The Tax Dilemma

Remember the moment?  It was an absolute light bulb moment, full of electric excitement.  You and your best friend looked at each other and just knew you were meant to go into business together.  You meshed.  You had the same taste and outlook on design.  She was strong in color knowledge, you had depth in business knowledge and design.  You knew you were meant to do this!

Fast forward  two years.  It’s been a whirlwind building your brand.  So much to learn and conquer!  You started out with a simple partner business setup.  Each year you have filed a form 1065 by March 15 and  the Schedule K-1 with individual returns which states your individual shares of the profits and independently paid the taxes due with your 1040’s.  It’s worked out fine.  But you recently heard about a fellow designer whose installer caused extensive damage by accidentally puncturing the water pipes of the new fire extinguishers now being required in their county while installing drapery hardware and was sued.  You and your partner realized how vulnerable designers are – all the things that can go so terribly wrong working in a clients’ home – it’s frightening. Remember the time the painter you used freaked out mid-job because he deemed something in the house put him into superstitious overload and he quit right then and there?   Sooo – you decided to change your business entity with the help of a CPA.

The choices presented another learning curve, and more work.  But the plusses soon became evident also.  You realized as a corporation, because the business becomes an actual individual entity,  your personal assets could be protected in the event of a lawsuit of your business.  You already learned after one serious disagreement that neither  of you had more control than the other and your business could suffer serious setbacks if you couldn’t resolve your issues.  A better business arrangement could outline a better structure to handle this.  Down the road, loans might be easier to come by with a corporate structure too.

At first you had thought a Limited Liability Company might be the business setup for you.  You thought it was a corporate structure, but came to find out it really wasn’t, it only has similar features.  The IRS doesn’t recognize LLC’s as taxable entities.  The single owner or  members pay with their personal income tax instead. An LLC is defined and can be taxed  as a sole proprietorship, a partnership or a corporation.  True, it gives you personal liability protection from the business debts, but you would still be taxed individually with a self-employment tax. The business profits and debits are reported to the IRS but instead of being paid along  with that business report, they are “passed through” or paid along with your 1040 on a Schedule C and your business self employment tax on a Schedule SE by April 15.  They can have unlimited amount of members (share holders) and they can be non- US citizens.  LLCs can spin off other companies or subsidiaries and IRS recommendations as to how the business is conducted is not mandatory, only suggested.  However, as a business owner who works in her company you learned that establishing an Operating Agreement best serves the members in this arrangement.  Someone has to be at the helm and the Agreement sets out the roles, duties and responsibilities.  One person needs to have the authority to sign contracts and legal papers for the organization.

Next you thought you might as well compare C corporations and S corporations.  You didn’t think you would deal with share holders down the road but the idea of one of your daughters taking over the business was within the realm of possibilities.  A corporation has a perpetual life and doesn’t end with the life of its owners.  You learn an interesting fact – business owners don’t have to be American citizens in any business or corporation EXCEPT – S corporations.  Choosing between an S or a C corporation depends on how you choose to be taxed.  You learned that under a C corporation you would be double taxed.  The corporation is taxed on its profits and the shareholders are taxed on their dividends.  If the owner works in the business, they must be paid a salary and are then taxed on that as well.  The S corporation files under form 1120S and its  profits and taxes are divided and sent along to its shareholders on a Schedule K.  Each is responsible for their portion on their individual 1040 form.  Its shareholders are not paid dividends.  But, if you work in the business, you must be paid a salary on which you are taxed.

Herein lies the greatest advantage of an S corporation.  As an owner (especially advantageous as a sole proprietor) who works in the business, your salary is a business expense.  So even though your business earns $200,000, your salary of $100,000  means your profit is only $100,000 on which you only have to pay on the $100,000.  The business gets to deduct the salary while the owner gets to be taxed on her salary in her personal income tax.  If you are a sole proprietor without the S corporation, you  must report the profit of $200,000, and you are taxed on $200,000 as well as required to pay Social Security and Medicare on it also.  So if your profits are greater than your reasonable salary, this may be a solution.  Paying quarterly as a corporation seems to be a hassle at first too.  But then you realize all the time you spend hassling trying to get all the paperwork done at the end of the year probably takes more time that it would every three months while the business is still fresh in your mind and the receipts are at hand.  Monetarily, spreading out taxes over the year is easier too.

You pat yourself on the back for having arrived at another business breakthrough as you both settle on the S Corporation. You realize you have to be aware of how long it takes to do all this if you want to start the next tax year off as a new entity.  First you learn you have to file in your state to form the corporation and pay the filing fee. Then you must go through the process of first filing form SS-4 with the IRS to receive an EIN (employer identification number).  It will take up to six weeks to get the number. Finally, you must file 2553 with the IRS where you list your company’s particulars and your EIN and elect for a S corporation.  Then you wait – again…  In about 60 days you will get an acceptance letter from the IRS acknowledging your status.  You can then take the information to your bank and update your status and give them your EIN. It’s a little time taxing but doable.  Now you both can settle into writing up that Operating Agreement and reviewing your business a little more objectively, getting yourselves on a better business footing.

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