In a previous post, we looked at some of the steps involved with starting a small business. This time I’d like to dig deeper into choosing an entity for your business from a financial and tax perspective.
The legal pros and cons are best left to your attorney, and consult your tax advisor for more details about your specific situation. These are general guidelines and in no way comprehensive.
As I mentioned last time, a limited liability company is a very popular form of business structure. It offers liability protection while being flexible in the taxation department. By default, your LLC will be taxed as a partnership if there is more than one member (owner), or if you are the only member, as a sole proprietorship on your personal tax return. You may also make an election for the LLC to be taxed as a corporation or S-corporation, each with nuances of its own in the departments of health insurance, taxation, paperwork and especially owner compensation.
One mistake I often see small business owners make is thinking they can do as they wish with their profits. Unfortunately, unless the business is taxed as a sole proprietorship, the IRS has a lot to say about how you get your money.
A C corporation is plainly just a regular corporation, without the subchapter “S” election. The C corporation has gotten a bad rap in my opinion. While it is true that its profits are subject to double taxation (taxed first at the corporate level and then again when profits are distributed as dividends), it is possible as a small business owner to manage the profit and keeping it small, by paying out profits in the form of salary. As the owner of a C corporation and working in the business, you will be compensated through the company payroll, with all of the payroll taxes and paperwork that would be involved with any other employee.
At the end of the year, the corporation will issue you a W-2 to claim your income on your personal tax return. What I find to be one of the biggest advantages of corporation is that its a great way to write off your medical costs as a single owner without other employees. A corporation can establish a Section 105 medical expense reimbursement plan, and run health insurance premiums and other medical costs like copays and prescriptions through the plan tax free.
At year end, the corporation files its tax return on a federal form 1120 and in Pennsylvania, a form RCT-101. Any profits left after salaries and expenses are taxed, and any losses may be carried backwards or forwards to offset profits in another year.
The S corporation is not a taxable entity unto itself, but rather acts as a conduit, passing profits and losses generated at the corporate level on to the shareholders personally. These profits are reported on a Schedule K-1, and are not subject to employment taxes. Sounds like a great way to save some taxes, right? Wrong. The IRS frowns upon taking profits in an S corporation solely through the K-1. For owners who work in the business, the IRS requires a reasonable compensation be paid out as salary. As the sole owner and sole person working in a business, you’d have a hard time justifying to the IRS that the profits of the business were a function of the business alone and had nothing to do with your efforts. When you file your personal tax return then, you will likely have two components from your S corporation: your wages reported on a W2, and any profit or loss reported on a Schedule K-1.
One of the downsides to an S corporation is that the rules for using the Section 105 plan mentioned above are complicated. If your spouse is a bona fide employee, he or she may benefit from the plan, but as a greater than 2percent owner, your options are limited.
Tax filings required of an S corporation include a federal corporate return, Form 1120-S; a Pennsylvania S corporate return, the PA 20-S; and the PA RCT-101. Any profit or loss flows through to your personal return. There are rules that govern how those are taxed or deducted, depending on your “basis” — meaning your investment in the company. Without basis, the loss is not deductible. The rules pertaining to the deductibility of your loss are complex and best left to your tax professional to determine in your individual situation. Do document how much you are contributing to the company or withdrawing; it is important to know that for proper tracking. Note, too, that an S corporation is limited to 100 shareholders.
A partnership, like the S corporation, is not a taxable entity but a conduit. All profits and losses flow through to the partners’ personal returns. But unlike an S corporation, a partner working in the company is not paid via payroll, but rather through “guaranteed payments.” Those are payments determined in advance by the partnership that the partner will receive in exchange for a contribution to the business, regardless of profits. Those payments received in exchange for working in the partnership are subject to self-employment tax. The partnership will file three returns also: the federal 1065, the PA 1065, and the PA RCT-101.
The most basic way to classify a single member LLC for tax purposes is to consider it disregarded. That means when the IRS looks at your LLC, it doesn’t see it, but only sees a sole proprietorship that is reported on a Schedule C on your personal tax return. That simplifies your tax reporting responsibilities, and also allows you to deduct losses more easily.
For owners who are active in the business and whose investment is at risk, losses may be used to offset other income. Any profits that are available from the business are yours to take at any time; they are considered to be draws and not salary or an expense. You should not pay yourself as an employee. The same rules apply as the S corporation with regard to a medical expense reimbursement plan; a spouse may participate as a legitimate employee, but not the owner.
Sole proprietors with an LLC don’t get off completely from filing corporate returns though. Pennsylvania requires all LLCs, whether disregarded or not, to file the PA RCT-101 corporate report. Within that report, a balance sheet is required, providing the assets, liabilities and owner equity at the prior year’s end. Finding out from the state that you should have filed the RCT-101 all along can come as an unwelcome surprise and lead to a scramble to pull together old information to file prior year returns in a hurry. Even if the return ends up with no tax due, the state still wants to know how your business did.
If you’re debating your entity choice, looking for business planning tools, or have other questions about starting and operating a small business, the Small Business Administration website has a wealth of information available for free. You can find them at www.sba.gov.