So, you want to start a business where you are in control to provide those engineering services that you have been offering to your employer for 20 years. This is a bold, courageous, and exciting move! What to do?
It is easier to set up a new business as a Sole Proprietorship. There is no need to register your business in your State. No paperwork and no filing fees.
The sole proprietorship is not considered a separate legal nor a separate tax entity. All income and expenses of the business as a sole proprietorship is accounted for, but a separate business income tax return is not needed. The income and expenses of such business are reported as part of your individual income tax return, utilizing a federal Schedule C.
Bookkeeping for the business is highly recommended for the sole proprietorship even though the income and expenses is reported as part of your individual income tax returns. Bookkeeping is a diary of all the information pertaining to your business and it is a very good idea to start with bookkeeping services right from the beginning, even if there aren’t many transactions for the business during such initial year.
Please note the following regarding sole proprietorships.
The sole proprietor can take money out of the business via what is called draws, but this can be limited. This is the only way for a sole proprietor to take money out of the sole proprietorship business.
A sole proprietorship CANNOT pay a salary to a sole proprietor as an employee because the sole proprietorship and the sole proprietor essentially is the same person. The same is true for independent contractors.
There is no legal protection against the sole proprietor owner if there is a lawsuit against the sole proprietorship business.
It may be more difficult to obtain business financing for a sole proprietorship business if the sole proprietor owner does not have a good credit rating because a lender will look at the individual sole proprietor along with the sole proprietorship business.
It is imperative to separate business income and expenses from personal income and expenses when you have a sole proprietorship. A separate bank checking account should be opened in the name of the sole proprietorship business. A separate credit card in the name of the business should be set up. Do NOT deposit business income, and pay business expenses, through your personal bank account; with a personal debit card; or with a personal credit card.
This mixing of personal and business income and expenses between business and personal bank, debit and credit card accounts can increase your fees that you will pay to your Accountant or Bookkeeper.
Also, the individual sole proprietorship business owner will pay a 15.3% self-employment tax on net income of the business of $ 400 or more. This is the payment of both the employer portion and the employee portion of Medicare tax and social security tax that would otherwise be withheld from an employee’s wages throughout the year, plus the required employer portion of such taxes.
A few years pass, and you have a viable business, and perhaps you may want a little more protection against your personal assets from creditors of the business. At this point, you can register with the home state of your business as a Limited Liability Company, or an LLC. A Limited Liability Company gives some legal protection in that the creditors of your business cannot encroach on your personal wealth and assets. Please note that a Limited Liability Company with one business owner is known as a Single Member Limited Liability Company, or SMLLC, and is also reported on the Schedule C of the owner’s individual income tax return. There is no separate business income tax return required for a SMLLC.
A self-employment tax will also be paid by the individual business owner of a SMLLC on his or her individual income tax return.
The business is known generally as a corporation when you file as a Limited Liability Company. You can change the LLC legal structure, and the tax structure of reporting on the individual income tax return, for federal income tax purposes. For example, you can elect on a separate federal form, 8832, to be treated as a regular C corporation. This form 8832 is filed with the return. There are two separate entities with a regular C corporation – the shareholder and the regular C corporation. The business as a regular C corporation must file a separate business income tax return and the income and expenses of the regular C corporation will not be reported on the individual shareholder’s income tax return. A regular C corporation can issue dividends to the shareholder during the year. The regular C corporation can pay a salary to the shareholder in his or her capacity as an Officer of such corporation. Please note that dividends disbursed by a regular C corporation to its shareholder is not tax deductible on the books of the regular C corporation. So, the money comprising the dividends earned within the regular C corporation is taxed. That same income is then taxed again to the shareholder upon distribution of such dividend. This is known as double taxation and is a disadvantage of having a regular C corporation.
The shareholder is protected from liability of the regular C corporation business. Also, financing is easier because lenders will focus on the regular C corporation business and not on the individual shareholder.
There is no self-employment tax on the federal individual income tax return of a shareholder of a regular C corporation.
The business can also choose to be treated as a subchapter S corporation, which is a status for income tax purposes only. The income and expenses of the subchapter S corporation is reported on the individual shareholder’s income tax return like a Sole Proprietorship and a Single Member Limited Liability Company. However, a separate business income tax return must be filed for the subchapter S corporation. You can work as an employee of the subchapter S corporation and get paid a steady salary if the subchapter S corporation has the funds to do so.
The shareholder can also receive distributions from the subchapter S corporation which are tax free if they are not more than a threshold amount which is called Basis. Basis will be discussed in a future Blog post. Any amount above this Basis figure will be a long-term capital gain and will have to be reported on the Schedule D of the shareholder’s individual income tax return.
An election is made to the Internal Revenue Service, and some State Tax Authorities, to obtain this subchapter S corporation status. The election is made on Form 2553 to the Internal Revenue Service. Not all states require a separate Election apart from the IRS election. Some States do such as New York State and the State of New Jersey in addition to the IRS election.
There is no self-employment tax on the individual income tax return of a shareholder in a subchapter S corporation.
Perhaps, you and a buddy or two would like to work together on the business at some point and become partners. This is known as a partnership and a partnership must file its own separate business income tax return, as well. You do not need to pick a partnership as an entity on the Business Entity Election form, 8832, which was discussed earlier. A partnership does not need to prepare and file an Election to the Internal Revenue Service to be treated as a partnership, unlike a subchapter S corporation, as discussed earlier. Just file the business income tax return as a partnership.
The owners of a partnership are known as partners of such partnership. Partners are NOT considered employees of the partnership, unlike a subchapter S corporation, where a shareholder of such subchapter S corporation can receive a salary as an employee.
However, partners of a partnership can receive payments from the partnership in two ways. First, one or more partners can receive steady payments throughout the year whether the partnership is profitable during such year. These are known as Guaranteed Payments. Such payments are tax deductible for the partnership making such guaranteed payment and it is included as income on the individual income tax return of the recipient partner. The partner in these transactions will be treated as an independent contractor of the partnership.
There should be a written partnership agreement between the partnership and all the partners that indicates the amount each partner will receive each year in guaranteed payments, if any, as well as the frequency and amount paid to each partner.
Also, partners can receive distributions from the partnership tax free up to the basis of the partnership interest of each partner in the partnership. Any such distributions above the basis are a long-term capital gain that needs to be reported on Schedule D of the partner’s individual income tax return. Such distribution will have an amount realized of the excess above basis and zero for the cost. This is like subchapter S corporations.
There are two types of partners of a partnership – a general partner and a limited partner. A general partner is liable for his or her share of the partnership’s liabilities. A limited partner is not liable.
Please note that a partner must pay self-employment tax on his or her individual income tax return if there is net income from the partnership of $ 400 or more allocated by the partnership to the partner.
Bookkeeping services should be obtained regardless of the legal and tax entity classification of your business.
Written By: Angelo Liberati