under.  Sole-proprietorship, S-Corp, C-Corp or ???  There are always reasons to be considered before you make a decision and one of my colleagues, David Herndon who is a tax and business advisor has written the following article about this subject.

Many times clients ask, when opening a business, “what about an LLC or an S Corp?”  The question is really a bigger one—should I operate as a Sole Proprietor, or operate through an LLC company, or in the form of a for-profit corporation?  I wish it were this easy, but to answer this seemingly simple question means asking lots of questions and gathering an intimate knowledge of the client’s situation.

Assuming a viable profit model for their business, I first ask questions trying to determine whether there is a need for some form of liability protection for their business.  Each states’ laws are different, but generally they all offer for-profit corporations and limited liability companies under their laws.  For the purposes of this discussion, I will assume we are dealing with a sole owner—that is, we are not talking about a business that will have two or more owners.

If there is a need for liability protection above and beyond that provided by a commercial or professional liability policy, I will then rule out the sole proprietorship form for the business.  I will next try to assess what the client’s ability is to keep pristine legal records and to follow a more rigid legal structure [which is both more stringent in a for-profit corporation than in a limited liability company] and whether their business model will have employees, other than the owner.

If the business will have employees other than the owner, then the business will have to process payroll and file payroll tax reports, etc., without regard to how we pay the owner.  If however, the business will not have employees, but only compensate the owner for his/her services, then the LLC form versus the for-profit form of entity may be the easiest for the owner to deal with—particularly if a less rigid legal structure seems easier for the owner to operate under.   If however the business appears to be one that will have profits in excess of that which the owner “needs” to live on, I will tend towards a for-profit corporation.  An LLC is reported on a Schedule C of the owner’s form 1040, personal income tax return, and the full profit is subject to ordinary personal income tax as well as self-employment taxes [social security and medicare].  Any profit left for savings or reinvestment is left over after maximum taxes have been applied.

But with a for-profit corporation, the owner is presented with a couple of choices perhaps limiting the income tax and social security/medicare tax bite.  This could represent a considerable annual cash savings for the owner.  With a for-profit corporation, although a more rigid legal structure, one can decide to leave the corporation taxable [referred to as a C Corp] or avoid the corporate level tax by a tax election under the income tax law [referred to as an S Corp].

But with either of these approaches, the owner needs to include him/herself on payroll from the corporation.  If the owner is going to be running payroll for other employees, then the small cost of processing payroll for him/herself is nominal—and the owner is already dealing with the fact of payroll reports, payroll taxes, workers compensation insurance, etc. for the employees.

If the owner has the ability to put aside a cash savings each year, to accumulate an amount of money without regard to needing it for reinvestment in the business currently, then a C Corporation might be best.  If the owner is otherwise at a high personal tax bracket, then the bottom federal rate of 15% might offer a 20% +/- savings on up to $50,000 of corporate profit each year.  The tax law currently allows you to accumulate up to $250,000 in a C Corporation without any “need” to justify retaining this amount of corporate profit.  So the basic financial model would be to form a for-profit corporation, do not elect S Corp tax status, put the owner on payroll, and “manage” the corporate profit at year-end by possible bonuses to the owner—you would target closing the books with $50,000 of taxable corporate profit for the company.  In addition to the tax rate spread difference in cash savings, the owner saves self employment taxes on the amount of profit left behind in the company versus what otherwise would have to be paid in either the Sole Proprietor or LLC mode. 

If however, the business model is a profitable one, but the owner may need all the money to live on or grow the business on, then an S Corporation tax election may be the preferred choice.  Under an S Corp model, the owner still must be on payroll as the IRS requires that the company pay the owner a reasonable, comparable salary for their labors and work efforts.  But the balance of the profits, representing a return on the investment to the owner as profit for money invested or business risk taken, can pass through to the owner’s personal income tax return free of any self employment [social security and medicare taxes] thus saving those two taxes being imposed on the S Corp income.

Ask questions and be sure you give complete information so that your advisor can give you their best advice concerning your true situation.  Building an effective business/tax model for a client is no different than building an effective estate plan for a client.  The adviser must ask lots of open questions, gather data and information, then apply his/her years of knowledge of the tax law and experiences with other similar client situations to best advise the new client of his/her opinion of the legal and tax route the client should take.

David Herndon
Herndon Co., Tax Accountants
4411 Holland Loop Rd
Cave Junction, OR 97523
541-592-6688 [office]

So after reading this you should be giving consideration to whether or not you are operating on an entity that is most appropriate for you.  This is why having an advisor that is not only familiar with business but taxes is a valuable asset to your support team.  In my experience not all CPA's or tax preparers 'advise' small businesses and not all business consultants have an in-depth knowledge of the tax laws and how they impact a business structure.  Take the time to find the right people to help you and in the end they will earn their weight in fees by protecting you from any unnecessary financial consequences.

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