How do you decide between LLC, LP, S Corp, C Corp, and what do all those things mean?
Between corporate structures and pass-through structures, there are five main ones we talk about: self-proprietor, partnership, C Corporation, S Corporation, and limited liability company. Those tend to be the ones that anyone thinking, “I need to form a company. I’m going to work for myself. I’m going to be self-employed,” tend to need. Each affords different legal protections, administrative burdens, accounting issues, and certainly tax issues.
What are the legal differences between the different entities?
From a legal liability perspective, sole proprietor is basically disregarded. It’s not a legal entity and has the same legal status as the owner. There’s no liability protection whatsoever. For a limited liability company, you could have a single member limited liability company, which for federal income taxes is also a disregarded entity. All the income and deductions get taxed at the individual owner level, but it offers a legal status separate and apart from the owner.
That same legal separation applies to the S Corporation and the C Corporation, and even to partnerships to some extent. They have more protections than a sole proprietor.
What are the tax differences?
Sole proprietor, single-member LLC, and S Corps tend to be taxed at the owner level, meaning all net income is taxed at the individual level as opposed to a corporate level. Of the five entities, the only one that’s a separate taxable entity is a C Corporation.
How hard is each type of entity to set up?
Sole proprietor is very easy. You can just get a DBA and an EIN number and start operating. Partnerships, C Corporations, S Corporations, and LLCs tend to be a bit more administratively burdensome. You need either articles of incorporation or articles of organization. With a partnership, you need a partnership agreement, and you usually need the assistance of an attorney and an accountant to help you with that.
What is an S Corp?
An S Corp is a C Corporation that has made an election to be taxed under the S Corp rules. It’s a flow-through entity taxed similarly to an LLC, but it gets a little more complicated. It’s a separate entity apart from its owner, but it’s not a separate taxable entity. All the distributive shares of income from an S Corp flow to the individual owner. You own shares in an S corporation, so you own stock. You get a K-1 from an S Corp, like you would from a partnership, and that K-1 gets reported on your individual tax return.
There’s an interesting quirk with S Corporations that make them unique from the other entities. One of the few gimmies in the tax code is that the distributive share of income from an S Corp that flows to the individual is not subject to self-employment taxes, but you need to pay reasonable compensation to your owners who have an S Corp — anywhere from 28-35% is a good barometer. It could be more, depending on the industry and the geographic area it could be less. So you need to pay yourself a salary out of the S Corp, and then the net gets distributed to you and taxed at your ordinary rates, but that net amount won’t be subject to payroll taxes. But you need to be wary. You need to pay yourself a reasonable compensation.
And a C Corporation is taxed doubly, on its own tax return and on dividends paid?
That’s right, and that affords some interesting benefits, because the corporate rate just went down from 35% to 21%, but there are anti-abuse provisions. If you’re trying to convert a service income that normally would be taxed as compensation at the highest rate and just leave it in as corporate profits, the IRS might say you’re accumulating income and not distributing it out. You could get a penalty for that.
If someone has income from other sources, or a considerable portfolio or a different arrangement with other consulting jobs or freelancing jobs, and they have a C Corp, maybe they don’t need to pull the money out. They’re saving that way. You have to look at the time value of money and what their exit strategy is. There are other tax benefits on the estate planning side and the exit strategy side that might make a C Corp more attractive. Generally, if you need 100% of the money you’re making, the C Corp may not be the most beneficial for you.
Do you recommend talking to a professional to sort out all these different issues before moving forward?
Absolutely, and I would encourage people to really think about this. There are a lot of unintended consequences from rushing to make these entities a reality. When you’re starting your business, you almost need to think about how you intend to finish, because that’s also going to be part of the analysis as well. If people are thinking of making this jump into legal formation and going out on their own, it would be important for them to think outside the box and really sit down and spend some time writing, “What are my goals? How am I going to operate? How much money do I think I’m going to plan to make? What are my expenses going to be?” It affords a deeper discussion with yourself and certainly with an attorney and an accountant.
It’s also important to consider the different benefits available based on the type of legal entity you choose, correct?
Defined contribution plans and defined benefit plans are even more important under the new tax law because we have income thresholds that would allow certain taxpayers to get a 20% deduction on their qualified business income. Those plans are a tool to help bring your income down within those thresholds.
With a defined benefit plan, you need to have W-2 wages. There are restrictions on income testing and discrimination rules on using it, but you tend to see DB plans used the most with LLCs and partnerships.
What’s your advice for tracking expenses for someone who’s running an independent consulting business, and what expenses are legitimate business deductions?
Don’t throw your receipts in a shoebox and give them to me, please. Technology today makes it very easy to run your business from an expense-tracking and a revenue-tracking standpoint. There are so many free pieces of software that you can use through your phone, your iPad, your computer, and software you purchase. I’m not going to recommend one over the other because it really depends on the volume and the types of expenses you’re using.
What an accountant is going to want at the end of the year is how much you made and what your expenses were, broken up into a couple different categories. How much did you spend on advertising? What were your business meals? You’re not allowed to deduct entertainment expenses anymore. How much did you spend on gas? How much did you spend on traveling? Think about whatever cash you’re putting out there in anticipation of generating revenue.
Is there such a thing as getting too much expense information from a client?
I’d rather get more from my clients than less. What I would encourage is keeping a contemporaneous log of business meetings you’re spending money on. If you ever get audited, it’s the taxpayer’s responsibility to provide support, and we have this concept of contemporaneous recordkeeping. If you’re traveling and you want to deduct auto, keep a log of your miles and who you met with. It seems cumbersome, but with technology, I think, it’s very easy to save that information.
Clients give me an Excel profit and loss statement and their check register or bank statements.
We’ll put together a basic balance sheet of cash at the end of the year, loans and money that’s due, and a very basic profit and loss statement. That information is going to be used to prepare your tax returns. Some of the software you can buy — even some of the free software — will download your bank statements in real-time and categorize them for you after it learns who the vendors are. You can give your accountant online access to that, and they can make any adjustments that they need, so it makes it very easy.
Do you really need to keep receipts?
I don’t think there’s a real need for it since you can get everything online. Use a credit card that’s just for your business, in the business name. Have a bank account in the name of the business. You always want to show you’re in business for a profit-motive. That way if you’re generating losses you can deduct those losses on your tax return. The more recordkeeping you do, it gives you another leg to stand on in the event of an audit.
If you do work in another state or city, what are the tax implications?
States want their money, so each state has their own sales and use tax issues. Each state has their own nexus issues. A lot of the states used to have a three-factor formula of how they tax income. Do you have payroll? Do you have rent? Do you have fixed assets in those states? But at a very basic level, think about, “Where am I performing those services and where am I earning my income?” It’s really facts and circumstances. The thing to keep in mind is if you’re earning income, if you’re performing services in a state, you may have a state filing requirement.
Are there deductions that independent professionals might not be aware that they can take advantage of?
For a defined benefit plan they can put in a lot more than a typical personal IRA, up to $54,000. You could even put $18,000 into a simple 401K. SEPs, you could do $6,000. Besides that, there’s something called section 179, which is another great freebie. Certain qualifying assets you purchase to support your business, you can write off the cost 100% in the first year you place those assets in service. That’s a big one to look at, and why it’s important to keep good records of what your purchases are. Anything you’re spending money on in support of the business could potentially be a business deduction.
What’s your expectation on when the defined detail and guidance for the new tax bill is going to be available?
There hasn’t been a lot of debate on what the legislative intent of some of the statutes are, so we really haven’t had a chance to say, “Put it through its paces.” We need technical corrections for obvious sections of the bill that are technically incorrect or technically ambiguous. Technical correction is a legislative process that can’t go through the budget reconciliation process, so depending on how good the administration is and how both sides come together, we may not get technical corrections. We need regulations to see how some of the statute gets applied in certain very specific circumstances. We need what’s called the “blue book,” which talks a little bit about legislative intent, but it’s basically the Joint Committee of Taxation, the senate’s committee on the tax bill, which goes a little deeper on how some of these rules apply, what they mean in literal language. I have my thoughts on what they mean, but I could be wrong tomorrow.
What about income coming from intellectual property than an independent consultant creates?
I don’t see that in the definition. It makes it even more important for good recordkeeping in terms of analyzing your revenue streams.
Are there any other major changes people should be aware of from the new tax law?
This is the biggest sweeping change in over 30 years. There are a lot of complicated things. In terms of independent consultants, I don’t think that there are many changes that really impact them on a day-to-day basis. One of the other major changes is the business interest limitation. They’ve limited that to 30% of your income. You could opt out if you’re a specified real estate trader business. If you’re a small business, you don’t have that limitation. There are new depreciation rules as well, but I’m not sure that’s going to really impact the independent contractor. I will say the individual mandate was eliminated, but that only goes into effect next year, so you still have to have health insurance for 2018, or else you’re going to get the penalty.
What’s the best way for people to get in touch with you or your firm?
I’m a tax partner at Mazars USA LLP. They can look us up on the web, and my bio is on the list of partners there.