Are you a sole proprietor who would be better off operating as an S-Corp? Are you a partnership without realizing it? What does the LLC designation really buy you? Watch this video for answers.
Video produced by Black Butterfly Productions
My name is Amy Wall. I am an Enrolled Agent, a tax practitioner licensed by the IRS. I'm very interested in small business taxation. I have a Master's degree in Business Administration; but, probably more importantly, I come from a small business family right here in Tucson. So I'm very familiar with the pains and joys and ups and downs of owning a small business.
One of the most important issues that the small business owner must deal with is business entity selection. What that means is what kind of business entity are you going to operate as? The five big ones - and there's lots of like kind of different flavors here -but the five big are sole proprietorship, partnership, S corporation, C corporation, and LLC. I'm not going to talk about C corporations today because they're pretty complex. That could be a YouTube video all by itself. There are very few small businesses that elect to go through the hassle of operating as a C-Corp.
The business entity you select is going to have a tremendous impact on many areas of your business life. It's going to affect how much tax you pay, what tax returns you have to file, your bookkeeping, whether or not you need payroll, how you save for retirement, how your health insurance gets paid. Many, many things are affected by the selection of business entity, so this is something you really want to get right.
Let me start with the sole proprietorship. The sole proprietorship is the most common form of small business. The reason for that is that essentially it's the default entity for a single owner business. If you haven't chosen to be something different, then by definition you are a sole proprietor. There are pluses to this. The sole proprietorship is pretty easy to form. You get a business license if you need one, hang out a sign saying open for business, and that's pretty much all there is to it. You have total control as the one and only business owner. You have complete control of this business. You get to make all the decisions. That's also one of the drawbacks of this kind of operation. If you're sick in bed with the flu there's nobody else to take that meeting. It’s all on your shoulders.
Another drawback to the sole proprietorship is that your net income is subject to self-employment tax as well as federal and state income tax. I'm going to talk about self-employment tax for a minute. I'm often surprised at how many small business owners don't understand what self-employment tax is or why they have to pay it. If you've ever had a W-2 job as most of us have, you probably noticed at some point that some of your money was being withheld for social security and Medicare. What you might not have been aware of is that your employer was matching that amount and sending both halves in to the government. These are your contributions to social security and Medicare. When you are self-employed – OK, here's a quiz! Are you the employer, the employee, neither of the above, or both of the above? Of course you are both, you are the employer and the employee, which means you are paying both halves of Social Security and Medicare. It comes to about 15% of your net income. In addition to that you get to pay federal income tax and state income tax.
Now it's not a problem to contribute to your social security account. This is a good thing and when you get to be a little older you get to see what a good thing that is. It's a problem when you're not prepared for it. It's a problem when you sit down to do your taxes (not on April 15th, hopefully earlier than that) and you discover – surprise! - you have self-employment tax. It's really important to meet with your tax advisor during the year to get a handle on what kind of taxes you're going to have and be prepared to pay them.
Next we'll discuss partnerships. The partnership is the default entity for multi-owner businesses. If we have more than one owner, and they're not spouses, then we have a partnership. The positive aspects of the partnership have to do really with the partners themselves. With more people involved, hopefully there's more funding. With the right combination of talents we can have a lot more energy and more people to share the responsibility. The drawbacks of the partnership: like the sole proprietorship all the income is subject to self-employment tax. Unlike the sole proprietorship, however, the partnership has its own tax return. It’s just an information return; the partnership itself does not actually pay tax. Instead the partnership return (due on March 15th, by the way) collects all the income and expenses and then doles that out to the partners through what’s called the K-1 form. The partners then take those K-1s, bring them to their tax preparer (not on April 15th) and that income and those separately-stated expense items are added to their own personal tax returns. So the partners are paying tax at their own tax rates, not at some other partner’s tax rate, not at some partnership tax rate, it just gets added into your own income.
The third business entity is the subchapter S corporation. We normally just call this an S-Corp. The S-Corp is not a default. It must be elected at by filing a form timely with the IRS. The S-Corp is special in that not all the income is subject to self-employment tax. Income from your S-Corp comes from two streams: profits and W-2 wages. All active shareholders in an S-Corp must get wages. You're actually an employee now and you have payroll. The IRS expects each shareholder to get what's called “reasonable compensation”, which we generally define as what you have to pay someone off the street with your qualifications to do that job. But if there's profit above and beyond that reasonable compensation to the active shareholders, it comes through as income not subject to self-employment tax. Remember that self-employment tax is 15%, so this could make quite a difference in your tax situation. Of course this only works for businesses that are bringing in a lot of money - enough money to pay wages and then also have profit in addition. The S corporation must have a separate text return just like the partnership and that's also due on March 15th.
When we get to the levels of partnership and S corporations, it becomes increasingly important to keep business and personal accounts separate. That old habit of using a business check to pay your personal electric bill or vice versa is not going to fly. The IRS expects you to be running your business in a businesslike manner. We must always keep business and personal accounts separate.
The LLC is an interesting entity. It's actually a state-created entity. The IRS does not have forms or schedules for LLCs. Instead, a single owner LLC is taxed as a sole proprietorship and multi-owner LLCs are taxed as a partnership. An LLC can also elect to be taxed as an S corporation. As an S corporation, you would still need the payroll and the separate tax return.
The concept of LLCs is that there's limited liability protection for the owners. We need to be careful about how we understand this. A lot of people think, “Oh, I'm an LLC so I don't need to have insurance because I can't be sued.” This is not true. What limited liability protection means in terms of an LLC is that your personal assets are not on the table to pay off the business debts. You can always be sued. There is no substitute for having liability insurance. Final note on this liability protection: there's a concept called piercing the corporate veil. If you have pierce the corporate veil by intermingling -mixing and matching - business and personal finances, than you have essentially destroyed your liability protection and a court will rule that you no longer have the corporate veil. So once again, it’s very important to keep your business and personal bank accounts, credit cards, whatever else separate.
You can tell this is a very complex subject. We haven't even discussed pensions or health insurance. There's a lot more involved here so I do recommend talking to a tax professional about your particular situation. I'll be more than happy to offer you a free half-hour consultation. Come and chat with me; I'd love to meet you!
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