WHAT BUSINESS ENTITY SHOULD I BE?
Selecting Your Entity -Your First Most Important Strategic Decision
Most business owners spend little time making this decision and it impacts everything you do from that point forward.
Don’t take the passing recommendation of a friend or “off the cuff” advice from an article on the web or in the media. These sources are not focused on the unique needs of your business or the tax considerations.
Now with substantial changes in business tax law, Tax Reform Act of 2018, entity selection is even more important. This decision can impact your tax life based on the structure of your company and how net income or loss impacts your bottom line.
Here is a brief summary of the fundamentals:
· The Most Basic Company Structure Is A Sole Proprietorship
Net income flows to your personal tax return. If you generate net income, it is subject to Self-Employment Tax on top of income tax.
Self-employment taxes are really Social Security and Medicare taxes charged to your business. Nothing fancy here. Very few filings or paperwork.
· Two Or More Members Or Partners In A Business May Operate As A Partnership
Net income of the partnership flows to its partners. The net income or loss is reported via Schedule K-1.
If a partner is an individual taxpayer, their portion of income or loss is reported on their personal return on Schedule E.
The partner’s share of Income may or may not be subject to Self-Employment Tax. This is a “Pass-Through Entity” discussed below.
· S-Corporation Is A Legal Entity And May Have As Many As 100 Shareholders
S Corporations are both similar and different from partnerships. The S-Corporation does not pay tax on its income but passes income or loss thru to its shareholders via Schedule K-1.
One important aspect of S-Corporation tax involves “reasonable compensation.” Active officers and majority shareholders are required to have a “reasonable” salary that is commensurate with the nature of the business and the role that is being played in the conduct of business activity. This is an issue that has generated many IRS audits with companies “pushing the envelope” too far while attempting to avoid taxes.
An S-Corporation does offer some significant tax planning opportunities. But, it has many “traps” that may create significant problems when not property complied with.
This is a “Pass-Through Entity”, discussed later.
· C-Corporations Are Not Limited As To Number Of Shareholders
C-Corporations pay tax on their net income rather than flowing the profit or loss through to shareholders. This creates the potential for double taxation.
C-Corporations offer many opportunities for tax planning and fringe benefits that other entities don’t offer their owners.
C-Corporation profits may be distributed to the active officers and employees salaries and bonus payouts or through after-tax dividends paid to shareholders. The discussion of “double taxation” enters the picture.
This is not a “Pass-Through Entity”.
· Limited Liability Companies [LLC’s] Are Legal Entities Of A Flexible Nature
LLC’s choose how they wish to be treated for income tax purposes depending on the number of owners they have.
LLC’s may function as sole proprietorships, partnerships, S-Corporations or C Corporations.
Making the entity election typically locks you in for at least 5 years before you may change.
If you have made a mistake in entity selection, it can be fixed. It is more complicated and expensive.
There are many additional details, advantages and disadvantages of each form of entity. Be aware that there are complicated issues, benefits and challenges associated with each entity form.
To peak your interest further, here’s one discussion:
All business forms will have a “Reasonableness Test” for wages, bonuses and benefits paid to a company’s owners and active shareholders.
This topic motivates the IRS because they have a lot to gain (more tax revenue) by challenging businesses in this area. The topic revolves around Social Security and Medicare taxes.
Every business form has scrutiny of business expenses that lower income and thus, taxation so we must be judicious about company perks that need to be usual and necessary to the conduct of business.
The 2018 Tax Reform Act created a new tax reduction to consider:
Pass-Through Entities may now enjoy a maximum of 20% deduction in income under Section 199A before passing income to their sole proprietors, partners, or S-Corp shareholders.
Will this be a significant boon to you or will you miss out? Planning is very important here.
Finally, in consideration you should now be given to the C-Corporation income that is only going to be taxed at a flat 21%. This is certainly reason to take a second look regarding the double-taxation argument when dividends from the C Corporation may be taxed at 23.8%, 18.8%, 15% or ZERO.
IT IS ALL ABOUT THE PLANNING
Our focus is to guide and advise clients to take advantage of and maximize the potential benefits and opportunities offered in today’s very complex tax world.
We generate value through our guidance.
Keep in mind what works for your friend or neighbor probably won’t work for you. Every client has specific needs and different objectives. A “cookie cutter” approach is not likely to achieve your goals as easily as a tailored approach.