Tuesday, May 24, 2016

Turnover Tuesdays - Choosing Your Business Structure

For those who are not familiar, I started a series a while back called Turnover Tuesdays. Every Tuesday I like to highlight one item that I have resold. This will include profitable and non profitable sales. I hope that there is always something to learn.

Last week, we discussed one aspect of getting your business legit, which was collecting sales tax.  Another very important aspect is to decide which business structure works for your business.

Even though I didn't know what I was talking about last week, I hope you still got something out of it and at least did some more research on your own.  This week, I really don't know the ins and outs but I will talk about the basics again and hopefully someone will find it useful.  My knowledge is based on my research in books and online and conversations with my accountant.  I highly recommend you find an accountant or tax specialist yourself who can guide you to the right business structure for your business.

I also recommend speaking to a tax professional about your possible tax deductions.  Many are straightforward like expenses related to shipping supplies.  However, once you have a business that is partially/fully based on your home, some of your "normal" expenses can be at least partially tax deductible.  That's a post for another time.

Feedback and comments are always welcome either at the end of the post or via email orensmoneysaver @ gmail.com  If you like these types of posts, let me know.  I'd be happy to continue on tax topics since it helps me learn as well.

I sometimes get busy (read:lazy) and don't respond so quickly but I'm usually pretty good.

Different Types of Business Structures

1) Sole Proprietorship.

By default, if you haven't incorporated your business you are running a Sole Proprietorship and there is nothing wrong with that.  Your business name is John Doe Sole Proprietor.

2) Limited Liability Company

This is the most basic type of business entity after a sole proprietorship.  Though it is not a corporation, it has many of the liability protections of a corporation so that your personal income can be shielded from debts on the company.

It is a separate business entity but it is also a "pass through" or "disregarded" entity.  All the income is reported on your personal tax return.  This is significant tax wise.

Technically, single member LLCs and multi member LLCs are different and are treated differently.  A single member LLC files on their schedule C while a multi member LLC usually files with a K-1.  If you are going the route of an LLC, speak to your accountant about whether it might be beneficial to file taxes as a partnership LLC with your spouse or other as a minority owner in the company.  Well beyond my knowledge.

3) S Corporation

An S Corp is called an S Corp because it is taxed based on the rules of Subchapter S in the Tax Code.
An S corporation has the same liability shielding advantage, but is a corporation which is a legal entity.  Similar to an LLC, the income of the corporation flows through to the shareholders and is taxed at the level of the individual only and not the corporate tax rate.  This avoids a "double taxation."

There are more formalities involved and you must file a separate business tax return but there can be some tax advantages of an S Corp vs. an LLC.

4) C Corporation

An C Corp is called an C Corp because it is taxed based on the rules of Subchapter C in the Tax Code
A C Corp is what most large businesses are since S Corps are limited to 100 shareholders.   This is not a flow through entity.  Any income is taxed at the corporate rate instead of the individual rate.  The owners/individuals who are paid dividends by the corporation then pay their own income tax on those dividends.  If you are the owner, you are essentially taxed twice.  Do not set up a C Corp for yourself without discussing with a tax professional!

Self Employment Tax

The US Government applies special wonderful taxes just for the self employed like you and me referred to as Self Employment Taxes.  These include Medicare and Social Security Taxes.  If you have ever had the question of whether you will receive a 1099 or a W2 for your wages, you know that a W2 worker splits the social security and medicare taxes with his employer and a 1099 (independent contractor) pays the entire portion by themselves.

This tax is roughly equivalent to 15% with most coming from the social security component.  That's important because the social security component (12.4%) is capped at $118,500 of your income in 2016.  Any income above $118,500 only has medicare tax (2.9), not social security tax.

A sole proprietorship and an LLC must pay the full tax 15.2% on the first $118,500 of income.  That's over $17,000 in taxes if you make exactly $118,500.  Of course, income tax is in addition.

An S Corp can be treated differently.  An S Corp must pay it's employees (you) a reasonable salary though the definition reasonable is vague.  How much is reasonable for a reseller?  Depends if you are doing it for profit or for the points. The IRS does publish a guide to try and help you determine what is a reasonable salary.  Talk to your tax professional for yourself.

Either way, once you have paid yourself a reasonable salary, the rest of the income can come to you as distributions from the corporation which are taxed as corporate dividends and are exempt from self employment tax since they are technically not income.

There are a few huge, I mean huge, disadvantages to doing this. Your social security income is tied to your social security payments.  If you pay less into social security you will receive less when you retire so you saving money now but losing out on income later.  Again, talk to a tax professional about that,

If you start a 401(k) (a topic for another time), your income is lower if you take distributions instead of income and your ability to contribute to the 401(k) will be lower as well.  That's a lost opportunity in both tax savings and in actually savings for your retirement.

Any income above $118,500 will have tax savings of avoiding the 2.9% in Medicare taxes.  That's a real savings but you can see that you have to make a lot for that to make much of a difference.  Remember that any extra annual fees you pay because your tax return is more complicated take away from the tax savings of the dividends approach.

Advantages and Disadvantages of Each

This is by no means an exhaustive list but it represents the basics.  Again, please talk to a tax professional (How many times did I say that?).

Sole Proprietorship 

Advantages - Easiest to set up.  

Disadvantages - No liability protection like any of the other business entities we've discussed.  No tax savings like an S Corp


Advantages - Liability protection, relatively easy to set up and maintain, save on professional fees for tax returns since you only have your personal tax return, not a separate business tax return (if you aren't receiving a K-1)

Disadvantages - Does not have the tax savings that an S Corp can have.  (It may be possible for your LLC to be taxed as an S Corp which takes away the main benefit of an S Corp - talk to your accountant for more information).

S Corp

Advantages - Liability protection, can have tax savings.  No double taxation (unlike C Corp)

Disadvantages - more formal requirements (annual meetings, etc.), more professional fees

C Corp

Advantages - Liability protection, can have more than one type of shareholder.

Disadvantages - Double taxation.

My Personal Decision

It took me a while to incorporate but eventually I decided to become an LLC.  At some point I made the decision that I would like to be an S Corp for 2017 for the "tax savings" (too late now to switch for 2016) but I'm not as sure anymore whether I should switch.  As with everything, my thoughts are constantly evolving.

So, what did I miss?  What type of business entity did you set up and why?  I would love to hear your comments.