Starting your own business is very stressful. However, if you set up your business correctly initially, you can alleviate the chances of future problems, leaving you time to grow your business.
First, you must consider the following factors when determining what type of business entity to set up:
· What are your business goals and strategy?
· How much control would you like to have?
· What type of structure you would like to put in place - each type of entity has its own unique criteria that must comply with Federal and State regulations?
· Is your type business more likely than the average to be subject to lawsuits?
· Which structure is most likely to reduce your tax obligations, while complementing your business strategy?
· Do you anticipate a profit or loss in the first few years?
· Will reinvestment of earnings be required to grow the business?
· And will you need to have immediate access cash for personal use?
Now you have answered the questions, you and your tax professional can determine which type of business entity would be right for you and your business.
For Federal Tax Purposes, there are essentially four different types of entities to consider:
As the name indicates, a sole proprietorship can only have one owner. This is the simplest form of business as no separate tax filings or legal filings are required. The business income and expenses are filed on a Schedule C of your personal tax return. Your net profit is taxed at your individual income tax rate. As a sole proprietor, your income is also subject to Self-Employment Tax (Social Security and Medicare) of 15.3%. While this can be expensive from a tax standpoint (up to 50% if you are in the highest tax bracket), it is sometimes worthwhile due to the simplicity of filing.
As with everything, there are pros and cons to a sole proprietorship. It is easy and inexpensive to set up, as the owner you have total control, and you receive all income/profits from the business. On the other side of the coin, sole proprietorships have unlimited liability, meaning as the owner you are responsible for all business debt - linking personal and business together.
Again, as the name indicates, a partnership has more than one owner. This form of entity requires a legal agreement between the owners specifying the details of the partnership, such as; how profits will be shared, how business decisions will be made as well as how disputes will be resolved, what the criteria will be to add new partners, how to buy out a partner, and how to dissolve the partnership.
When filing taxes, the business must submit a separate filing reporting the total business income and expenses. Each partner will then receive a schedule (K-1) reporting his/her share of the profit. This profit is taxed on the owner’s individual tax return, and generally is subject to Self-Employment Tax as a Sole Proprietorship would be.
Conversely, there are exceptions to the Self-Employment Tax as well as opportunities for liability protection that not offered to a Sole Proprietorship. This trade off is usually accompanied by increased professional fees for the preparation of the partnership agreement as well as additional tax filings.
A Corporation can have one or many owners. It is a separate legal entity from the owners and unlike Sole Proprietorships and Partnerships; it pays its own tax (instead of passing it through to the owners). The owners are simply shareholders, paid by the corporation in the form of wages, shares, and/or dividends.
As Corporations are not subject to Self-Employment Tax so it can often result in a lower tax bill. However, if you are a Professional Service Corporation (i.e. medical professionals, attorneys, architects, etc) you are subject to tax at the highest rate, 35%, regardless of your level of income.
Another major drawback is that when the owner decides to take income out of the business it is taxed at his/her individual tax rate at that time. This means that the same income can be taxed twice…once at the corporate level and again at the personal level.
Double taxation can be avoided by paying the owner wages. But this also means now the corporation must pay into Social Security and Medicare (the same 15.3% as Self-Employment Tax). While Corporations can be expensive from a tax standpoint, they are often necessary to involve foreign shareholders, publicly traded companies, and other special circumstances.
If you want to take advantage of some of the benefits of a partnership and some of the benefits of a Corporation, an S-Corporation (S-Corp) may be the way to go.
An S-Corp is similar to a partnership. Income or losses are taxed at the individual shareholders’ individual tax rate. Like a Corporation the earnings are not subject to self-employment tax, but like a partnership the income is taxed only once….at the individual tax rate. This avoids the possible double taxation of a Corporation and the higher 35% rate for professionals.
Too good to be true? Here is the catch - the officers/owners must take a wage from the company and subject themselves to Social Security and Medicare taxes on that wage. This wage needs to be reasonable for the position, but additional funds withdrawn from the S-Corp may not be subject to this extra 15.3%.
Corporations and S-Corps alike usually have increased administrative burdens in the form of legal fees, accounting fees, and payroll processing, but if planned correctly the tax savings can far outweigh these costs.
Each business has its own set of circumstances and no type of business is right for everyone. Please contact your legal advisors and tax professionals to see what is best for you!
Kevin Gardner, EA Vice President Sterling’s Bookkeeping & Tax Service. www.sterlingstax.com
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