Choosing a Better Business Structure

Of all the choices, you make when starting a business one of the most important is the type of legal organization you select for your company. This decision can affect how much you pay in taxes, the amount of paperwork your business is required to do, the personal liability you face, and your ability to borrow money.

Business formation is controlled by the law of the state where your business is organized.

This fact sheet provides a quick and most common forms of business entities.

The most common forms of businesses are:

1.Sole Proprietorship

2.Partnerships

3.Corporations

4.Subchapter S Corporation

5.Limited Liability Companies (LLC)

While state law controls the formation of your business, federal tax law controls how your business is taxed. Federal tax law recognizes an additional business form, the Subchapter S Corporation.

All businesses must file an annual return. The form you use depends on how your business is organized. Sole proprietorships and corporations file an income tax return. Partnerships and S Corporations file an information return. For an LLC with at least two members, except for some businesses that are automatically classified as a corporation, it can choose to be classified for tax purposes as either a corporation or a partnership. A business with a single member can choose to be classified as either a corporation or disregarded as an entity separate from its owner, that is, a “disregarded entity.” As a disregarded entity, the LLC will not file a separate return instead all the income or loss is reported by the single member/owner on its annual return.

The answer to the question “What structure makes the most sense?” depends on the individual circumstances of each business owner.

The type of business entity you choose will depend on:

• Liability
• Taxation
• Record keeping

1. Solo Proprietorship

A sole proprietorship is the most common form of business organization. It’s easy to form and offers complete control to the owner.

It is any unincorporated business owned entirely by one individual.

In general, the owner is also personally liable for all financial obligations and debts of the business. (State law may also govern this area depending on the state.)

Sole proprietors can operate any kind of business. It must be a business, not an investment or hobby. It can be full-time or part-time work. This includes operating a:

1. Shop or retail trade business
2. Large company with employees
3. Home based business
4. One person consulting firm

Every sole proprietor is required to keep sufficient records to comply with federal tax requirements regarding business records.

Generally, sole proprietors file Schedule C or C-EZ, Profit or Loss from Business, with their Form 1040. Sole proprietor farmers file Schedule F, Profit or Loss from Farming. Your net business income or loss is combined with your other income and deductions and taxed at individual rates on your personal tax return.

Sole proprietors must also pay self-employment tax on the net income reported on Schedule C or Schedule F. You may also be able to deduct one-half of SE tax on your 1040. Use Schedule SE, Self-Employment Tax, to compute this tax.

Sole proprietors do not have taxes withheld from their business income so

you will generally need to make quarterly estimated tax payments if you expect to make a profit.

These estimated payments include both income tax and self-employment taxes for Social Security and Medicare.

2. Partnership

A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill and expects to share in the profits and losses of the business.

A partnership does not pay any income tax at the partnership level. Partnerships file Form 1065, U.S. Return of Partnership Income,

to report income and expenses. This is an information return. The partnership passes the information to the individual partners on Schedule K-1, Partner’s Share of Income, Credits, and Deductions. Partnerships are often referred to as pass-through or flow-through entities, for this reason.

Each partner reports his share of the partnership net profit or loss on his personal Form 1040 tax returns. Partners must report their share of partnership income even if a distribution is not made.

Partners are not employees of the partnership and so taxes are not withheld from any distributions.

Like sole proprietors, partners generally need to make quarterly estimated tax payments if they expect to make a profit.

General partners must pay self-employment tax on their net earnings from self-employment assigned to them from the partnership. Net earnings from self- employment includes an individual’s share, distributed or not, of income or loss from any trade or business carried on by a partnership.

Limited partners are subject to self-employment tax only on guaranteed payments, such as professional fees for services rendered.

3. Corporation

A corporate structure is more complex than other business structures. It requires complying with more regulations and tax requirements.

It may require more tax preparation services than the sole proprietorship or the partnership.

Corporations are formed under the laws of each state and are subject to corporate income tax at the federal and generally at the state level. In addition, any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal tax returns.

The corporation is an entity that handles the responsibilities of the business. Like a person, the corporation can be taxed and can be held legally liable for its actions.

If you organize your business as a corporation, you are generally not personally liable for the debts of the corporation. (Exceptions may exist under state law.)

When you form a corporation, you create a separate tax-paying entity. Unlike sole proprietors and partnerships, income earned by a corporation is taxed at the corporate level using corporate tax rates. Regular corporations are called C corporations because Subchapter C of Chapter 1 of the Internal Revenue Code is where you find general tax rules affecting corporations and their shareholders.

A corporation files Form 1120 or 1120-A, U.S. Corporation Income Tax Return.

If a shareholder is an employee, he pays income tax on his wages, and the corporation and the employee each pay one half of the social security and Medicare taxes and the corporation can deduct its half. A corporate shareholder pays only income tax for any dividends received, which may be subject to a dividends-received deduction.

4. Subchapter S Corporation

The Subchapter S Corporation is a variation of the standard corporation.

The S corporation allows income or losses to be passed through to individual tax returns, similar to a partnership.

An S corporation has the same corporate structure as a standard corporation. It is a legal entity, chartered under state law, and is separate from its shareholders and officers. There is generally limited liability for corporate shareholders. The difference is that the corporation files an election on Form 2553, Election by a Small Business Corporation, to be treated differently for federal tax purposes.

Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income.

It is treated in the same way as a partnership, in that generally taxes are not paid at the corporate level.

An S corporation files Form 1120S, U.S. Corporation Income Tax Return for an S Corporation. The income flows through to be reported on the shareholders’ individual returns. Schedule K-1, Shareholder’s Share of Income, Credits and Deductions, is completed with Form 1120S for each shareholder. The Schedule K-1 tells shareholders their allocable share of corporate income and deductions. Shareholders must pay tax on their share of corporate income, regardless of whether it is actually distributed.

5. Limited Liability Company

A Limited Liability Company (LLC) is a relatively new business structure allowed by state statute.

LLCs are popular because, similar to a corporation, owners generally have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.

Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities.

Most states also permit “single member” LLCs, those having only one owner.

A few types of businesses generally cannot be LLCs, such as banks and insurance companies.

Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs.

Which structure best suits your business?

One form is not necessarily better than any other. Each business owner must assess his or her own needs. It may be important to seek advice from business incorporation and tax professionals when considering the advantages and disadvantages of a business entity.

Tax Avoidance is Legal; Tax Evasion is a Crime

As an individual taxpayer and as a business owner, you often have more than one way to complete a taxable transaction. Tax planning evaluates various tax options to determine how to conduct business and personal transactions in order to reduce or eliminate your tax liability.

Although they sound similar “tax avoidance” and “tax evasion” are radically different. Tax  Avoidance lowers your tax bill by structuring your transactions so that you reap the largest tax benefits. Tax avoidance is completely legal and extremely wise. Tax  evasion, on the other hand, is an attempt to reduce your tax liability by deceit, subterfuge, or concealment. Tax evasion is a crime. Often the distinction turns upon whether actions were taken with fraudulent intent.

The IRS notes that the following are some of the most common criminal activities in violations of the tax law:

1. Deliberately under reporting or omitting income.

Omitting your income deliberately is not desire.

2. Keeping two sets of books and making false entries in books and records.

Engaging in accounting irregularities, such as a business’s failure to keep adequate records.

3. Claiming false or overstated deductions on a return.

This can include claiming a large charitable deduction without substantiation. The IRS is always vigilant when it comes to inflated deductions from pass-through entities.

4. Claiming personal expenses as business expenses.

This is an easy trap for a sole practitioner to fall into because often assets, such as a car or a computer, will have both business and personal use.

5. Engaging in a sham transaction.

For example, if payments by a corporation to its stockholders are in fact dividends, calling them “interest” or otherwise attempting to disguise the payments as interest will not entitle the corporation to an interest deduction.

6. Hiding or transferring assets or income.

From simple concealment of funds in a bank account to improper allocations between taxpayers. For example, improperly allocating income to a related taxpayer who is in a lower tax bracket, such as where a corporation makes distributions to the controlling shareholder’s children, is likely to be considered tax fraud.

Note: Keep in mind that tax evasion isn’t limited to federal income tax. Tax evasion can include federal and state employment taxes, state income taxes, and state sales taxes as well.

Minimizing Taxes Requires Skillful Tax Planning:

Tax avoidance requires advance planning. Nearly all tax strategies are based on structuring the transaction to obtain the lowest possible marginal tax rate by using one or more of these strategies:

• Minimizing taxable income
• Maximizing tax deductions and tax credits
• Controlling the timing of income and deductions

Forecasting income and expenses are critically important.

To make use of any of these strategies, it is essential that you estimate your personal and business income for the next few years. The effort to come up with crystal-ball estimates may be difficult and by its very nature will be inexact. The better your estimates, the better the odds that your tax planning efforts will succeed.

Deductions and Credits Reduce Your Taxes

Your tax planning goal is to pay the least amount of tax that is legally possible. You can reduce your ultimate tax bill by attacking on two fronts.

• First, take full advantage of every available deduction—both business and personal—to reduce your taxable income.
• Then, once determine the tentative tax due; claim every tax credit that is available to you.

Claiming Deductions Minimizes Taxable Income

To reduce your taxable income, you must be aware of what is deductible and what isn’t. In many cases, a business owner can deduct benefits that would be considered non-deductible personal expenses for an employee. Don’t overlook the possibility of purchasing health insurance, investing for your retirement, or providing perks like a company car through your business.

Consider the big picture when claiming deductions.

One example is electing to expense (deduct) the entire cost of a business asset in the year of purchase. While this will lower your tax liability for the current year, you will not be able to claim depreciation deductions in the future. If you anticipate your business income increasing in the future, you may want to scale back the current deduction so that you can claim depreciation deductions in future years.

Tax Credits Shave Dollars off Your Tax Bill

Once you have claimed every tax deduction that you can, turn your attention to uncovering every possible tax credit that you can claim.

Most federal income tax credits currently available to small business owners are very narrowly targeted to encourage you to take certain actions that lawmakers have deemed desirable. Examples include credits designed to motivate you to make your company more accessible to disabled individuals or to provide health insurance to your workers.

Although you can’t literally lower your tax rate (the rates are established by Congress), there are certain actions you can take that will have a similar result.

These include:

• Choosing the optimal form of organization for your business (such as corporate, sole proprietorship or partnership).
• Structuring a transaction so that payments that you receive, are classified as capital gains rather than ordinary income. Long-term capital gains earned by non-corporate taxpayers are subject to lower tax rates than other income.
• Shifting income from a high-tax-bracket taxpayer (such as yourself) to a lower-bracket taxpayer (such as your child). One fairly simple way is to do, by hiring your children. The tax laws limit the usefulness of this strategy for shifting unearned income to children under age 18, but some tax-saving opportunities still exist.

Control the Tax Year for Income and Deductions

By choosing an appropriate method of tax accounting and by thinking ahead to accelerate (or delay) when you receive income or incur expenses, you can exert some degree of control over your taxable income in any given year.

Careful planning can delay the timing of an event or transaction that gives rise to tax liability. Delaying recognition of income can be valuable.

Control Tax Liability by Postponing Income, Accelerating Deductions

By taking actions that delay the time when particular income items must be reported on your return, you can shift liability on that income to a different tax year. In general, you will be better off if you can postpone the receipt of income until the next year and accelerate payment of expenses into the current tax year. In this way, you can delay your tax liability on the deferred income to the next tax year

Consider These Simple Ideas to Delay Income and Accelerate Deductions

Of course, you should check with a tax professional before taking action in order to ensure that you haven’t overlooked critical factors.

• Delay collections
• Delay dividends
• Delay capital gains
• Accelerate payments
• Accelerate large purchases
• Accelerate operating expenses
• Don’t try to camouflage the substance of a transaction by the form the transaction takes.
• Don’t try to disguise the tax impact of a single transaction by breaking it into multiple steps.
• Don’t expect the IRS to treat your relatives as if they were strangers.

Be Alert! Avoid Common Tax Planning Traps

IRS Focuses on Substance, Not Form

Choosing to use one form of transaction, rather than another, to minimize your tax liability will not (in-and-of-itself) invalidate a transaction for income tax purposes. For example, you can elect to give your child a gift of $10,000 or put the child on the payroll where she can earn $10,000. Doing the tax calculations and picking the method that results in the lowest overall tax liability for the family is a wise course of action.

However, you cannot avoid tax liability simply by the label that you give a transaction. The IRS is going to look at the real purpose—the substance—of the transaction and tax it according. For example, you can give your son a car, or you can sell your son your car. However, you can’t sell your car and claim it was a gift.

Business owners often run afoul of the “substance over form” rule when they attempt to disguise compensation as “dividends” or “return of capital.” The IRS will not be amused; nor will you be when you receive an increased tax bill, plus interest and (most likely) penalties.

Related Taxpayers Face Closer Scrutiny

The IRS pays close attention to transactions that involve taxpayers who have close business or family relationships. In fact, the tax laws have given the IRS special powers to deal with specific areas where related taxpayers have historically used their relationships to unfairly reduce their taxes.

You can expect that IRS agents will closely scrutinize business dealings that you have with family members or other related parties. Often, the IRS will combine its audit of returns for a closely held corporation with an audit of returns of the corporation’s owners or principal officers, in order to discover any attempts to shift personal expenses to the corporation.