Setting Up a Business
This is by far the easiest and cheapest way to go, in my opinion.
You are automatically a sole-proprietor if you do not file any papers to become a partnership or incorporate. Having your spouse working with you in the business does not keep you from being a sole-proprietor, assuming you are filing a joint return. You simply file a Schedule C and some related forms along with the rest of your return. This Schedule C details your income and expenses of the business. The net profit or loss is either added or subtracted from your other income such as W-2’s.
If you have shown your business deposits as income, and later wish to withdraw monies from your business account for personal reasons, you can do so. The money is yours to do as you see fit. You have complete control and flexibility.
If you decide to discontinue your business, then you simply stop doing business and either keep or sell any assets. No major paperwork involved. If you are selling your business, then a good tax preparer (like MTL, of course) knows how to show the sale of the assets and goodwill on an additional form that goes with your tax return. No big deal here, either.
Deductions are great for a sole-proprietor. You can deduct mileage (usually one of the largest deductions), you can pay your spouse or kids under 18 without their wages being subject to some employee-type taxes, such as unemployment. With partnerships and corporations, you lose these deductions.
A net loss is subtracted from other income, such as spouse’s W-2, etc, reducing your tax bill and/or increasing your refund.
Your tax preparation fee will be cheaper for you than a partnership or corporate return as you only have the Schedule C and related forms to be added to your personal return.
Sole-proprietorship income is subject to an additional tax called Social Security Tax. This tax is roughly 15 percent of the net income. If you have a loss, you won’t have this tax, of course.
This structure does not prevent your personal assets from lawsuits.
You have someone else to share the income, liabilities, etc.
Perhaps that person has the additional funds or level of expertise you need for your business and wants a share of your business in return.
A partnership files a form 1065. This is a totally separate return from the partner’s personal return. The partnership itself does not pay any tax. Each partner takes their individual share of the profit or loss onto their personal return. Therefore a loss will subtract off from other income just like a sole-proprietorship, however read about “guaranteed payments” below.
You no longer have complete control over your business. Someone else has a say in it and it can cost you a lot of money to buy them out if you don’t get along. There is an old saying-don’t go into business with family or friends. That is a very true statement, as most of the time people end up with hurt feelings and totally destroyed relationships.
Forming a partnership is more complicated, as you generally need an attorney to file a “partnership agreement” between you and your partner deciding things such as who gets your share of the partnership if you die, who gets what if the partnership dissolves, duties and responsibilities of each partner, etc.
Also, you have to file paperwork with the state you reside in (and the state you are doing business in, if different). Of course, the state(s) will charge you a fee for this.
When partners draw monies out of the partnership, they do not get W-2’s. They are usually considered “draws” or “guaranteed payments”. These guaranteed payments are deducted from the partnership income. However, along with the partnership income, the draws are subject to income as well as social security tax on the partner’s personal return. This can result in some pretty stiff tax bills as usually the partners aren’t really keeping up with their payments and thinking of the tax consequences. There are usually no deductions, as the partnership has deducted most of the expenses involved. Both guaranteed payments and the share of the partnership income/loss is reported to the government and to each partner on a form called K-1.
As you may have guessed, partnership returns are more expensive for the taxpayer. We tax preparers have to spend more time calculating and filling out additional forms such as balance sheets that a sole-proprietor does not have to have. As stated above, it is a return onto itself, even though it is a “flow-through” return with no tax.
Well, all I can say about these structures are if you have to, you have to. Otherwise DON’T. I personally feel the disadvantages and expenses far outweigh the advantages for most small businesses, but I’ll try to be fair.
Protection for personal assets
Some banks insist on your being incorporated in order to obtain funds.
It may sound more professional having an “Inc” after your business name.
More complications, more expense, and less control. Even a one-person corporation does not have flexibility.
Corporations are treated as a separate entity, which means that while they do afford some asset protection, you have to consider a corporation that you own as a “separate person”. Taking out funds (even after they’re taxed) can cause you to have to report those funds as dividends and get to pay tax again! Using the corporate bank account as your own personal account can destroy the asset protection, as in a lawsuit against you, a good attorney for the opposing side can “pierce the corporate veil” if you have been using your corporate account personally, i.e. paying house payments, groceries, etc. You have to be very diligent and careful not to co-mingle funds, pay personal expenses, etc.
If you want to be paid out of the corporation, it should be as a W-2 employee—as you are an “EMPLOYEE” of the corporation (remember it is a separate entity, even if you are the sole owner). This opens up a whole new keg of worms if you don’t have any other employees—now you have to do the payroll taxes and forms on yourself. Some corporation owners pay themselves as contract labor. This is frowned upon by the IRS, and they are cracking down and auditing companies that do so.
As in partnerships, you have to file papers with the state or states involved. You may not need an attorney if it is just you, but you will pay a fee to incorporate and you will also have to pay an annual fee to the state every year, regardless of any profit or loss. Fees are different for each type of corporation. An LLC will pay anywhere between $300-$3,000 per year annually in Tennessee.
You have to now file at least three returns: A corporate return for the federal, a franchise/excise tax return for Tennessee, and then your personal return. One exception is a LLC sole proprietorship discussed later which only eliminates the federal return. Hmm…reckon how much the preparation of all those returns is going to cost you? They can require balance sheets and lots of other forms… and that Tennessee return is very complex…getting my drift? If you are a Tennessee resident and doing business in another state, you have to file a state return for that state, also! Better yet—you can have a loss on your federal return, but have to pay on the state---because Tennessee makes you take whatever you pay in rent (as in a storefront to a landlord) multiply the annual amount by 8, then makes you pay tax on that amount-.25 per $100 with a minimum of $100, regardless of loss. If you have profits, this is an additional tax. Are we having fun yet???
Okay—so now we’ll talk about the 3 different types of corporations (if you must be one):
C Corp-this is the oldest one of the bunch. You are automatically a C Corp if you incorporate and don’t elect otherwise. No particular advantages or disadvantages except those listed above. A C Corporation pays its own tax on its own return.
S-Corp-this is the best one, I think. The profit/loss flows from it to your personal return much like a partnership, and the income is not subject to the Social Security Tax. You incorporate just like a C Corp, then you file an election which switches you from a C to an S Corp. You have about 3 months after date of incorporation to do the election. Otherwise, still the same advantages and disadvantages as listed above.
Limited Liability Corporation (LLC)-The newest kid on the block, it allows for the corporate protection without as much formality as the others. The IRS DOES NOT recognize LLC’s, period! You either file as a sole-proprietor, a partnership, or a corporation for your federal return. For example, if you are a sole-proprietor LLC, you will file a Schedule C (and be subject to the Social Security Tax as well) just as you would if you were just a sole-proprietor. However, most states DO recognize LLC’s, and you still have to file the separate state returns. Some attorneys disagree on whether the LLC has as much asset protection as the other two business structures; you should consult with your attorney on that. Otherwise, same advantages and disadvantages apply.
Okay, now that you have decided on what type of business structure to adopt, you have other issues to consider:
If you will have employees, become a partnership, or incorporate--you will need to obtain a Federal Employer Identification Number (or FEIN). You can get this by simply going to the IRS.gov website. On the left side of the page they give the link you click to start the process. You simply fill out the requested information, press send, and within five minutes or so, they respond back with your own unique EIN number. It’s that easy, and it’s free. No need to pay anyone to do this for you!
You will also need to get a city business license, and the following from the state if applicable: Sales tax license, unemployment, and state withholding. In most cases, the application forms are on-line, easy, and free of charge.
These resources are great references for small business owners:
This link is a great guide for small business owners in Tennessee.
If you are feeling a bit overwhelmed, you can always contact the Memphis Tax Lady. Consultations are free, and I’ll be happy to help you anyway I can. Call me anytime.
Starting Up a Business Thinking of starting up a business? Don’t know what to do first? Perhaps these guidelines will help. First... decide what type of business structure you want. Do you want to be a sole-proprietor, a partnership, or incorporate? Too often, my clients have failed to consider the tax consequences of a given business type … don’t assume that you should automatically incorporate your small business just because Walmart or FedEx did!
Notice: The information presented here is intended to provide guidance to the new business owner about some of the possible tax consequences of various forms of business structure and is not intended as legal advice; small business owners are advised to consult an attorney as to other issues that might be pertinent to their own situation.