DAN PILLA’S GUIDE TO STARTING YOUR OWN BUSINESS
Considerations for a Business Structure and Operation
by Daniel J Pilla
More people every year consider starting their own business, either because they are forced to due to loss of employment or because they wish to finally strike out on their own. Because of this, I am regularly asked whether it’s true that a small business in general, and a home-based business in particular, really can provide tax benefits that ordinary wage-earners usually miss out on. The answer, without a doubt, is yes.
Once people make the decision to start their own small business, the next question is always, “What type of business structure should I use for my new business?” The answer to that question is not quick or simple, as many factors must be evaluated before making a decision.
The number of new businesses operating within some type of entity structure is growing by about 5 percent annually. Common business entity structures include corporations, partnerships and Limited Liability Companies (LLC). These structures provide various tax and business benefits, depending upon the situation. The problem is that there are also decided disadvantages to operating a business under some kind of structure. The most obvious of these disadvantages is the fact your bookkeeping and tax return filing obligations generally increase.
The purpose of this Special Report is to provide insight and guidance on starting and operating a small business. I also point out some of the most common problems new business owners make in operating small businesses.
What Kind of Business to Start
Start a business working in an area you know something about. This might seem obvious but you would be surprised at how many people go into businesses they know little or nothing about. People take cash from retirement fund distributions or early retirement buy-out packages and strike out into an area they’ve always “dreamed about” but with which they have no practical experience. This is generally a big mistake. There are always curveballs that show up in business, even when you’re highly skilled and experienced. But when you have no experience, the curveballs are harder to see coming and more difficult to hit.
On the other hand, nearly everybody has a hobby they could turn into a business just by making a few simple changes to the way the activity is operated. By turning a hobby into a business, you have the distinct advantage of already knowing something (and perhaps a great deal) about the nature of the business. This could include the market you’re dealing with, market competition, price points, etc.
The key change you must make to convent your hobby activity into a business activity is to operate the activity in a “businesslike manner.” By doing so, you evidence a “profit motive.” When there is a genuine profit motive associated with your operation, you’re entitled to claim deductions for all the expenses associated with the undertaking. That is, the hobby becomes a legitimate business. By contrast, if there is no profit motive, the expenses of your operation are not deductible beyond the income you earn. That is, you cannot use a loss to cut your taxes on other income.
You have a profit motive when you carry on your activity in a “businesslike manner.” Internal Revenue Regulation section 1.183-2(b) provides guidance on the elements that the IRS looks at to determine whether a profit motive exists. Among the key elements are:
· Advertising your product or service,
· Keeping books and records in a business-like manner to get and keep a handle on your revenue and costs,
· Following reasonable business practices to be profitable and control costs,
· Already having or working to gain expertise in the area of concern, and
· Spending a reasonable amount of time working in your business.
Must I Show a Profit in My First Year?
Many people are scared away from starting their own business because they believe they must show a profit or the IRS will disallow the deductions incurred in operating the business. In fact, many people have heard horror stories about people who’ve been audited and the IRS called their business a “hobby,” then disallowed all their deductions.
This is a risk if your small business loses money for several consecutive years. When this happens, the IRS is likely to claim that your activity is not engaged in for profit. You may deduct only those expenses associated with a business operated for profit. You cannot deduct expenses for activities carried on primarily for sport, hobby or recreation. If your business is reclassified as a hobby, you are asked to pay taxes on all the receipts without the benefit of any expense deductions.
It is important to understand that there is no legal provision requiring you to earn a profit in connection with your business or lose your deductions. This runs contrary to popular belief but it is nevertheless true. There are, however, two specific provisions of law you need to understand to avoid problems in this area. Let us turn to them now.
The first is code section 162. This is the code section that allows deductions for business expenses. It reads, in pertinent part,
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
Two rules emerge. First, expenses are deductible if they are “ordinary and necessary.” Second, they are deductible if incurred while carrying on a “trade or business.” Expenses not related to a trade or business operated for profit are considered non-deductible personal expenses.
The second relevant code section is the source of the confusion. It is code section 183 and reads, in part,
In the case of an activity engaged in by an individual or an S corporation, if such activity is not engaged in for profit, no deduction attributable to such activity shall be allowed except as provided in this section.
When engaged in a trade or business, you may deduct all ordinary and necessary expenses. But if your activity is not engaged in for profit, the related expenses are not generally allowed as deductions. That might seem simple, but the confusion arises after reading section 183(d). That section reads as follows:
If the gross income derived from an activity for 3 or more of the taxable years in the period of 5 consecutive taxable years exceeds the deductions attributable to such activity . . . then, unless the Secretary establishes to the contrary, such activity shall be presumed for purposes of this chapter for such taxable year to be an activity engaged in for profit.
Section 183(d) creates a presumption. The presumption is that the activity is in fact engaged in for profit if it produces profit in any three of five consecutive years. In that case, all proper deductions are allowed under code section 162.
That is what the law says. Now let us look at what it does not say.
It does not say that if no profit is realized in three of five years, you are not entitled to claim deductions. If you fail to earn profit in at least three of the five years, what happens is the presumption of a profit motive dissolves. That means you must prove a profit motive. And as long as you can prove a profit motive, you can lose money ten out of ten years and still claim your deductions.
The reason is the test in section 162 for allowing deductions has nothing to do with whether your business actually earns a profit. The test is whether you engaged in the activity with an honest objective of making a profit. It boils down to a question of intent. Did you undertake to earn a profit or did you intend to play and have fun? If the former, you are entitled to the deductions; if the latter, you may not be.
You should also note that the expectation of profit need not be reasonable. That is to say, your activity need not necessarily be a smart or savvy business move. Instead, you need only have a good faith objective of making a profit. When a good faith profit objective exists, you are entitled to your deductions even if actual profit does not.
How a Home-based Business Saves Money
Let us now turn to the question of how a home-based business in general can save money on your taxes, assuming you have the requisite profit motive as discussed above. There are several ways a home-based business can cut your taxes. Just a few of the key strategies are discussed below.
The home office deduction. A home-based business allows you claim a deduction for a portion of the costs of maintaining your home. To qualify, you need meet only a few simple rules. They are:
· The space in your home must be used regularly and exclusively for business purposes. For example, say you use a spare bedroom or den for your office. To meet this test, the bedroom cannot be used as an office during the day and a TV or playroom for the kids in the evening. Only business activities can be conducted in the space.
· The space must be used to conduct administrative and management tasks necessary to the success of the business. These tasks include bookkeeping, client contacts, letter writing, phone calls, account collections, or any other task you must carry out to be successful.
· There must be no other suitable location available to conduct your business. You don’t qualify for the home office deduction if, for example, office space is provided by someone associated with your operation.
Your deduction is based on the percentage of space used for business. For example, if the space you use is 250 square feet and the total square footage of the home is 2,500, you can deduct 10 percent of costs of maintaining your home. This includes utilities, trash removal, lawn care, insurance, repairs, routine maintenance, etc.
Deduct all your medical expenses. If you operate as a sole proprietor, you can get a full deduction for all you family’s medical expenses, just by hiring your spouse. Under sections 105(b) and 106, if your spouse is a “bona fide” employee, you as the employer can pay all your spouse’s medical expenses, including her family’s expenses (and that includes you, as your employee’s spouse) and you get a full business deduction for those expenses. Code section 162. To qualify, the spouse must,
· Provide legitimate services based on the nature and needs of the business,
· The medical reimbursement plan must be in writing and the spouse must meet the terms of the plan,
· Medical insurance under the plan must be in the name of the employee-spouse, NOT the employer-spouse, and
· The spouse cannot be a co-owner of the business.
This is an excellent way to capture a 100 percent deduction for your medical expenses at a time when you’re probably not getting any deduction at all.
Even if you don’t hire your spouse, you can still increase deductible medical expenses as a sole proprietor. This is because 100 percent of the medical insurance costs paid by a sole proprietor for himself, spouse and dependents are fully deductible.
Hire your kids. A child working for his parents, who is under the age of 21, is exempt from social security taxes and unemployment taxes. This means that by paying a child an amount equal to or less than his standard deduction, the child gets tax-free income and you get a business deduction. A single person could earn up to $5,700 in 2010 without incurring an income tax debt. (That amount is inflation-adjusted so will rise slightly for 2011 and beyond.)
To qualify, the kids must:
· Perform services that are directly connected to the parents’ business. This can include stuffing envelops, cleaning the office, doing computer work, bookkeeping, filing, etc.,
· Actually perform the service. This element may be subject to review by the IRS, so it’s best to have a time-sheet describing the tasks performed and the time spent on the task, and
· The payments must actually be made to the child. Again, this might be reviewed, so you have to cut a check to the kid. However, there’s no restriction on how the money can be spent. It can be used to buy clothes, school supplies, food, or other non-deductible items.
Increase retirement savings deductions. As a self-employed person, you can establish a SEP-IRA or KEOGH plan, instead of a traditional IRA. The benefits are tremendous. Under a SEP or KEOGH, for example, you can sock away up to 25 percent of your net self-employment income ($49,000 max) in your tax-deferred retirement account. Compare that with the $5,000 annual cap on traditional IRA deductions. (Note: these amounts change from year to year depending upon congressional action.)
Deduct commuting expenses. Normally, the costs of driving from home to work and back are considered non-deductible commuting expenses. However, if you’re self-employed with an office in your home, more of your travel costs can become deducible business expenses. To qualify, you must,
· Travel between your home office and another work location, and
· The work location you travel to must be related to your business.
For example, if you leave your home to travel to a client’s office, then go to the print shop, then to the post office, then return home, all that mileage is tax-deductible. Even if you make an incidental, non-business related stop along the way, say at the grocery store or to pick up the kids from school, your mileage is still tax-deductible business mileage.
Convert vacation expenses to business expenses. Businesses enjoy tax-deductible travel when that travel is at least partially related to carrying out your business. For example, if you travel to Florida for a trade show but stay an extra few days, you don’t lose the deduction for your airfare and all expenses associated with business. By making all of your out-of-town travel at least partially related to business, you’ll be able to deduct a substantial portion of these expenses that you’d otherwise not be able to deduct.
Reduce Social Security taxes with an S corporation. By adopting the status of a small business corporation, the so-called “S corporation,” you can substantially reduce your Social Security taxes by taking a portion of your compensation in the form of dividends, rather than self-employment profits. Self-employment profits are subject to Social Security taxes but dividends are not. To qualify, you must,
· Establish a corporation under state law and make the S election with IRS Form 2553,
· Pay yourself a minimum salary commensurate with the value of your services, and
· Take the balance of your compensation in the form of a dividend, not a salary.
Since the Social Security tax is equal to 15.3 percent of profit, this strategy can save thousands of dollars every year. The S corporation is discussed in more detail below.
Deduct this newsletter. The cost of educating yourself on the tax laws is fully deductible for small businesses. You can get the same deduction if you don’t have a business, but it’s limited. And don’t forget to read this newsletter. A key element is that I provide continuing education to small business owners on how to maximum your deductions. Don’t miss a single issue because this is the kind of information you just can’t get any place else, and it can save you thousands in taxes every year.
Considerations for Choosing a Business Structure
It is important to carefully consider which type of business structure to adopt. The right one for you depends upon the nature of your business, whether you have partners, the potential for liability, the need for flexibility in making business decisions, etc.
The problem is that too many people don’t know all their options. Consequently, many don’t adopt the structure that’s best for them. Since small businesses are the backbone of our economy, and because more small businesses are being formed today than ever before, it’s about time somebody lays out the options for small business structures. I do that here, together with the pros and cons of the five most common forms.
The five main business structures are: 1) the sole proprietorship, 2) the partnership, 3) the corporation, 4) the small business corporation, and 5) the Limited Liability Company (LLC). Here are the basics of each structure.
The sole proprietorship. This is the simplest and most common business structure because there’s nothing to set up. A sole proprietorship simply exists by virtue of the fact that one declares himself to be self-employed. State or local business licenses may be required and it may be desirable to file an “assumed name” declaration with the state. However, nothing is required for federal tax purposes to use this business structure. (This assumes your company has no employees.) A sole proprietor reports business income and expenses on Schedule C, Profit or Loss From Business, or Schedule F, Profit or Loss From Farming.
· Simple to set up and operate and the owner has complete control of business decisions,
· No other forms or statements are required by the IRS, and
· Easy to terminate if necessary as there no formal dissolution documents required.
· The owner assumes full liability for potential debts and lawsuits,
· Owner’s assets can be reached by creditors even though the assets may not have been used in connection with or acquired as a result of business actions,
· Lack of formal business structure limits the ability to raise capital, and
· All profits flow through to the owner’s tax return, limiting the capacity to defer income tax.
The sole proprietorship is the ideal way to start a business because it’s fast, easy and carries no cost. It’s also flexible and easy to alter. However, it may not be the best structure for growing a business, especially for professionals with potential liability for their business actions.
The partnership. This business form is also very easy to set up, generally requiring a simple partnership agreement that specifies the partners and their respective interests. State law may require a partnership declaration to be filed. A partnership reports business income and expenses on Form 1065, US Return of Partnership Income.
· Does not pay taxes -- profits flow through to the tax returns of each partner based on their percentage ownership of the partnership,
· Losses can offset other income, such as wages,
· Written agreement defines the legal interests of the partners and their responsibilities,
· Easy to organize and requires limited documentation, and
· Formal business structure is helpful when dealing with banks, potential suppliers, investors and others.
· Requires a separate federal income tax return and compliance with separate reporting requirements,
· Each partner is fully liable for the debts of the business even though the income is split on the basis of ownership interests (limited liability partnerships operate under different rules),
· Decision-making becomes more cumbersome as opinions may clash, and
· All profits immediately flow through to the partners’ tax returns limiting the capacity to defer income tax.
The partnership is the easiest way to start a business with another person. The formality of the partnership agreement defines each party’s interest and responsibilities for the sake of the future.
The corporation. A corporation is the most complex business structure to establish and maintain. State law determines which documents must be filed. At the very least, you must file Articles of Incorporation that conform to strict legal standards. While most states allow for a single person corporation, corporations generally exist to facilitate ownership interests of more than one person. A corporation reports its income and expenses on Form 1120, US Corporation Income Tax Return.
· Limited liability for officers and shareholders (though this may not be the case with single person corporations),
· Separate legal entity lives on even though the founder or an officer dies,
· Personal assets of officers or shareholders cannot be reached to satisfy corporate obligations,
· Ideal entity for soliciting investors and raising capital because stock ownership is easily transferred,
· Tax-deductible fringe benefits can be paid to employees, and
· The ability to defer income in certain situations.
· Corporate acts must be accounted for separately for federal tax purposes, for state reporting purposes and for banking purposes,
· Income and assets cannot be co-mingled with the income and assets of officers, employees or shareholders,
· Officers must have board meetings and record their decisions in accordance with standard business practices,
· More difficult and cumbersome to dissolve, and
· Profits are subject to double-taxation, both at the company level and at the shareholder level.
Corporations are best suited to mid-size and large businesses with several employees participating in decision-making processes. The corporation structure is also well suited to a growing business with the need to raise capital and acquire assets. The corporation’s limited liability feature is important for those with potential risk of lawsuits, such as medical professionals or certain product manufacturers.
The small business corporation. The small business corporation is known as the S corporation. The organizational requirements for an S corporation are the same as for any other corporation. The “S status” applies to federal income taxes only. To become an S corporation, the corporation must file an election on IRS Form 2553, Election by a Small Business Corporation within the time required by law. An S corporation files its tax return on Form 1120S, US Income Tax Return for an S Corporation.
· May have just one owner,
· Owner can arrange a compensation package consisting of wages and dividends to cut Social Security taxes,
· Taxed like a partnership, that is, no double-taxation of profits,
· Simple to add employees to a growing business, and
· Enjoys limited liability for shareholders and officers, and perpetuity of life.
· All the disadvantages of corporations generally apply to S corporations (with the exception of the double taxation problem),
· Legal limits on the type of corporations that can adopt S status, and
· Legal limits on who can be a shareholder, the number of shareholders and the class of stock the corporation is allowed to issue.
The S corporation is suited to small and mid-size businesses and even single person corporations, when allowed by state law. Full flexibility is retained with the S corporation but with the added legal protections that come with the corporate umbrella.
The Limited Liability Company (LLC). The LLC limited liability company is a cross between a corporation and a partnership. An LLC may have two or more owners owners (like a partnership) or may be a single member LLC. In either event, the LLC enjoys limited liability protection (like a corporation). The process for establishing an LLC is set by state law and generally patterns those of a corporation.
For federal tax purposes, the LLC is treated as a “disregarded entity.” That means that the federal law does not create a separate tax return filing scheme or tax structure for LLCs. Rather, the LLC is treated as either: 1) a sole-proprietorship, 2) a partnership, or 3) a corporation, depending upon an election made by the LLC.
For example, if the LLC is a single-owner entity, it can be taxed either as a sole-proprietorship or a corporation. If the LLC is a multimember entity, it can be taxed as either a partnership or a corporation. The election is made on Form 8832, Entity Classification Election.
Failure to make the election means the entity will be classified on the basis of the default rules. Internal Revenue Regulation section 301.7701-3(b)(1) sets out the default rules. Under the rules, an entity is treated as a partnership if it has two or more owners. If the entity has just one owner, it is taxed as a sole proprietorship.
In any case, the LLC files it tax return on the form that’s applicable to how the entity is treated. If it’s treated as a sole proprietorship, the income and expenses go on the owner’s Schedule C. If the entity is a partnership, income and expenses go on Form 1065 and the profit is reported on the owners’ tax returns. If the entity is treated as a corporation, it will file either Form 1120 or 1120S, as the case may be.
· Can be treated like a corporation or partnership for income tax purposes, and
· Provides some of the same protections of a corporation without the legal requirements of corporate status.
· State law determines nature and extent of limited liability and life,
· Some states may required at least two owners, and
· Profits are subject to Social Security tax.
A Word About Trusts
Many people often ask about using a trust structure as a means of operating a business. A trust is legal entity much like a corporation. A trust is an entity created by a contract between the grantor (the person setting up the trust) and the trustee (the person who controls the income or assets of the trust). The trustee controls the assets of the trust for the benefit of beneficiaries, the people who ultimately receive the income and assets from the trust.
Trusts are most often used in estate planning as a means of gain perpetuity of life but without the public disclosures that often accompany the corporation status and the probate of traditional wills. Families often put investment assets into trust to avoid probate, thus allowing the assets to continue to work and grow without the need having to liquidate them on the death of the original owner. Used properly, trusts can be very effective as part of a comprehensive estate plan.
In the past twenty years or so, a number of tax shelter promoters created trust packages that were sold to business people and professionals as a means of operating their business. These packages were sold as aggressive tax reduction schemes. The promises centered on the idea that trusts were entitled to a host of deductions and financial privacy that other businesses did not enjoy. Some promoters even went so far as to claim that trusts had no legal duty to file tax returns, thus making their income essentially tax exempt.
As these programs were increasingly marketed more broadly and openly, the IRS took notice and did two things. First, it started criminal investigations that led to the prosecution of many trust scheme promoters. Secondly, it aggressively audited those who operated the trust schemes sold by the promoters. The audits led to the disallowance of the very structures the promoters promised were airtight tax avoidance mechanisms.
Despite the long, checkered history of trust litigation and enforcement, there never seems to be a shortage of people willing to continue marketing these schemes on essentially the same terms as those described above. Even today, I regularly talk with people who either have been pitched on the idea of buying a trust package to run their business or, unfortunately, in fact bought such a package and now have tax problems.
Because of this, my best advice regarding trusts is to simply do not use them for purposes of operating your business. For more details on this issue, please see my report, “Why Trusts Don’t Work,” which is available here also on my website.
Choosing the Business Structure That’s Right for You
Before opting for a given business structure, make a list of the attributes that you need and rank them in order of importance. Use your list of priorities to drive your decision. For example, if it’s mandatory that you have the utmost simplicity in terms of paperwork and tax compliance and want the most flexibility possible, opt for the sole proprietorship. However, if limited liability and tax savings are more important, consider an S corporation or LLC.
Your decision must also be guided by whether you have partners. If there’s more than one person involved, you’re automatically cut out of sole proprietor status. That leaves the partnership, corporation or LLC. If you need liability protection, you’re now down to the corporation or LLC. However, if your state law does not afford sufficient protection through the LLC, your answer is the corporation.
After listing your priorities and needs, discuss the issue with your tax pro or make an appointment to speak to me over the phone. I’ll help you evaluate your options and make better sense of the options. If you don’t currently work with a tax pro, contact one of our Tax Freedom Institute members. Obtain the list of members.
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