Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories. First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.
In today's ‘theory’ article, Contributing Author Rob Shaff finishes-up his 2-part mini-series on choosing the right business entity type for your business.
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In the last installment, I introduced the primary types of business entities a prospective business owner should consider when pondering a new business venture. In that article, I presented a matrix-style table with various attributes of each business entity type. While this ‘at-a-glace’ view is helpful to many, a brief narrative of these attributes might provide additional thoughts for consideration. In addition, I’ve provided some experiential commentary that could prove beneficial when making decisions or advising clients. Please note that these are simply comments and observations; they should not be taken as advice. Every new business owner should carefully consider their specific business, industry, geographic region, general economy, experience, capital sources, and a variety of other issues before making this important decision, as well as consulting their chosen advisor.
Sole Proprietorships
Let’s say you’ve set up an online presence on Amazon or eBay and are selling various trinkets. If you have done this ‘on the side’ (i.e. you have another job), your online business is considered a sole proprietorship (unless you take the steps to formalize it). This is why so many new businesses, part-time or otherwise, begin with this entity type; it’s easy and requires no formal filings (other than the optional taxpayer identification number {TIN}). And, should this be nothing but a supplemental source of income, the sole proprietorship can be a great structure for the foreseeable future.
The primary reasons an owner of a sole proprietorship decides to move to a different entity structure are: a) complexity of business increases, b) concerns about increasing liability exposure, c) self-employment tax on business profits becomes onerous, and/or d) access to other retirement planning vehicles.
I rarely discourage a client from this form of entity primarily given the ease of operation and lack of formality; however, I try to caution the successful entrepreneur about the tax aspects of their business as it grows, as well as the liability issues. One additional issue I bring up with budding entrepreneurs is the matter of employees. Once they bring on that first employee, while the business structure may not have changed, the business culture just did. The business owner is responsible for his employee’s actions as if they were his own. Consequently, additional concerns about expanded liability should be considered when hiring employees. There is too much ground to cover to have this discussion here (probably a topic for an article all its own), but make sure it happens. Leveraging your time and ability through human resources is smart and efficient, but understand the other side of the equation as well.
Partnerships
At a certain level, partnerships are nothing more than sole proprietorships with more than one owner, so most of the benefits and consequences of sole proprietorships apply to partnerships. However, because more than one owner exists, it is prudent to consider the adoption of a strong partnership agreement to guide the partners and govern certain aspects of the business. Other than the creation of the partnership agreement, which should be prepared by a competent attorney, partnerships are easy to establish. You will be required, most likely by your bank, to obtain a TIN.
Partnerships are great structures if the business stays small and is not subject to significant liability exposure. When these factors dissipate, the partners will typically gravitate toward a Limited Liability Company for a greater level of liability protection. The taxation of a partnership, and that of an LLC and sole proprietorship, are very similar, so this is typically not a significant consideration.
[Editor's Note: My friend Rob, the author of this article, is a young man (by my standards) so he doesn't remember when almost every law firm, physician's practice and pair-of-brothers in the heat & air or plumbing business were 'partners'. Perhaps it was the nature of such 'professionals' to be able to get along in a partnership environment, in part because most physicians hired business managers for their practice partnership, and most lawyer partners were just too busy 'being lawyers' to get mad enough to split up their partnership. But it was common in my 'hay day' for 'the two brothers' to always get in a big fight and their partnership go 'down the tubes.' As business has matured, structure 'between people' became less of a handshake understanding and more of a 'binding agreement' and so the lawyers got involved and far fewer true 'partnerships' exist, although you will still hear the term bantered around by lawyers and doctors practicing in a common setting even if they are really a corporation.]
Limited Liability Companies
An easy way of thinking of a Limited Liability Company (LLC) is a partnership desiring the maximum liability protection afforded to a pass-through entity. Limited Liability Companies are certainly the ‘vogue’ entity structure today, and that reputation is probably well-earned.
A Limited Liability Company provides its owners the greatest level of liability protection afforded to any pass-through entity, but with the added benefit of being able to choose your taxation method. This is available to an LLC courtesy of the Internal Revenue Service. When you form a Limited Liability Company, you have a choice of electing to be taxed as a sole proprietor (if you’re a one-member LLC), a partnership (if you have multiple members), or a corporation (C-corporation or S-corporation). This taxation flexibility coupled with the limitation of personal liability provides significant allure to the new business owner.
Like the partnership, a Limited Liability Company needs/requires a governing document. This is known as an Operating Agreement. The Operating Agreement establishes the protocols, rules, obligations, limitations, and responsibilities of the LLC and its members. My advice is to have an attorney prepare this agreement for you, with significant participation by the members. While there are canned Operating Agreements on the web, use of these non-customized agreements can be dangerous and costly.
Many Limited Liability Company owners today are choosing this structure for the liability protection, but are coupling this protection with a conversion to an S-corporation for tax purposes. This combination can be incredibly beneficial to LLC members: the greatest pass-through entity protection available and a friendly taxation structure (the scope of this article is not expansive enough to cover the positive and negative attributes associated with the complexities of the taxation of each of these entities; consequently, make sure you question your advisor(s) in depth prior to making these decisions).
S-Corporations
While not as popular as the LLC today, the S-corporation still has a large and loyal following primarily due to the corporate protections afforded an owner, as well as the potential tax benefits.
To address the elephant in the room, many gravitate to S-corporations because a buddy told them they can avoid the FICA and Medicare taxes by foregoing a salary and just taking “S-corporation distributions” instead. Take Note: This advice should not be heeded! The requirements associated with an S-corporation does require the owner/officer/shareholder to pay himself a reasonable salary (just google: Watson v. Commissioner, 668 F.3d 1008 (8th Cir., 2012)). A read of this case will provide a glimpse into the seriousness of the word “reasonable.”
Now, all that said, should the net income of your business be attributable, in part, to the efforts of your employees, the dual compensation system of salary and profit distributions can be quite beneficial to an owner. Why? As long as your salary is considered reasonable, the profit distributions are not subject to FICA and Medicare (the self-employment tax). Again, check with your tax advisor before venturing into this structure. While the appeal of reduced taxation is palpable, the complexities and pitfalls could cost you dearly should you forego the proper level of due diligence.
C-Corporations
The venerable C-corporation still exists and thrives, although in a more segmented arena than the past. Most C-corporations today are either i) those older, private companies set up decades ago, or ii) a public corporation subject to Securities and Exchange Commission (SEC) oversight.
For the small business owner or the entrepreneur dipping his toe into a new business venture, the C-corporation structure is probably not one worthy of consideration. The organization and maintenance of the organization is costly, onerous, and substantial…not something a small business needs. In addition, short of excellent and timely tax planning, the owner of a C-corporation could find themselves on the short end of double taxation issue. As an example: ABC corporation, a C-corporation, earns a net income of $100,000, and pays its required income tax on these profits in Year ‘x.’ The next year, when the owner takes a salary out of the corporation, he is paying himself with previously taxed funds, and is taxing himself again via wages, which are subject to federal and state income taxes as wells as FICA and Medicare.
So, bottom line, unless there is a compelling reason to do so, C-corporations are probably not the best vehicle to drive your small business.
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Article 3 wrap-up
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Editor's Note: It’s easy to see from these first two articles, Rob has written, just how critical the selection of the proper entity type is is from a foundational standpoint governing everything applicable to your accounting for end of year tax forms, and record-keeping requirements.
From a practical standpoint, this importance is one reason why your business entity type is one of those first essential questions you are required to complete when you start your new subscription to Zoho Books. Just select your business entity type from the drop down check box found under the Organizational Profile section of the Settings menu.
Zoho Books
Business Entity Type in Zoho Books
If you fail to select the proper ‘entity type’, you can expect that many of the accounts within the chart-of-accounts will be improperly coded and will most likely impact the accuracy of your reports used for tax reporting purposes. So be sure to make the proper selection when you are recording the rest of your business settings information.