Option 2: LLC or Limited Liability Corporation
The birth of a VAR typically goes something like this: the employee of an IT service provider comes to the realization that he can do the same work himself and collect the profit without having to answer to superiors he might disagree with. The employee quits and calls on a few of the clients he served at the larger company plus some new ones, provides the same services, collects a check and cashes the check.
On April 15 every year many come to a second realization about self employment -- the manner in which they cash that check effects how much it they actually get to keep. This past April 18 (income taxes were postponed to April 18 this year to accommodate a holiday in Washington, D.C.), no doubt, many realized they had made a mistake.
A business owner’s tax footprint has less to do with the accounting done at the end of the year than the business structure elected at the beginning of the year. Whether the outfit is a simple business license (commonly called a DBA), LLC, S-corporation or C-corporation -- will impact how much of the income stays with the owner and how much goes to Uncle Sam.
"Unfortunately, it’s never black and white until end of fiscal year and taxes are due and you think you should have done this or that," said Deborah Sweeney, CEO of MyCorporation http://www.mycorporation.com/ Business Services, which advises corporations and business owners on incorporation options. "You learn and grow. You start to figure out which is the best option for you, what is a more reasonable salary. You take more in salary and less for corporate, but pay more self-employment tax. You figure it out."
Multiple factors will impact a decision on corporate structure, but taxes should be one of them.
Small-business owners like VARs have four primary options to structure their business and there isn’t an easy formula to determine which is the correct option.
Out of the starting blocks most VARs elect to operate as a DBA, an acronym for "Doing Business As," and most of them are wrong, said Sweeney and several tax preparers. A DBA entity means you are operating as yourself, or perhaps you’ve gotten a business license under a company name. You might have separate bank accounts and letterhead with the company name. But you and the business are one.
For tax purposes, the IRS recognizes no difference between you and your business. The business revenue and your personal income are filed on the same 1040 IRS form. The DBA option is rather inflexible and disqualify you from many some of the advantages and deductions of business ownership.
It also increases your chanced of being audited 800 percent, according to Sweeney. Because the IRS computer programs and human reviewers are programmed and trained to treat 1040 returns as individuals, standard business deductions will jump out as anomalies, Sweeney said. The rate of audit for incorporated businesses is 0.3 percent, but 2.7 percent for DBA/sole proprietors.
A DBA also places a tremendous risk on you and your family, said Gordon W. Ulen, a certified professional accountant and head of the Tax Planning & Preparation Department at the Retirement Financial Center in Danvers, Mass.
"In a DBA, or sole proprietorship, you’re wide open for losses," he said. "If you are sued or audited as a business, you are sued and audited personally. Unless you have a lot of insurance coverage to protect your personal assets, I wouldn’t recommend people operate as a DBA."
The biggest shock for small business owners in their first year of business as a DBA is what is known as the "self-employment tax," which is about 15.3 percent, said Scott Berger, a tax principal at the accounting firm Kaufman-Rossin, in Boca Raton, Fla. Berger is a specialist in entrepreneurs and business owners.
"Until now they’ve had an employer who cut them a paycheck and automatically took out their federal and state withholding taxes.That doesn’t change; you still pay that," Berger said. "What changes is the social security and medicare withholding. Yes, you paid for about half of it out of your paycheck, but employers pick up the other half. Entrepreneurs forget about this and they’re usually surprised at the end of the year when they have to pay it.
2. LLC or Limited Liability Corporation
Often considered the best option for small business owners, this doesn’t offer all the advantages and tax deferrals of a corporation, but it is simpler and cheaper.
Like a DBA, the revenue of the LLC flows as income directly to the business owners(s) personal 1040, and the business owners still pays the 15-percent self-employment tax, but the LLC separates the person from the business.
It also allows you to put certain assets in the ownership of the business, making it less likely you would be audited.
Significantly, an LLC also offers an extra layer of protection from law suits and audits. Many business owners like the LLC option because it the filing rules are the same as personal income taxes and there are no quarterly reporting requirements like those of a corporation.
An S corporation is an IRS declaration for corporation with few stakeholders. The primary difference between an S-corp and an LLC is that the business owner must pay themselves a salary from the company, which separates the business revenue from your personal income. It requires more maintenance than an LLC, but can come with significant tax advantages, said Sweeney. Unlike a C-Corp, the business does not pay a corporate tax.
"The biggest advantage of the S-corp is that it can reduce your self-employment tax," said Sweeney. "If you are a DBA or an LLC you are paying the [15.3 percent] self-employment tax on the entire revenue of the company. As an S-corp, you’re only paying the self-employment tax on what you pay yourself as an employee."
Berger offered this example.
A business owner operating as an LLC makes $100,000 in revenue (Assuming a 20 percent tax rate) That owner pays $20,000 in federal withholding taxes + $15,300 in self employment tax = $35,300
A business owner operating as an S-corp makes $100,000, but pays himself only $50,000 in salary. (Assuming a 20 percent tax rate). That owner pays $20,000 in federal withholding taxes + $7,650 in self employment tax = $27,650.
(The other $50,000 may have gone back into the business or, can be paid to the business owner as a dividend, but self-employment tax won’t apply to it.)
Where business owners must be careful is to pay themselves a reasonable salary, said Sweeney. You can’t go from making $150,000 at XYZ corporation one year and then open your own business the next and say you only took a $20,000 salary while the business took in $130,000. They will catch that fast."
An S corp can be a good option for a business owner who knows there will be significant losses up front.
"Someone might say 'We’re gonna rely on my spouse’s salary for the first few years and we won’t take a salary from the business for a while.’" Berger said. "If that’s the case, then you probably want to separate your income from the business revenue with an S-Corp."
The disadvantage of the S-Corp is that it is more work and more expensive. As a corporation you are required to maintain a payroll -- regardless of how many employees you have -- and file quarterly financial reports.
"All that costs money and time," Berger said. "Is the tax savings worth it?"
The other disadvantage of the S-corp is that you are limited to 100 shares of a single class, so anyone trying to bring in investors or multiple partners can find it limiting.
A C-Corporation, is a full corporation and must maintain a board of directors and pay a corporate tax in addition to the personal taxes of the salaried employees including the owners.
Because of the extra tax, it is a poor option for most small business owners like VARs.
There are two reasons a VAR might consider a C-Corp status, said Berger.
One is that they expect to take on multiple investors early, which will require more than 100 shares and different classes of stock for active and passive investors.
The second is if they desire to operate on a fiscal calendar. This is more expensive and difficult to do, but it would allow the business owner to to defer income to the next calendar year and pay the corporate taxes and their own dividend outside the calendar year.
"No one-size fits all"
Unfortunately, it’s a difficult decision that might require accountants, business planners and lawyers.
"They’re all good options for the right situation," said Ulen. "It’s just a matter of knowing what your situation is and what you're expecting your situation to be.
"Ask yourself how many investors will you have? Do you expect losses in the first year? Second year? Will there be profits, net income, net losses right away? If so, for how long?" he said. "Be honest. What are you gonna live on? Will you have employees? When?"
It requires professional advice, but perhaps not as much as you think, said Sweeney.
"Most accountants will tell you that they won’t file articles of incorporation for you, that you need an attorney. And that’s mostly true," said Sweeney, a lawyer herself. "But you don’t need to have an attorney do all the advising for you. No one knows your finances better than your accountant. You can go to them for the guidance, than have the attorney file the paperwork. It might save you some money."
For her part, Sweeney generally recommends business owners treat incorporation like a sort of progression.
"You can start life as an LLC and then when you see where things are going and you want to take on the extra maintenance of an S-Corp, do that. And then maybe one day you graduate to a C-Corp," she said. "These aren’t for life. You can always opt to change it."