As we discussed in Part III of “How to Reduce Your Taxes”, starting a small business can be a great avenue for lowering taxes. But starting a business isn’t as simple as deciding on what your business will be and jumping right in.
Setting up an entity for your business is necessary for separating the liability of your business from the liability of you, the individual owner. It is also difficult to audit records of a business when those records are interspersed with the records of the individual owner. That is why keeping the records separate is very beneficial in the long run.
There are many kinds of entities, so many that the process can be extremely daunting. You should have the guidance of an excellent CPA and your board’s input in selecting the right entity.
For the purpose of this particular post, we are going to focus on four particular types of entities: sole proprietorship, partnership, subchapter S-Corporation, and subchapter C-Corporation.
However, we recognize in planning that other entities could be more appropriate for your situation, particularly in complicated scenarios with multiple partners or family-owned businesses. Make sure to consult with your CPA and attorney if you feel you may need guidance.
Before we get into each structure, let’s discuss a topic you cannot avoid no matter which structure you choose.
It is the tax called the Self-Employment (SE) Tax. If you have ever been employed by somebody else, the employer used to pay half of this tax on your behalf. Now that you are self-employed, you cannot avoid it. Whether you are a sole proprietor or a corporation, you should have some sort of salaried income and thus pay the SE tax.
The tax rate is 15.3 percent of net SE earnings, broken down as follows:
- Social Security portion: Net SE earnings x 12.4 percent
- Medicare portion: Net SE earnings x 2.9 percent
The good news is that currently there is a maximum limit on the Social Security portion.
While this is good news, the Medicare portion has no limit. You have to pay it no matter your compensation.
We know this may seem a bit confusing, but this will be the key to choosing the right entity. Here are the entities:
SOLE PROPRIETORSHIP
This is usually seen as one individual who carries on an unincorporated trade or business. If you do not have an entity, you are a sole proprietor.
Many realtors, consultants, and one-man or one-woman offices fall into this category. Perhaps you are in sales and receive a 1099 every year from the company that does contract work with you. If this describes you, you may be a sole proprietor.
Alternatively, one could also consider husband and wife businesses that may elect not to be taxed as a partnership and file instead as two sole proprietorships.
If you are starting a business with perhaps one other employee, a sole proprietorship is probably your best bet. As revenues grow and your business becomes more complex, you want to start thinking about other structures.
In the meantime, there are all sorts of tax write-offs and abilities that you maintain as a sole proprietor. Although there are restrictions and you may find that the financing obtained will often tie directly to your personal assets rather than to your company’s.
PARTNERSHIP
As many sole proprietors grow, they get to the point where they need to hire employees, keep the employees they have, and look to spread the risk. A partnership is worth exploring if you are willing to let go of some control. There are many ways to do this – limited partnerships, multi-member limited liability corporations, and others.
What you need to understand is that partnerships can be remarkably simple and straightforward or they can be exceedingly complex. They are easy to form, but can be tough to exit.
Also, taxation of the partnership can be particularly advantageous because the partners receive profits directly and the partnership has no taxes on its own. Historically, individual tax rates have been lower than corporate tax rates.
SUBCHAPTER S-CORPORATION (S-CORP)
Perhaps a partnership is not for you because you do not want to give up control, but you need more of a tax shelter than a sole proprietor can provide. In this case, a Subchapter S-Corporation may be the best fit.
As an S-Corp, you pay yourself a salary plus some money also gets passed through as profit sharing. The profit sharing is not subject to payroll taxes such as Social Security and Medicare whereas when you are a sole proprietor, you are subject to payroll taxes on all of your profits.
What you want to understand is that by using an S-Corp, you can limit (but not eliminate) the pay-roll taxes by having both W-2 income and pass-through income. Take caution with how much pass-through income you take. If you have 80 percent or more of your income coming through a pass-through, the IRS may make a ruling that could cost you tens of thousands of dollars.
SUBCHAPTER C-CORPORATION (C-CORP)
Notice that all the previous entities were primarily for a smaller number of shareholders. If you want to expand your business at a rapid pace and need the funds to do so, a C-Corp may be the best fit for your organization.
When you have a C-Corp, you can raise money through a public stock offering. It can be terribly expensive so the company will need to be ready to deploy the money effectively to meet its new income needs.
BE PREPARED FOR AN AUDIT
The IRS has more ability than ever to cross-check your returns. Here is a list of things to do to prepare for an audit:
- Keep good records. Keep all receipts and worksheets used to do your returns. If your accountant keeps them, get copies. Keep records for at least seven years.
- Prepare very carefully and check your math. Math errors are very common, especially if returns are prepared manually. Math errors can cause an audit.
- Send a representative. If possible, send an accountant to keep the audit scope limited. Have them take backup documents and relevant worksheets.
- Consider your answers carefully. How an audit ends up may affect future years, if there is a problem.
So, to sum up our series on “How to Reduce Your Taxes,” by being prepared, proactive, informed and by receiving good advice you can enjoy real tax reduction.
Give all your support data to a competent accountant to make sure you did the return correctly. Expect the accountant to offer ways to reduce taxes in the future. Having a personal board meeting with your investment advisor, tax advisor and business mentor can improve your finances in general and your taxes in particular.
With a tax advisor, you gain one more set of eyes to catch a mistake before the IRS does. It also gives you representation if there is a problem.
Consider different ways to change your taxes: donate; add to a retirement account; or if your income is very low and save regularly, consider an IRA distribution.
Reduce other taxes like state, property and estate taxes. Consider making some personal expenses to be business expenses like cell phones, laptops, or photographic equipment. Keep a log of the business use.
Have a review of your current corporate entity. Make sure you are using the right tax efficient vehicle.
Be prepared for an audit.
Have questions about our four part series on reducing taxes? Shoot me an email and let me hear them at dave@daviddenniston.com.
Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation. Please consult with your accountant or tax advisor for specific guidance.