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
4. Taking losses
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
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.
[2018 Update]
A new provision in the Tax Cuts and Jobs Act of 2017 (TCJA) now allows for a "Section 199A" deduction. In general, this deduction is 20% of the profit from a passthrough entity. There are a number of limitations on this deduction, so please be advised that it is not applicable for everyone. (will update with exceptions and thresholds in the near future).
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).
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.
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.
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).
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.
Separate entities are subject to income tax at the entity level, not at individual rates.
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.
[2017 and prior]
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.
[2018 Update]
With the passage of the Tax Cuts and Jobs Act (TCJA) of 2017, the tax on C Corporation earnings starting in 2018 is a flat 21%. This now drastically changes when a C Corp may be more beneficial than an S Corp, so an analysis should be done based on the goals and future of the specific business
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.
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.
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.
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:
3. Self-employment taxi. Sole Proprietorship
ii. General Partnership (GP)
iii. Limited Partnership (LP)
iv. Limited Liability Company (LLC)
v. S Corporation (tax-only election)
B. Separate entity:ii. General Partnership (GP)
iii. Limited Partnership (LP)
iv. Limited Liability Company (LLC)
v. S Corporation (tax-only election)
i. C Corporation
4. Taking losses
A. Capital basis
B. Recourse debt 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.
[2018 Update]
A new provision in the Tax Cuts and Jobs Act of 2017 (TCJA) now allows for a "Section 199A" deduction. In general, this deduction is 20% of the profit from a passthrough entity. There are a number of limitations on this deduction, so please be advised that it is not applicable for everyone. (will update with exceptions and thresholds in the near future).
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.
[2017 and prior]
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.
[2018 Update]
With the passage of the Tax Cuts and Jobs Act (TCJA) of 2017, the tax on C Corporation earnings starting in 2018 is a flat 21%. This now drastically changes when a C Corp may be more beneficial than an S Corp, so an analysis should be done based on the goals and future of the specific business
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.
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