What I love most about Colorado, more than the 300+ days of sun every year and the glorious rocky mountains, are the people. For the most Coloradans are risk taking job creators, starting new businesses from scratch out of their garages and turning passions for a hobby into a business with a profit motive.
Of course I surround myself with these people that live and play outside their comfort zone and quite often I am asked about the nuanced tax law implications of starting a new business. Specifically what might be the most appropriate business structure to form, if any, so I’ve decided to draft a post about this topic for general edification. Hopefully you find these words helpful.
Most of the time if you are just starting out and toying with the idea of turning your hobby into a business the most appropriate course of action as a first step is to start as a sole proprietor and report income and expenses on IRS Form 1040 Schedule C. The rationale for this opinion is rooted in the complexity and subsequent expenses both direct and indirect of forming a business entity.
It can be quite a financial burden to form a business entity and even more so to properly close one down. Hence the Schedule C sole proprietorship reporting becomes valuable as it offers fairly streamlined reporting and doesn’t necessarily need the expense of an accountant or tax practitioner to accurately report taxable income. The biggest problem with the Schedule C is that it subjects all profits to both income and self-employment tax.
If however you are going to hire employees and/or have partners buy into your vision, help you accomplish objectives, and build a mission towards that vision you are going to need to have employees and other people you can rely on to prospectively add value. If this is the case the general rule of thumb is that you are best served operating the business as a separate and distinct entity to protect yourself from potential negligence of your employees, partners, or other people you surround yourself with in pursuit of a defined mission.
Once you are committed to forming an entity the next question is what type of entity is best.
The most popular options are a partnership, corporation or a limited liability company (LLC). For federal income tax purposes corporations and LLC’s can elect to be treated as S-corporations by filing IRS Form 2553. If the entity qualifies and the election is approved by the Commissioner the entity’s income is reported using IRS Form 1120-S. LLC’s with more than one partner that are not husband/wife and have not elected to be treated as an S-corporation by default report federal income via IRS Form 1065. Full corporations or C-Corporations report income via IRS Form 1120
There are some basic advantages of the S-corporation from a tax perspective.
First it is considered a disregarded entity for income tax payment purposes meaning there is no income tax liability at the corporate level. The ordinary business income (or Loss) as well as several other ‘things’ pass directly through to the shareholders via IRS Form 1120-SS Schedule K-1 and are subject to federal income taxation at the shareholder’s marginal personal tax rate. Keep in mind that if your S-corporation has employees it will be subject to employment tax obligations.
Regular or C-corporations on the other hand are subject to income tax at the corporate level. If the shareholder wants to pull cash out of the C-corporation they must do so generally speaking either as wages (subject to employment tax); as a dividend paid out of after tax corporate profits (and subject to another level of income taxation again at the shareholders marginal income tax rate); or, as a return of capital subject to capital gain taxation on gains or capital loss limitations on losses.
Income of the S-corporation is reported to the shareholder irrespective of whether the revenues are distributed in whole or in part to the shareholder.
This is where many people get confused as many S-corporations report ordinary business income but do not distribute cash to shareholders. Particularly when an S-corporation aspires to grow there is a built in predisposition to reinvest all spare cash in organically acquiring property or equipment.
The other tax advantage of an S-corporation is that as long as the owners who work in the business pay themselves a reasonable salary, any extra revenue of the S-corporation can be distributed to the shareholder without imposition of self-employment taxes, but is still nevertheless subject to income tax at the shareholders marginal tax rate. Another area where many people get confused is the fact that self-employment taxes are separate and distinct from employment taxes which are also separate and distinct from income taxes.
The main disadvantage of an S-corporation, from a tax perspective, is that any distributions made to multiple shareholders must be made on a pro rata basis at the same time. This basically means that an S-corporation structure does not work well in situations where there are capital contributions to the S-corporation that are to be repaid on a non-pro rata basis.
A second disadvantage of an S-Corp is that if you aspire to experience substantial growth and attract major investors the S-Corp is limited to 100 shareholders and must be converted into a C-corporation to deal with the Securities and Exchange regulations of making the entity a publicly traded entity. There are other limitations that we can discuss if you wish to send me a message on my TaxConnections Profile.
A third disadvantage is that appreciated assets distributed from the S-corporation to its shareholders can result in a 35 percent tax on the appreciation, meaning that S-corporations are rarely a good vehicle for ownership of real estate as real estate continually seems to appreciate.
LLCs are the second main choice of owners to establish a business.
The main advantage of an LLC is the simplicity in taxation since the entity is taxed as a partnership using IRS Form 1065, unless of course you are a single member LLC or a husband/wife LLC in which case the income is reported on IRS Form 1040 Schedule C essentially being treated as though you were a sole proprietor.
The biggest disadvantage of an LLC is that in most cases all profits are subject to both income tax and self-employment tax.
Another main advantage however, is unlike the S-corporation’s disadvantage of equal pro rata distributions, LLC distributions to the owners can be structured in any way that meets the economic agreement among the owners as long as those distributions otherwise have substantial economic effect which essentially means that any tax deductions taken must be supported by economic arrangement of the members.
If two owners were opening a consulting practice and one owner was providing the initial capitalization and the other was going to run operations, the LLC could allow for initial distributions solely to the member providing the initial capital so as to return his capital as soon as possible. Then after member’s return of capital, there could be equal distributions of cash to the members. This is not something you could accomplish in an S-corporation.
A third advantage of an LLC is that it is much more difficult for a creditor to obtain an interest in an owner’s ownership position in the business. Creditors more than likely would receive what is simply called a Charging Order, which provides that the creditor is entitled only to receive any distributions of cash or property that would otherwise be made to the owner. This provides for continuity of ownership of the business should one owner get into financial problems outside of the business.
1. It is most common that a single-owner non real estate type business that is an operating business would be established as an S-corporation. S-corporations will also serve multiple owners if there is no differentiation between the economics of the owners since they will share all revenues based on their percentage ownership.
2. In the context of any type of real estate-oriented business or a business where the economics are not going to be equal in pro rata at some time, the LLC becomes the preferred entity over an S-corporation even taking into consideration the fact that most always profits of an LLC are subject to both income tax and self employment tax.
Original Post By: John Dundon