Startup Steps #3: Entity Taxation Issues
As I alluded to in Startup Steps #2, the question of whether a business owner should form a LLC or a S corporation is largely a tax question, rather than a legal question. In order to answer this question, I’ve asked my good friend, CPA Pam Ricker, to share her insights on the taxation of business entities.
First, a bit about our guest author: Pam Ricker has been in public accounting since 1980. She obtained her CPA certification in 1992. She has always worked with firms specializing in small business accounting and income taxes. From 1996 through 2001 she had the position of corporate controller for a group of rental stores. The time spent as a controller is valuable to assisting our clients as she was responsible for acquiring all financing, insurance and handling all human resource functions in addition to the accounting needs. She and her team take a proactive, educational approach to accounting. They help their clients understand their financial statements so they can use them as tools for their business. To help make doing business easier for their clients, they give them access to strategic partnerships they have established for overall financial success. Referring clients to the financial section of their business plan or “road map” for success helps them create and maintain it. “There will always be detours and bumps in the road, but if you come back to the plan, you can get back on track.” She encourages other entrepreneurs to keep their focus.
You can reach Pam via email at email@example.com.
Taxes – what’s the cost – Pam Ricker
Starting a business is very exciting. Structuring the business correctly is very important!
One of the considerations in the choice of entity is taxation. The shift from employee to self employed can catch new business owners by surprise at tax time if they do not have advice and guidance from the start.
Let’s look at an example: You have just ended your employment with company A and are now self employed starting your business B. With company A your net paycheck every two weeks was $950. You get a great contract for your business and ask them to pay you $1,500 every two weeks – Wow $550 more each “pay period.”
Oops – let’s look at it this way.
At company A you actually made $1,300 every 2 weeks and $350 was taken out for social security, Medicare, federal and state income taxes. Company A also covered your office supplies, equipment and other costs. (Tax rates based on 4.2% social security, 15% federal and 7.5% state)
Now at your business B you receive your $1,500 check – you have to pay $200 for the office supplies and the phone bill – so you have a $1,300 profit – but on that you owe $430 in taxes because you owe self employment tax which is the equivalent of both employer and employee social security and Medicare along with the federal and state income taxes.
What happens often though is many business owners forget to set the $430 aside or they have immediate bills to pay and figure they will catch up on the taxes later. Since taxes are not deducted automatically from the check it can be easy to justify these thoughts. This attitude can be very detrimental because if nothing was set aside all year the $430 every two weeks turns into over $11,000 in a year’s time.
The above example is a common occurrence with sole proprietors and single member LLC’s (Limited Liability Companies). Losses in a sole proprietorship or single member LLC are directly deducted from ordinary income on the individual’s tax return.
Multi- member LLC’s and partnerships vary in the method of computation because there is a separate tax return filed for the business but the income still flows through to the member or partner subject to income taxes. Guaranteed payments (wages paid to partners) and the general partner’s shares of income are also subject to self employment tax. These are also entities that can cause tax trouble for owner’s who are unaware because again there isn’t any withholding of taxes from the guaranteed payments, partners are paid a gross income and are responsible for paying in the taxes. Going back to our example above a $1,300 guaranteed payment every two weeks would mean you need to set aside $430 from each check to cover the tax liability. If the partnership had a loss it would be directly deducted from the partner’s ordinary income for income tax purposes for general partnerships. Limited liability partnerships require partner’s to have basis (an investment in the business) to deduct the loss.
S Corporations are another popular entity for small businesses. In this type of entity the owner (shareholder) is treated as an employee. The shareholder takes a reasonable wage from the business and pays taxes on those wages as any other employee would. The S Corporation gets a deduction for the employer portion of the payroll taxes. Any taxable net income of the S Corporation passes through to the shareholder’s personal return and is taxable as ordinary income. This income is taxed on the shareholder’s return whether they take it out of the business or not. Once it is taxed it becomes part of the shareholder’s investment in the business and they can take out a distribution without paying additional tax. As in limited partnerships an S Corporation shareholder has to have basis in the S Corporation to be able to deduct the loss.
The C Corporation is probably the least used type of entity for small businesses as it creates double taxation. The C Corporation is a separate entity which is directly subject to taxes on its income. If there is any additional income in the corporation to be paid to the shareholders it is paid as dividends. These dividends are again subject to income tax on the shareholder’s return. The owner / shareholder can be an employee of the C Corporation and can take a wage for their services. This wage is subject to normal employee taxes.
Another difference between the types of entities is how retirement fund contributions are calculated. As an employee it is based on your gross wages. This would be the same working for someone else or being an owner / employee of a C or S Corporation. In the partnership or multi-member LLC the retirement contribution is based on earnings from guaranteed payments. As a sole-proprietor or single member LLC the retirement contribution is based on the net income on Form 1040 Schedule C or F. Why do I bring this up – the answer is easy. One of the “selling” points for an S Corporation is the fact that not all of your income is subject to self employment tax as it is on Form 1040 Schedule C. Though a valid point it is not always a fact. If your goal is to be able to contribute more money into retirement funds which are based on higher wages then you may not have less money subject to self employment (social security) taxes.
Weighing all the pros and cons of entity choices from protection of assets, liabilities, personal responsibilities, taxation and long term goals all are part of the decision making process. Being educated about them helps you make a more informed decision. Not just a decision based on what everyone else is doing. Look for advice from professionals in your area to help you make this decision and guide you as your business grows.