Starting a new business can be a harrowing experience, whether it’s a full time or part time venture. Tax planning must be part of your basic strategy. Many of the decisions you make when starting a business will affect your after tax profit, and therefore your personal tax liability as well, for many years to come. So it is a word to the money wise, to choose carefully when setting up your company. We’ve outlined below some of the choices you can make along with a few suggestions on which path to take.
A regular C corporation is rarely the best choice for a start-up business. A pass-through entity such as a limited liability company (LLC), partnership, or S corporation is usually better. Here’s why. With an LLC or and S Corp.:
Limited Liability Company
- Business income is taxed directly on the personal income tax returns of the business’s owners. Therefore, the owners avoid the double taxation created by a regular corporation, with the exception of salary. The business income of a regular corporation is taxed first at the corporate level and then taxed again on the owner’s level when funds are distributed.
- Losses, as may be expected during a start-up phase, are generally deductible on the owners’ personal returns.
- Taxes paid on the business’s income may be reduced by giving shares of the corporation to low-tax bracket family members.
In most cases, an LLC is your best choice. It provides legal protection against personal liability for the business’s debts just as a corporation does, together with the flexibility of a partnership. A problem could arise if the LLC were funded by investors who are not material participants in the business. It is unclear whether LLC's funded by investors who are not material participants would be subject to self-employment tax since Congress previously prohibited the IRS from issuing regulations to clarify the issue. It is possible that an LLC's passive investor could incur an employment tax bill that would be avoided with another kind of entity.
A partnership offers flexibility in allocating income and expenses among the partners. But at least one partner must serve as a general partner who is personally liable for the business debts.
This entity provides corporate protection against personal liability for all owners. However, it is subject to restriction on types of permissible shareholders, the maximum number of shareholders, and classes of stock that may be issued and others.
A sole proprietorship is usually a good fit for a small one-owner business. Its income is simply reported on the owner’s personal tax return. But it provides no legal protection against liability, so the owner should consider another form of organization if the business grows.
A C corporation can provide the most sophisticated tax favored benefit plans, but this is rarely a primary concern for the start-up stage of business. And, as the revenues and assets grow in value, it becomes harder to avoid the double taxation inherent in the structure of a C corporation.
It is much easier to convert from a pass-through entity to a C corporation than the other way around. So, starting a business as a pass-through entity will give you more planning options.
Valuable assets such as real estate may be best held by business owners personally, or through a separate pass-through entity, and be leased back to the business, especially if it is a corporation. This gives the owners another way of receiving funds from the business that aren’t subject to employment taxes. It also preserves their ability to finance or dispose of the assets for their own purposes. Each state has their own laws governing pass-through entities, so we recommend getting professional counsel.
In order to maximize business deductions, get the business operating as soon as possible. Start-up costs are not deductible as business expenses. They are capital costs. However, a business can elect on its first tax return to deduct start-up costs over a period of at least sixty months. Start-up costs are those incurred before a business begins operating. They typically include the cost of researching the business opportunity and of legally organizing the business. They may also include costs of travel, market surveys, training and advertising to build a market. Clearly separate your own expenses from the business’s. There is no clear test for when a business begins to operate. To be safe get the business running quickly.
If your new business is a pass-through entity and you are active in managing it, you can deduct your share of its losses on your personal tax return to the extent you have an interest in the business. If losses continue, and the business is a sole proprietorship, the IRS may conclude that you do not have a profit motive for running the business and disallow your deductions. Even if your business never has a profit, you can demonstrate a profit motive by running it in a business-like manner.
We hope that these suggestions are helpful, at least to point out to let you know that there are a number of ways you can go when setting up a business and that each path has it’s advantages and disadvantages, according to your needs. Still have questions? Call us. That’s what we’re here for.