How to set up a business !!!How to set up a business to pay less in taxes!
Proprietorship, corporation or partnership?
Each of these business structures differs in how your profits are taxed and how much liability you must shoulder. Read on to see which works best for you. It’s all in how you structure your business.
The way you conduct business determines how your profits are taxed as well as the nature and magnitude of your benefits -- both as an owner and an employee. Let’s examine the various forms of doing business and illuminate the advantages and potential traps with each one.
Proprietorships
The simplest form of doing business is as an individual proprietor. Here, you are your business. All revenues are taxed to you and you’re personally liable for any negligence arising from the business operations.
Under a proprietorship, there is no separate business entity. Your profits are reported on the Schedule C attached to your personal 1040 tax return. Most proprietorships simply use the name of the owner as the name of the business. If you don’t want to use your name as the name of the business, that’s OK too. All you have do is file a form called a “fictional name certificate” or a “doing business as” (D.B.A.) certificate with your municipal recorder. It’s usually a simple one-page certificate stating that you, at your address, are doing business as “New Name Of Business” at its address. The form does nothing more than give notice that you are really the business.
The pros:
The advantage of the proprietorship form is that it’s easy. No forms or government permission are usually required. You simply declare yourself to be in business.
There is no double taxation of your profits. You pay the tax only once, on your personal income tax return. The tax is based on the income of the business, not what you take out of it. For example, if the business earns $100,000, you pay tax on the $100,000. It doesn’t matter if you only took out $80,000 or if you actually took out $110,000. (Your income is calculated after you’ve depreciated items and service, which are considered non-cash expenses. So it’s possible to have more in cash than in actual “income.”) You only pay the tax on the income of the business -- $100,000.
Note that you get no “deduction” for any salary that you pay yourself. As a proprietor, you get no “salary.” All income, and all expenses, are yours.
The cons:
As a proprietor, you must pay twice the amount of Social Security and Medicare taxes that you would as an employee of another entity. For example, for 1998, you must pay 12.4% in Social Security taxes on income up to $68,400, as well as 2.9% in Medicare taxes, with no income limit. If you were an employee, working for someone else or for another entity, you would only have to pay half (a total of 7.65%, rather than 15.3%). Unfortunately, you cannot be an employee of your own proprietorship. However, as a proprietor, you do get a deduction for half of these taxes paid, which reduces the pain somewhat.
Proprietorships get no life insurance deduction and a deduction for only part of their health insurance premiums (45% in 1998.)
As a proprietor, you have no liability protection. If you, or anyone working for you, is negligent or is found liable for any act or incident arising from the operations of your business, all of your assets are at risk. This includes both business assets and personal assets. There is no limit to your liability.
That’s one reason why many proprietors keep their home and investments in the names of their spouses. Unless the spouse is an owner or commits the “bad act,” those assets are protected from any claims against you. That’s why, as a proprietor, you need some form of errors and omissions insurance. Even if you are not found liable, the legal costs to defend are enormous. The insurance, if purchased right, pays all of those legal costs.
Corporations
A corporation is a separate legal entity. It is an invisible, intangible entity, recognized only in the contemplation of the law. You can point to the assets of a corporation, but not to the corporation itself.
The pros:
A corporation offers limited liability. If a negligent act is committed arising out of the operations of the business, the person who committed the act and the corporation itself is liable.
Only corporate assets are at risk. That’s one reason why the owner usually leases assets to the corporation. (The other is to get money out of the corporation without having to pay payroll taxes.) Note, however, that if you are the one committing the negligence, limited liability doesn’t apply. All of your assets, including the corporate stock, are at risk.
If you have several employees, your assets are protected from an employee’s mistakes. Moreover, while pension and retirement plan options are about the same as with proprietorships, the corporate form does offer somewhat better employee benefits. For example, health insurance premiums and group life insurance premiums of up to $50,000 in benefits are fully deductible by the corporation and are nontaxable to the employees.
Corporate tax rates never climb as high as they do if you’re a sole proprietor. As a proprietor, you pay taxes at a rate of 39.6% on all taxable income in excess of $278,540 on a joint return. The corporate rate doesn’t reach that high. In fact, for between $335,000 and $10 million in taxable income, the marginal rate is only 34%.
If you don’t need the money to live on, you can re-invest a lot more of what would have gone to taxes inside the corporate umbrella than outside of it. However, the corporate marginal tax at lower income levels may be higher than your personal rate. Make the comparison.
The cons:
Corporations are subject to double taxation. The income of the corporation is taxed once, and again a second time to you as dividends paid out of earnings. Dividends are not deductible corporate expenses.
Some advisers suggest zeroing out the corporation by paying enough salary and bonus to have a zero corporate income. Here, your compensation is deductible by the corporation, but it has to match your Social Security and Medicare payments. If you are the sole owner (shareholder), you end up paying the same as a proprietor, except it comes out of two different pockets.
If you are the sole owner, and the sole employee of a corporation, this form may give you little in benefits in exchange for a ton of new paperwork.
Alternative entities
There are several other forms of doing business. For example, you can operate as a partnership. With a general partnership, all income is taxed proportionately to each of the partners. There is no double taxation, but there also is no limited liability. Limited partnerships offer limited liability to the limited partners, but these partners must give up any voice in the management or control of the partnership.
Alternatively, you can do business as an S Corporation. This is a corporation that has elected to be taxed like a partnership. Here we have both no double taxation and limited liability. S corporations are limited to only 75 shareholders, and those owning 5% or more in stock have limited employee benefits.
For those needing more than 75 owners, we have limited liability companies and limited liability partnerships. In both cases, limited liability is coupled with single taxation.
The comparison of various ways to do business is a subject more for a book than a column. I have attempted to give you some areas on which to focus your analysis. However, since the stakes are so high and the minutia so abundant, I strongly recommend a consultation with an attorney or CPA who specializes in this area to review your specific situation.
Starting your own business is the American dream. Getting sued for all you’re worth is the American nightmare. Something new called an LLC will let you sleep at night. LLC means Limited Liability Corporation.
Tax treatment of LLCs
Generally, corporations and their shareholders are subject to double taxation, first at the corporate level and then at the shareholder level. If a limited liability corporation meets certain IRS criteria, an LLC is treated as a partnership.
That means that as an LLC you pay taxes only once. The LLC passes its profits and losses to its owners, who then pay taxes individually. LLCs file tax returns and issue Form K-1 to members showing their share of the profits or losses. Members then file individual partnership tax returns to the IRS at regular individual tax rates.
In addition, members who are active in the business (not investors) are subject to the self-employment tax for Social Security and Medicare.
Most states tax LLCs in the same way the federal government does. One notable exception: California, which imposes a tax on profitable LLCs that can go as high as $4,500 per year.
If you’re thinking of starting your own business and the LLC sounds right for you, by all means do some homework before you run to a lawyer and trip his meter.
LLCs are relatively new and state laws governing them are still being developed. Contact the office of your local secretary of state for information on status, forms, etc.
One of the best resources for information about incorporating and LLCs is the Nolo Press Web site; another is Business Filings, Inc., which will even help you form your LLC without a lawyer. One of the best books on LLCs is "Form Your Own Limited Liability Company" by Anthony Mancuso.
Family Limited Partnership !!!
Though the IRS is targeting abuses, the family limited partnership is a legitimate way to protect your assets. And it's not just for the rich anymore.
The family limited partnership is the new poster child of the Internal Revenue Service, which has targeted the program as one that allows family-owned businesses to dodge estate taxes. In the past year, the IRS has made it known that it's "cracking down" on abuses of family limited partnerships.
The agency has realized that family limited partnerships, sometimes called FLIPs, aren't just for the rich anymore. It's a solid tax strategy that advocates a way to protect a family's assets, potentially cutting in half or more what's owed on an estate-tax bill.
That prompted the IRS to send out a flurry of "advisory notices" over the last year, telling people that the agency may invoke a section of the tax code that allows it to disregard FLIPs because of potential abuses.
If you or your family members have created a FLIP or are considering one, don't let this chest-thumping get in your way. As long as your motivation is to manage your assets more effectively -- just as in any limited partnership -- you're starting out on solid ground.
To understand a FLIP, you have to understand the basic structure of any limited partnership. After all, a FLIP is merely a traditional limited partnership where all the partners are family members. Remove the family relationship, and a basic FLIP is the basic limited partnership.
All limited partnerships have one thing in common. They all are run by general partners only. Under the law of all 50 states, by definition, no limited partner has any vote or voice in the running of the partnership business. A general partner, who may only own 1% of the partnership assets, will control 100% of those assets.
In a family situation, the parents put their assets into the partnership. They start by being both the general partners and the limited partners. Then, under the most common and simplest form, they gift their limited partnership interests to their children. Let’s see what they have really done ...
Several effects on the gift and estate tax
First, even though the parents have given away the limited partnership interests, they, as the general partners, still retain full control over all the assets in the partnership. The limited partners (who become the general partners upon the death of both parents) own and have title to the limited partnership interests, but have no voice in the management of the partnership. In effect, the parents have given up ownership of the assets but have retained control. This does several things with respect to the gift and estate tax.
The assets are out of the parents' estates. A completed gift has been made to their children. A gift tax, however, may be due on the value of the gift. The parents, however, can use their unified gift and estate tax credit to pay that tax. In 1999, this credit, between both parents, shelters the tax on as much as $1.3 million in transfers ($650,000 x 2). It is scheduled to increase to $2 million in 2006 ($1 million for each parent).
Since the gift has been completed, all appreciation on the assets is out of the parents’ estate. Assuming both parents are age 40 when the transfer is made, and that one lives another 40 years, we have excluded 40 years of appreciation from the parents’ estate. Further assuming a $2 million transfer (made gift- and estate-tax-free in 2006), and a conservative rate of appreciation of only 7.2% per year, $32 million has been excluded from the parents’ estate and they have saved approximately $16 million in estate taxes.
Here’s where the IRS gets really annoyed. Even if the parents die immediately after making the transfer and even if there is no appreciation in the assets, there is an immediate and substantial transfer-tax saving. Stay with me on this -- it’s complicated. Remember that the parents gifted the limited partnership interests to their children, not the assets in the partnership itself. While the limited partners own the assets, they have no control over those assets. Because they have no control over those assets, the value of the limited partnership interests (the value of the gift) is less than the value of the assets transferred.
Look at it this way: If you can buy an asset for $1,000 and have complete control over that asset, it has to be worth more than a limited partnership interest where you have no control. The value of the limited partnership interest must be less than the market value of the asset. That's because you don't control the money. All of the courts that have reviewed this, and even the IRS, agree that there must be a discount. The more liquid (meaning cash), the lower the discount. The IRS historically has allowed a discount of about 40%, depending on the assets transferred. That means that the parents can transfer (as of 2006) as much as $3,333,333 in assets structured as limited partnership interests without paying any federal transfer taxes (60% of $3,333,333 is the $2 million credit exclusion). That’s $1,333,333 more than they could without the limited partnership.
The IRS argues that this is unfair to those who are unaware of the law or who can’t afford high-priced attorneys to draft partnership agreements for them. And anyone with an estate of $2 million or less (married) can, if their will is appropriately structured, pay no federal gift or estate taxes. The FLIP is a real tax benefit only if your estate is more than $2 million. If you have that kind of money, you can afford to pay for competent estate planning.
Lower tax brackets and asset protection
The IRS does have one legitimate concern. In some cases, taxpayers have tried to take outrageous discounts of as much as 90%. Unfortunately, some people try to cheat; that’s why we have audits.
Since the children as limited partners own 99% of the partnership, 99% of the income will be taxed to them. This also has concerned the IRS. Traditionally, the parents will be in a higher income tax bracket than their children. If the parents are in the 40% bracket and the kids are in the 28% bracket, we have reduced the tax bite by 12 percentage points. If the $2 million in assets generate a return of only 5%, that’s $100,000 in income, $99,000 of which is taxed to the kids at their lower bracket.
The FLIP also provides asset protection. Before the transfer, 100% of the parents' assets were subject to their creditors, now only 1% is exposed. But what if the kids were sued? Well, against a limited partner, a creditor can only get a judgment called a "charging order." This places the creditor in the same shoes of the limited partner. So if the partnership earns $100,000 and the limited partner owns 99%, the creditor is going to be taxed on $99,000. But as general partners, the parents decide whether to distribute any cash to the limited partners. So the creditors could then end up getting taxed on $99,000 in income every year, even though the general partners aren't giving them a single penny. This is a great motivator for creditors to settle.
Family limited partnerships are legitimate wealth-preservation and asset-protection structures. Just because they are costing the government tax money doesn’t make them bad. Remember, it’s your money, not theirs.
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