Now is the time to consider, and perhaps reconsider, the business structure using for your business.
The 2018 tax changes continue to make inroads into traditional tax planning. For example, the S corporation that was four years the darling of attorneys and tax accountants may not be the best structure for you today.
Let’s take a look at business structures and what I call the good, bad, and the ugly.
Let’s start with the bad structure. It’s also the simplest business structure which is why so many people use this. I’m talking about a schedule C or sole proprietorship. This reports as part of your form 1040. That means you don’t need to pay someone to prepare another tax return. Additionally, the IRS makes it really easy for you. You don’t need to include regular financial statements. Most business returns require you to use double entry bookkeeping so that you can prepare a schedule that goes with your tax return and shows financial statement balance sheet items, such as assets liabilities and equity. If you’re doing your own bookkeeping or nobody’s doing the bookkeeping, that’s a difficult thing to do. So the default often is to do a sole proprietorship.
And, after all, isn’t the IRS trying to make your life easier? (That was sarcasm, in case you couldn’t tell.)
The price you pay with a sole proprietorship is more tax, no asset protection, and since you are not considered a real business, you may get challenged for the deductions you take. To add insult to injury, you can’t build business credit.
That’s why, at a minimum, I suggest that my clients start off with an LLC. The LLC may still have the excess tax, called a self-employment tax. But the LLC, if properly set up and run will provide asset protection. That’s a big one.
An LLC with a single member that does not elect how it wants to be taxed will default to the schedule C tax form. It’s easier, but it’s also more expensive. That’s why I call the sole proprietorship a bad entity. But an LLC that defaults to schedule C tax is kind of a neutral business structure. At least if something goes wrong with the business someone isn’t going to be easily able to take your personal savings accounts, investments and your house.
The ugly structure, thankfully, isn’t seen as much anymore. The only ones of these I sometimes see are the ones that were inadvertently formed or have been around for a lot of years.
I’m talking about general partnerships.
In the case of a limited partnership, there are general partners and limited partners. A limited partner has limited liability. Basically, all he can lose is what he has invested. On the other hand, a general partner is fully liable for any acts that the company might do. And, worse still, a general partner in a general partnership is also fully liable for any errors he makes but also he is responsible for any crazy things his partner may do. That’s why I call a general partnership and ugly structure. You have an unknown liability floating around in the form of one or even more partners.
Luckily, most people form LLCs these days so we’re much less likely to see a general partnership. However, if two people partner together on a venture and they are just doing it in their own names, maybe as a way to trying it out to see if it’s in a work, they could have a de facto general partnership. If something goes wrong, you can bet the plaintiff’s attorney is going to be looking for the deepest pockets in that partnership. In that case make sure you use a company structure to partner in a “trial period” partnership.
There are many good structures to consider. A limited partnership is a good structure, but don’t forget the general partner has full liability. For that reason, we usually recommend that to use an entity as the general partner. Also, the S corporation is a good tax structure. It’s eveneven better than a limited partnership, with better asset protection, but even better than that for you is to start with an LLC and then elect it to be taxed as an S corporation. A C Corporation can be a great structure, especially with the new tax law. Again, though, I prefer to see an LLC that elects to be taxed as a C Corporation.
The question for you now, for your year-end planning, is whether you are in the best business structure for your own circumstances.
If you have an LLC, you can possibly change the tax structure you currently have. The actual answer will depend on whether you have previously elected a tax entity status. If so, you may have to wait a certain number of years before you change it.
Or if you are just working in your business in your own name, you may realize the risk you have and want to change that. It’s unlikely you can do anything to give you retroactive tax relief and asset protection but it’s certainly better to be prepared from here on out. You’re not sure what to do, because you don’t know how successful your business is going to be, always start with an LLC. For that matter. It’s probably best to just default to starting with an LLC. For tax purposes, they give you the choose of how you want to be taxed.
At this point, the best thing you can do is assess where you are. That probably means you need a tax strategywith a tax professional who is familiar with business structures, business and, if applicable, real estate investments.
That’s what we do. In fact, that’s all we do. We work with business owner and real estate investors exclusively.
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