Courtesy of Whittemore, Dowen, Ricciardelli
By Susan Elise Campbell
Year-end may be a good time to consider restructuring a small business to shield personal assets from potential liabilities.
The tax code allows for several options, according to Paul Dowen, CPA, and partner at Whittemore, Dowen & Ricciardelli, LLP, certified public accountants serving the North Country and Saratoga County. Dowen said the typical choice today is between a limited liability company (LLC) or a Subchapter S corporation (S corp), although there are other entities.
Both provide some protection for the owner by limiting personal liability, just as a corporation does. If the company has debt or other financial obligations, owners are not personally responsible for satisfying them.
“In a retail store or restaurant with people coming in and out of the building, you might have product liability,” he said. “Both LLCs and S corps give you some protection.”
“The confusion is that an LLC can be organized as a sole proprietorship, a partnership, a C corp or an S corp,” he said. “If a client tells me their business has been set up by the attorney as an LLC, I know there is some liability protection, but that doesn’t tell me how the company is being taxed.”
Dowen explained that LLCs have been around only a few decades. They exist by state regulation and blend together some of the features of corporations, partnerships and sole proprietorships.
LLCs do not pay corporate tax on profits, but pass through income to the owners, who report their share on their individual returns using the documents received from the partnership. But that means 100 percent of those earnings are subject to social security and medicare taxes.
“At a certain income range, it might be time to convert the business and go on the payroll,” said Dowen.
One option is an S corp, for which regulators require partners to take a “reasonable salary.” The advantage is that members do not pay into social security, he said.
Wage earners have a cap on the amount of income for social security purposes and no cap for medicare. For the self-employed, there is no earnings cap for the corresponding self-employment, or SE, tax. Dowen said that for those taking $75,000-$90,000 out of their business annually, this might be the point where it makes sense to convert to an S corp to avoid those taxes.
A business can start off as one entity, switch to another, and may be able to convert back, but not always, Dowen said. Therefore he advises clients to consider what needs to be accomplished from a tax perspective and how the company might evolve in the future.
“Most of our clients are not C corps anymore, but have become an S corp or a partnership or sole proprietorship that is also an LLC,” he said.
These are pass-through entities that file an informational return and whose partners are responsible for filing individual income taxes.
C corps are the big corporations like GE and AT&T, but a few of Dowen’s clients are small, privately owned entities that have been C corps since the beginning, he said.
“When you sell a C corp, the corporation pays the tax,” Dowen said. “The disadvantage is that when the owners take their money out, those amounts are taxed, so there is double taxation.”
Dowen said when a C corp converts to an S corp, assets accumulated in the C corp “are stuck there but at least you are not building up more value that would be subject to the double tax.”
“There is cost to go from an S corp back to a partnership,” he said. “There was no cost to go from a partnership to the S corp but there is going the other way.”
So while it may be appealing to save 15.3 percent from social security and medicare tax as the S corp grows, there may be an offsetting expense at the sale.
Dowen said the easiest business structure is the sole proprietorship and then the partnership. An S corp is more complicated to qualify for and if one member takes out money, the rule is the others must take an equal amount.
“But in a partnership, if I take out $1,000 my partner doesn’t have to, so there is more flexibility over an S corp,” he said, “the downside being self-employment tax.”
Dowen advises setting up an LLC initially for its flexibility, applying for a federal tax identification number, and paying the annual filing fee, especially if the business is one that registers for sales tax, motor vehicle, excise or other taxes with their ID.
“If in the future it makes sense to go from a partnership to an S corp but you don’t have a partnership LLC, you need a new federal ID number and notify everybody it has changed,” he said. “So just start with an LLC for the flexibility to change later, even if you may not need liability protection now.”
Dowen said it is “unfortunate” when people try to set up or convert a business entity on their own because a CPA may be doing “clean up” down the road.
To every prospective business owner he says, “Consult with us up front and early on. The consultation will pay you a dividend.”
Learn more at wdrcpa.com.