Small business ownership is a good way to take more control of your time and puts more money in your pocket. But what is the true cost of small business ownership? Surprisingly, many small business owners are faced with many challenges that may leave them with less time and less money than when they were earning a living working for someone else.
One of the most common mistakes that small business owners make is made within the first few weeks of starting up their business. Choosing the wrong entity and/or business structure can severely hurt a small business trying to get on its feet. While each state is different, the common types of business structures are: sole proprietorship, partnership, limited liability company, and corporation (C and S are the most common). It is important to understand who the structuring of your business will affect your tax situation, how you raise money, the paperwork that is needed to be field, as well as your own personal liability requirements.
A sole proprietorship is the easiest to form and gives you complete control over how the business is run. In most cases, you are automatically considered a sole proprietorship is you perform business activities and do not register as any other type of business. Sole proprietorships report their taxes on the owner’s personal Federal Form 1040 tax return. They are also subject to self-employment taxes, and the owner cannot take a W2 wage. As they are not seen as separate from the owner, all assets and liabilities are also not separate from the owner, and you may be held personally liable for any debt and obligation incurred on behalf of the business. Sole proprietorships are considered low risk, and a good place for owners looking to start out before creating any more formalized business.
Partnerships are the simplest structure for two or more owners to do business together. There are two common types of partnerships: limited partnerships and limited liability partnerships. With a limited partnership, there can be only one general partner and the rest are limited liability partners. The limited liability partners also have limited control over the company and its decisions. Profits and losses are passed through to the general partner to report on their personal Federal Form 1040, and any profit is subject to self-employment taxes. The limited liability partners only pay self-employment on any guaranteed payments they receive. In the limited liability partnership, the liability is limited to each owner. This protects all partners from debts against the partnership and the actions of the other partners.
A limited liability company gives the small business owner the benefit of both the corporation and partnership structure. Limited Liability Companies are designed to protect the owner(s) from personal liability, thereby protecting their assets from lawsuits or debt created in the business. The profits and losses are passed through to the owner’s personal Federal Form 1040 for taxation. They are, however, considered to be subject to self-employment taxes. Each state has different rules regarding the treatment of limited liability companies, so it is important to determine I the regulations of your state will work for your business.
A C Corporation is a legal entity completely separated from its owners. As a separated entity, it is responsible for its own taxes as well as legal liability. While this structure provides the most legal protection for the owner, there is also the greatest cost to set up a C Corporation. They also require the most amount of record keeping, operational process and reporting. Additionally, they are subject to double taxation. The profits are first taxed on the corporate level, and then the dividends paid to each owner is taxes on the owner’s personal Federal Form 1040 return. If an owner chooses to leave the Corporation, he/her shares are simply sold, and the Corporation feels little to no affect. Raising funds can also be easier, as the Corporation can sell stock.
Sub Chapter S Corporations are designed to avoid the double taxation that occurs in the more traditional C Corporation. The S Corporation allows for profits and losses to be passed directly to the owner’s or owners’ personal Federal Form 1040 for taxation purposes without being subject to self-employment taxes. Again, each state has different regulations when it comes to the treatment of S Corporations, and so it is important to understand your own states stance. The S Corporation is limited in its shareholders to one hundred, and they must all be US Citizens. It also retains the strict processes and operations reporting that a C Corporation has. And like a C Corporation, it is easy for a shareholder to leave the company.
As business owners begin to navigate their structure, often underpayment or overpayment of taxes become a key issue. Many owners are not aware of what income is reportable, participate in barter systems in their first years but do not report them as income, or engage in cash transactions that are not reported to the IRS. Often owners are unaware of what expenses can be taken against the income, and this can lead to over or under reporting of expenses. In many states there are taxes associated with the location of the consumer, special licenses and other items that the small business owner may not be aware that they must track or have. Small business owners often have difficulty complying with the complex tax code that surrounds business ownership because they simply are not aware of it.
It is important to take advantage of deductions and credits available to your business. It is often hard to keep up with the ever-changing landscape of tax laws and tax reform. Over forty percent of small business owners say they spend eighty or more hours working on tax and accounting related issues a year, and generally all in the last quarter of the year. Often it can seem overwhelming to a small business owner, especially those just starting out. It is important to make sure you start out on the right foot and seek the help of a professional or your state’s business regulatory site to ensure that you are capturing all of the requirements and reporting correctly.
If most of your money is tied up in your business, retirement can be a challenge. So if you haven’t already set up a tax-advantaged retirement plan, consider doing so this year. There’s still time to set one up and make contributions that will be deductible on your 2018 tax return!
Not only are contributions tax deductible, but retirement plan funds can grow tax-deferred. If you might be subject to the 3.8% net investment income tax (NIIT), setting up and contributing to a retirement plan may be particularly beneficial because retirement plan contributions can reduce your modified adjusted gross income and thus help you reduce or avoid the NIIT.
If you have employees, they generally must be allowed to participate in the plan, provided they meet the qualification requirements. But this can help you attract and retain good employees.
And if you have 100 or fewer employees, you may be eligible for a credit for setting up a plan. The credit is for 50% of start-up costs, up to $500. Remember, credits reduce your tax liability dollar-for-dollar, unlike deductions, which only reduce the amount of income subject to tax.
3 options to consider
Many types of retirement plans are available, but here are three of the most attractive to business owners trying to build up their own retirement savings:
1. Profit-sharing plan. This is a defined contribution plan that allows discretionary employer contributions and flexibility in plan design. You can make deductible 2018 contributions as late as the due date of your 2018 tax return, including extensions — provided your plan exists on Dec. 31, 2018. For 2018, the maximum contribution is $55,000, or $61,000 if you are age 50 or older and your plan includes a 401(k) arrangement.
2. Simplified Employee Pension (SEP). This is also a defined contribution plan, and it provides benefits similar to those of a profit-sharing plan. But you can establish a SEP in 2019 and still make deductible 2018 contributions as late as the due date of your 2018 income tax return, including extensions. In addition, a SEP is easy to administer. For 2018, the maximum SEP contribution is $55,000.
3. Defined benefit plan. This plan sets a future pension benefit and then actuarially calculates the contributions needed to attain that benefit. The maximum annual benefit for 2018 is generally $220,000 or 100% of average earned income for the highest three consecutive years, if less. Because it’s actuarially driven, the contribution needed to attain the projected future annual benefit may exceed the maximum contributions allowed by other plans, depending on your age and the desired benefit.
You can make deductible 2018 defined benefit plan contributions until your tax return due date, including extensions, provided your plan exists on Dec. 31, 2018. Be aware that employer contributions generally are required.
If the benefits of setting up a retirement plan sound good, contact us. We can provide more information and help you choose the best retirement plan for your particular situation.
As we approach the end of 2018, it’s a good idea to review the mutual fund holdings in your taxable accounts and take steps to avoid potential tax traps. Here are some tips. Avoid surprise capital gains Unlike with stocks, you can’t avoid capital gains on mutual funds simply by holding on to the shares. Near the end of the year, funds typically distribute all or most of their net realized capita l gains to investors. If you hold mutual funds in taxable accounts, these gains will be taxable to you regardless of whether you receive them in cash or reinvest them in the fund. For each fund, find out how large these distributions will be and get a breakdown of long-term vs. short-term gains. If the tax impact will be significant, consider strategies to offset the gain. For example, you could sell other investments at a loss. Buyer beware Avoid buying into a mutual fund shortly before it distributes capital gains and dividends for the year. There’s a common misconception that investing in a mutual fund just before the ex-dividend date (the date by which you must own shares to qualify for a distribution) is like getting free money. In reality, the value of your shares is immediately reduced by the amount of the distribution. So you’ll owe taxes on the gain without actually making a profit. Seller beware If you plan to sell mutual fund shares that have appreciated in value, consider waiting until just after year end so you can defer the gain until 2019 — unless you expect to be subject to a higher rate next year. In that scenario, you’d likely be better off recognizing the gain and paying the tax this year. When you do sell shares, keep in mind that, if you bought them over time, each block will have a different holding period and cost basis. To reduce your tax liability, it’s possible to select shares for sale that have higher cost bases and longer holding periods, thereby minimizing your gain (or maximizing your loss) and avoiding higher-taxed short-term gains. Think beyond just taxes Investment decisions shouldn’t be driven by tax considerations alone. For example, you need to keep in mind your overall financial goals and your risk tolerance. But taxes are still an important factor to consider. Contact us to discuss these and other year-end strategies for minimizing the tax impact of your mutual fund holdings. © 2018