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Ask Me Anything US-Based Taxes/Business Formation (CPA)

Discussion in 'Asset Protection/Taxes/Legal' started by CareCPA, Aug 31, 2017.

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  1. CareCPA
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    Since this section of the forum is not as robust, I wanted to add some info that would hopefully help those starting out in their business. There is a short stickied thread, but I didn't want to hijack it. This is a work in progress, and will be updated and people ask questions/I have extra time to build it out (I'll reserve a post or two after this one for when I add content).

    This discussion is intended for US-based companies. I make no claims as to the applicability to other countries.
    Note: This discussion is for general information only. Your tax situation is always unique, and thus you should consult with a professional before making any tax decisions. Any advice contained herein is not intended to be used in the avoidance of penalties imposed by the IRS.
    This discussion is also only on the tax/accounting aspects of the entities. It is in no way a legal discussion as to the liability protection, if any, offered by the formations. Consult an attorney for any questions on legal liability.

    Even if you ask me a specific question, and I give an answer, you should still consider it general information. Given the intentionally vague nature of this forum, there are details about your financial and tax situation I do not know. Therefore, always check with a professional who knows your entire situation.

    1. Business basics
    2. Entity Types
    A. Pass-through:
    i. Sole Proprietorship
    ii. General Partnership (GP)
    iii. Limited Partnership (LP)
    iv. Limited Liability Company (LLC)
    v. S Corporation (tax-only election)​
    B. Separate entity:
    i. C Corporation​
    3. Self-employment tax
    4. Taking losses
    A. Capital basis
    B. Recourse debt basis​


    1. Business Basics

    To formally begin a business, you must first register with your state’s Secretary of State to claim your business name. Depending on the type of business you are starting, there will be different documents and formalities needed. You will need Articles of Incorporation, a Shareholder Agreement, or a Partnership Agreement for anything other than a Sole Proprietorship. Craft these carefully, as they will contain important tax provisions. If you get a generic one off the internet, make sure you understand all the sections.

    Once your state registration has been completed, you can register with the IRS to receive your EIN.

    If your company is required to run payroll, you will also want to register with the federal and state payroll authorities.

    Note: As a sole-proprietor, you do not need to do any of these steps; you can simply begin conducting business in your name. Alternatively, you can obtain a “doing business as” from your state, and still not need to register for an EIN. However, you may want to obtain an EIN anyway to avoid giving out your social security number as you do business with other companies.


    2. Entity Types

    A. Passthrough Entities:
    The following are the most common pass-through entity types. There are some specialized entities beyond the scope of this write-up (for example REITs, LLLPs [usually used for professional organizations]).

    What is a pass-through entity? A pass-through entity means the income or losses from the company “pass through” to your individual return, and get taxed at your individual income tax rate. This income may or may not be subject to self-employment tax, the net investment income tax, or the Medicare surcharge.

    i. Sole proprietorship.

    If you are doing business by yourself, and have no separate legal entity, you are considered a sole proprietorship. You may still have an EIN as mentioned previously, which is especially useful for giving out to companies instead of your SSN. It may also be necessary if you choose to open a retirement account for your business (not an IRA, but a Solo 401K or similar).

    ii. General Partnership

    You can either intentionally, or unintentionally, create a general partnership. A General Partnership is formed between two or more individuals (or entities), who wish to do business together. As a General Partnership, there is no intention to limit liability for any of the partners.

    If you do business with another individual and do not register a partnership, the IRS may still find that you had formed a de facto General Partnership. All other entities require intentional formation.

    iii. Limited Partnership

    A Limited Partnership is formed between two or more individual (or entities) who wish to do business together, and limit liability for one or more partners. This usually occurs when one of the partners merely wants to be an investor, in return for capital.

    iv. Limited Liability Company

    A Limited Liability Company is one of the most versatile entity structures. As a single-member LLC (meaning only one partner), it is, by default, disregarded. This means it will show up on your Federal tax return as if there was no separate company (on your Schedule C for a business, or Schedule E if you have rental activity). Any LLC can elect to be taxed as a C Corporation, or as an S Corporation. An LLC who elects to be taxed as an S Corporation, can undo that election after 5 years (especially helpful for winding down the entity).

    v. S Corporation

    The S Corporation is a tax-only election. This means you cannot “form” an S Corporation. Your legal entity is either an LLC or a C Corporation, but for federal tax purposes you elect to be treated as an S Corporation. An S Corporation is limited to no more than 100 shareholders, all of whom must be US Citizens or Residents, or certain trusts or estates. The exception to this is that an S Corporation can be owned 100% by another S Corporation (this is referred to as a Qualified Subchapter S Subsidiary, or QSSS).

    Note that the S Corporation is a federal election. As such, your state may or may not recognize this tax treatment.

    Distributions from an S Corporation must be made pro-rata to all shareholders, which sometimes makes this entity tricky to get cash out of. This is also one reason you don’t want to hold real estate in an S Corp – if a piece of property gets distributed to a shareholder, then a proportionate amount of property/cash must be distributed to the other shareholders. You also have to worry about gains on distributions to shareholders.

    An S Corporation must run payroll, and pay its owners a “reasonable salary.” The IRS does not give guidelines as to how much would constitute a reasonable salary. There are also specific rules as to what can and cannot be deducted in regards to expenses paid for a shareholder that owns more than 2% of the S Corporation.

    Any amounts beyond the salary can be distributed to the shareholders. Distributions are generally tax-free, since you paid income tax on the profit in the year it was earned – not the year the cash was distributed to you.

    B Separate entities:

    Separate entities are subject to income tax at the entity level, not at individual rates.

    i. C Corporation

    The C Corporation is the only basic entity that is subject to taxation at the entity level. For the purposes of these discussion, we will include an LLC which elects to be taxed as a Corporation in this section.

    Similar to individual taxes, a C Corporation has tax brackets. They are:

    Over—........But not over............Tax is:.............Of the amount over
    $0...................$50,000..........................15% .................$0
    50,000 .............75,000...........$ 7,500 + 25%..............50,000
    75,000............100,000............13,750 + 34%..............75,000
    100,000..........335,000............22,250 + 39%.............100,000
    335,000.....10,000,000..........113,900 + 34% ............335,000
    [...clipped for illustrative purposes…]

    As you can see, as your individual tax rate increases, a C Corporation can begin to make sense, if you keep income under $50,000.

    3. Self-employment taxes

    Self-employment tax can be tricky. The IRS states that you must pay SE tax on “Your net earnings from self-employment (excluding church employee income) were $400 or more.”

    In general: Income from Sole Proprietorships and General Partnerships will be subject to SE tax. Income from S Corporations will not be subject to SE tax. Income from LPs and LLCs may or may not be subject to SE tax.

    SE tax is Social Security and Medicare taxes. When you are an employee, you pay half of these from your wages, and your employer pays the other half. When you own the business, you are both the employer and employee*, so you pay the entire 15.3%.

    * the term employee is used loosely here. You cannot be an employee of a partnership if you own the partnership.

    Income from rental real estate is never subject to SE tax, no matter what type of entity it is recorded in.

    4. Losses

    The upside to having business losses in a pass-through entity is the ability to offset wages and other income with these losses. However, in order to do this, you must have basis in the entity that is passing the loss through to you. There are two ways to create basis: capital and debt.

    A. Capital Basis

    Capital basis is determined by the amount of money you put into the business. As a partner in an LLC, LP, or GP, you can put money in and take money out at any time (as long as your partnership agreement specifies this).

    As a shareholder in an S Corporation, you capital basis the amount you paid to obtain your S Corp stock.

    You can take losses from the entity up to your basis.

    B. Debt basis

    Any time you as a partner of an LLC, LP, or GP guarantee debt, or loan money directly to the partnership, you receive debt basis. The logic behind this is that you can take losses up to the extent of any money that you have “at risk.”
    If you are a shareholder of an S Corporation, you can obtain debt basis only for money you loan directly to the company. You do not get debt basis in an S Corp simply by guaranteeing debt.

    If you take losses against the debt basis, and then the debt is repaid or forgiven, you may have to pick up a taxable gain on your income taxes.
     
    Last edited: Sep 1, 2017
  2. CareCPA
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    Reserving for future use, as I expect this to grow.
    Feel free to ask questions, and I will incorporate (see what I did there) into the post.
     
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    Let's say I create an LLC and want to transfer everything to another LLC of mine 2 months down the road, is this easily possible or a complicated process?

    If I close one of my LLC's is there generally a wait period before I can re-open under that name? (I understand this will differ per state).

    EDIT: I should specify...

    I opened one of my LLC's and elected the tax structure of an S corporation but quickly regretted the decision (too late election letter was already dropped off at the post office) as I realized I opened myself up to some future problems with the business.

    Now I am trying to decide if I should shut this LLC down and re incorporate with a similar name. Or see if I can transfer everything over a few months from now to an LLC with my preferred tax structure for this specific business.
     
    Last edited: Sep 1, 2017
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    You actually have a couple different options.

    My assumptions:
    1. You are the sole shareholder/member of the LLC taxed as an S Corp
    2. You have not carried on substantial activity yet (so your basis is essentially what it was at the time of formation).
    3. Assets in the S Corp have not substantially appreciated.

    Option 1:
    Call the IRS, explain you inadvertently made an S Election, and ask them to disregard it. Since it is still within the same tax year, they may just ignore that you filed it.

    Option 2:
    Distribute the assets from the S Corporation to yourself, dissolve the S Corp, and re-contribute to the new LLC. This depends heavily on the assumptions listed above in order to be tax-free.

    Option 3:
    This one is a little more complex, and requires someone who knows what they're doing when they file your tax return, and for recordkeeping.
    You can do a tax-free reorganization. You would create a new LLC, and contribute the assets of the S Corp to the LLC. In exchange, the S Corp would receive ownership in the LLC. So you would now have a single-member LLC holding the assets, where the S Corp is the sole member.
    You could then distribute the LLC ownership out to yourself (or even keep it in the S Corp if this made sense in your situation). Remember, distributions from an S Corp to a shareholder are not a taxable event.
    This option also relies heavily on my original assumptions.

    You should consider whether the S Corp would be beneficial in the long-run. Without knowing your business, I can't give any advice on that. Just don't be too rushed to "fix" things right away.

    Also, check your state d/b/a rules. D/b/a names in some states are not exclusive like a business name.
    Unfortunately, I do not know how long it would take the business name to "reset" and be available again at the state level. It may be worth a call to your Secretary of State's office.
     
  5. Scot
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    Awesome thread @CareCPA rep++ for this.

    My question to you. Let's pretend someone wants to do a "friend's and family" round of investing or there is an angel investor you've met who wants to invest in your company.

    If you have an LLC, is this possible, and how do you allocate a percentage or number if shares to the investor?

    If the LLC is not the best entity to do this through, do you recommend having a separate business entity that's tied in with the LLC that can handle this type of ownership?
     
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    Hey @Scot, the answer is either.

    Some people like to make their entity structures complicated. LLCs owned by other LLCs owned by S Corps, etc. This is certainly an option. You can set up a separate entity that owns part of the LLC, and is intended only for family and friends to own parts of. This would be good for privacy reasons (generally any member of an LLC has access to the books and records. You may not want everyone to have this insight).

    If you have a solid Operating Agreement, you can also let friends and family invest directly in your LLC. You would want to make sure you spell out what type of member they are (i.e. that they are an investor, with no say in your business). In exchange for their investment, you can give them whatever ownership percentage you deem appropriate. You would then write up your agreement (i.e. 2% ownership with no management ability for $10k) and keep it with all your other corporate documents.
    In my opinion, it's always worth having a lawyer look over these documents to make sure it actually says what you want it to say, and that everyone is receiving what they are intended to receive.

    In this situation, you would probably not want your LLC taxed as an S Corp, because you would be stuck with the pro-rata distribution rule.

    Personally, I favor structuring the investments as loans with an appropriate interest rate that everyone can agree on. This maintains your complete ownership in the entity, and avoids the other complications of dividing your interest. I'm not a fan of having more people own my business than necessary ;)
     
  7. Scot
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    Solid advice, thank you for that.

    I've always been curious about this. I don't plan on actively seeking out investment but the food industry can always eat up capital quickly, so it's something, at some point, may be necessary. And I'd definitely get a lawyer involved.
     
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    This has come up a few times lately......
    Two owners. One works in the business and draws a standard salary ($45k). Other is passive. 51/49 split so the one working in the business has control.

    LLC as partnership means self employment tax for 'salary', can split profits however operating agreement says.
    LLC as s-corp means W2 for salary, must split profits 51/49.
    Corp elect S-corp means same.... just shareholder meetings, only one class of stock, etc.

    Initital revenues <$500k w/ 20% profit. Target is $1.5M w/ additional investors brought in. Exit strategy to be bought out by competition.

    LLC, LLC as S-corp, Corp, Corp as S-corp?
     
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    With the info provided, I would stay LLC. It avoids the pro-rata distribution rule.
    For the "investment only" members, I would not subject them to self-employment tax. If they are truly passive and not doing work for the LLC, then their earnings should not be considered self-employment income.
    Technically the $45k isn't a salary, it's a guaranteed payment, but I understand what you're getting at here.

    You could also be an S Corp, pay the W-2 salary to the one working in the business, and just retain all excess cash in the business. By making no (or minimal) distributions, you don't have to worry too much about the pro-rata rules (you would probably want to make a distribution at year-end to pay the additional income taxes on the passthrough income). Then, just take the gains on the sale when you exit, which would be split according to ownership percentage.

    I don't see a benefit to C Corp electing S in this situation. Just extra formalities for no apparent benefit.

    Does this help at all? You haven't really identified what problem you're trying to solve. The optimal solution will ultimately depend on the needs of the individual members and investors. There is not necessarily a one-size-fits-all solution.
     
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    I have a question..

    LLC with 2 partners ( 50/50 ). We have a bank account under the LLC that merchant processing revenue gets dumped into the LLC bank account.

    Just noticed the merchant processor has everything under my name and SSN ( old setup from before, didn't get updated to the LLC EIN and name ), but the money is dumped in the the LLC's bank account.

    Will this create an issue? Did the LLC suddenly "create no revenue" this year and it's all going to be taxed under me personally when I file?
     
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    You'll want to correct this with the payment processor ASAP.
    The reason being, when they report the payments to the IRS (which they will), it will all be under your SSN.

    The business still earned the revenue, so it needs to be reported on the business taxes, but it's potentially a lot of back and forth with the IRS if the payments get reported under your SSN instead of the LLC's EIN.

    There are some work-arounds on the 1040 side, but they are neither elegant nor court-tested. One of them being that you could show the income coming into your Schedule C, and then right back off (zeroing out your Schedule C income). This would be supported by the fact that the deposits are made into the bank account with the LLC's EIN. In effect, you would earn the revenue, but the LLC would be your subcontractor for the exact amount of the revenue on your Schedule C.
    Again, I have not seen this OK'd by the IRS, but I have seen it done in practice to reclassify income to the proper place when a 1099 was received.
     
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    @CareCPA Awesome stuff. This comes up a lot where an investor backs a 'sweat equity' owner. So just looking to get some general info out there for those coming behind.
     
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    I feel kinda bad asking a 2nd one.. but I assume people will learn from it reading it.

    I have another LLC with another partner ( 50/50 ). It's registered in the state I live in, but my partner is out of state which creates a foreign entity for him and he has to pay tax to the state the LLC is in even though he lives in a non-tax state. This creates a small chunk of money every year he has to pay just for the pleasure of being a partner in the LLC from my state while being a resident in another state.

    Would it be possible to form the LLC in another state like Wyoming that doesn't have this issue with the same exact name, and close down the original LLC in my home state? Would there be any issues with the company having the same name in both states even though the original one would get dissolved?

    Also thanks for the advice you are giving. If it was in bad taste to ask a 2nd question, please forgive me.
     
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    Speaking to the name issue only (and not the non-resident taxes, since you seem to have already done your research on that part).
    There should not be an issue using the same name in another state. Business are incorporated under state laws. The IRS merely gives you an identification number (similar to how you can have two individuals with the exact same name, and the IRS will issue them each a SSN. Uncle Sam doesn't care as long as he gets his money). I have never seen a case where the IRS has rejected a business for having a duplicate name.

    You would just need to update your information with anyone who currently has your EIN (banks, other businesses, etc), and re-register with any state department (such as sales tax).

    Depending on what kind of business it is, if you have nexus in your state, you may still need to register the business in your state and file taxes, and he may still be subject to the non-resident taxes. This would probably cause an issue with the name, depending on timing. This will vary from state to state. Often having a partner live in a state will create nexus, and force a filing.
    NY, for example, is so strict, that even if no business is being conducted in NY state, simply the fact that any partner is a NY resident triggers a NY state return requirement.

    As you can see, a lot of the rules vary from state to state, which makes it difficult to give an overall answer.

    That being said, if you do get rejected by the IRS, let me know.

    Also, I don't care how many questions you ask. My intention is to create a thread/guide so people are getting accurate information in one place. If you have the question, I'm sure other people have it and just haven't asked (or haven't realized it was even an issue yet).
     
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  15. Scot
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    I almost feel embarrassed posting this here, but I'm pretty sure I'm not the only one this will apply to.

    Friend and I started a business last July. LLC with 50/50 partnership. Business went no where, made $0 in revenue (literally never got off ground floor).

    We just kind of, walked away. Closed bank account and wiped our hands.

    Is there anything formal that needed to be done to "dissolve" this? Are there any tax implications that I may not know of?
     
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    There is usually a procedure with your state to formally dissolve. There should be no tax implications.
    For federal tax purposes, a partnership does not need to file a tax return if it "neither receives income nor incurs any expenditures treated as deductions or credits for federal income tax purposes."

    ETA: I see you're in Florida. If it was a Florida entity, FL has an annual filing fee not related to income taxes, that you would still most-likely be liable for.
     
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    I also had a similar query. Thanks for the expressive information on this.
     
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    Edit: found my answer
     
    Last edited: Sep 12, 2017
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    Awesome.
    The answer to your original question was no, and that many people are in that position the first year (and some for quite a few years thereafter).
     
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    @CareCPA

    Do you think it'd be appropriate to add an "AMA" tag to this thread and the thread title to something like AMA about US Based Taxes / corporate entities? If so, just tag a mod and let them know.

    Not sure if that's your intention or not, but just thought I'd mention it.

    I think that might get more people clicking.

    The current thread title... I'm not even sure why I clicked on it, but here I am.
     
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    You clicked because you knew it was me - who else would write about taxes?

    I would be fine with that, but I believe @MJ DeMarco has a vetting process for his AMAs?
     
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  22. MJ DeMarco
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    MJ DeMarco Raving Lunatic Staff Member Read Millionaire Fastlane I've Read UNSCRIPTED FASTLANE INSIDER Speedway Pass LEGENDARY CONTRIBUTOR Summit Attendee

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    @CareCPA -- thank you. Rep given, and AMA tag added. (I'm sure GOLD will follow...)
     
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  23. InspireHD
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    InspireHD Bronze Contributor Read Millionaire Fastlane I've Read UNSCRIPTED FASTLANE INSIDER Speedway Pass

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    I've been waiting for this thread. Not sure how I missed it.

    My question is similar to Blake's and you may have answered it in the other thread where I asked.

    I set up my LLC through LegalZoom and they made it seem like I had to pick an S-Corp or C-Corp. I think I may have even been advised by a family member to register as an S-Corp. He worked in, started, and sold multiple businesses in the same line of work that I am doing so I trust him. I am a single-member LLC and funded the company originally through a new business checking account with my own money.

    My thoughts right now are that the business expenses flow through to my personal income to help with tax deductions regarding expenses related to the business, including home office, vehicle maintenance, gas, food, utilities, etc. Does the S-Corp affect that in any way?

    And I saw that you gave instructions how to stop the S-Corp. I think I received confirmation of the S-Corp around April of this year and have only made one sale as of August (assuming the product is accepted). My point is that I haven't done anything 'substantial' within the business at this point other than have expenses like I stated above. And, I am going to take a loss on the entire first contract that I won because I needed to buy shipping labels for the little boxes. So, should I consider calling the IRS and trying to cancel the S-Corp designation? I'm still not really sure what is going to change or how it will affect me being a single-member.

    Thanks!
     
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  24. G-Man
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    G-Man Legendary Contributor Read Millionaire Fastlane I've Read UNSCRIPTED FASTLANE INSIDER Speedway Pass LEGENDARY CONTRIBUTOR

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    #goldthread
     
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  25. Scot
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    Scot Ductus Exemplo Read Millionaire Fastlane I've Read UNSCRIPTED FASTLANE INSIDER Speedway Pass LEGENDARY CONTRIBUTOR

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    I've got another one. Have you ever read the book Profit First by Michealowicz, if so, do you think it's a viable accounting method or reckless?
     
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