Entity Selection: Tax Implications

Wondering which type of entity you should choose for your new business? Wondering if you’re stuck with the one you currently have? Dark Horse CPA, Erik Hegstad, joins us to explain the ins and out of the common entity types that entrepreneurs choose.

Transcript

Copy Transcript Copied

0:04

Welcome back everyone. To episode two of taxes made simple dive into critically important tax details for small businesses and individuals in terms that the average person will understand with us today is chase Berkey, CEO of dark core CPAs, as well as a guest speaker, Eric Hegsted who runs our dark horse office out of Colorado. Eric is actually going to give us a little overview on the most common types of small business entities that most entrepreneurs can choose from when formalizing their business. So we're going to go into some of the pros and cons and let's dive in. So chase, give us a lower view of what we're going to talk about. Yeah. So this is actually that I'm pretty excited about because all entrepreneurs, at some point along the line asked this very same question, um, and you know, may ask it multiple times as they have multiple businesses. And you know, that question is what type of entity should I be for this venture? Um, and so as Darcor CPAs, we're working with small businesses, you know, really from. Start to, uh, that point where they're, you know, really scaling beyond about 50 employees, you know, so we're in this conversation often and it's one that is invaluable because you want to get started on the right foot. You want to make sure you understand. Uh, you know, what type of entity is right for your situation, which you might have to put away some of the tax considerations to look at some of the other considerations, like, you know, investment. Uh, so, you know, there's just a lot, you know, that really needs to be, uh, talked about here. And Justin, you know, I know that we specifically had this conversation with you, you know, so it's a one that's definitely a familiar for you as well. Um, and you know, it was just one of those things you want to get right from the start. Uh, so there's no better time to start thinking about it than now. Yeah. I mean, I remember when we had, like, I mean, that was four years ago now, and that was pretty important. I mean, I was just jumping into starting my business and I had no concept of what I was supposed to do and how I was supposed to set it up. And so, yeah, that, that was critical in my business's success. And I'm sure there's a lot of people out there that were saying the same thing, you know, am I set up for success? If I'm going to start this venture, it's. It's one of the first things that could make or break right. Your longterm success. So. Right. 100%, you know, so, and there are, you know, a lot of instances where you start off one way, because it makes sense when you're small, you know, and then you scale to a certain point where it's like, you know, maybe that S-corporation, doesn't make as much sense, you know, because you've got investors that can't invest in an S corporation. Um, you know, or you just have, uh, investors that don't want to right. So there's, there's things that enter the equation, but you want to get started on the right foot, you know, so that you can, you know, have the best foundation to grow that business, you know, and then be able to pivot if need be, you know, once you have that level of success. So, you know, without giving away too much, uh, of what Eric's going to talk about, uh, Eric, we're very happy to have you, how's it going? It's going well, thanks for having me. Good. So let's kick it off here. Let's get right into it. Uh, tell us a little bit about what your experience has been with clients when it comes to entity selection, you know, are there any common misconceptions that people typically have? Yeah, I've had quite a bit of experience everything from, you know, a sole proprietor up to, up to the corporate level entities, um, helping people along the way, kind of finding what's the best fit. What makes the most sense for them? Um, which like you mentioned, will. Potentially change as time goes by over the years, um, some to reevaluate and come back to and, and, and kind of check in and see where they're at and what, what, what the best option is going forward. Um, some of the misconceptions there's. You know, some people think, you know, starting out of the Gates that they need all the bells and whistles and they need to go full blown with their entity when it may not be the case. And then on the other side of the spectrum, there's others who think, you know, I'm just, I'm just a small, a small business, a small little venture. I don't, I don't need to set up an LLC. I don't need, you know, to. To go, go down those roads. Um, so really, I mean, overall, it's just helping people know what they don't know and, and educating them along the way for everything from taxation to, you know, potentially raising money down the road. So how exactly have you gone about figuring out which entity type that you're going to recommend to a client based on their situation? Well, yeah. Like to learn, you know, what, what their industry is, what they're doing. Um, there are certain restrictions, certain professional organizations, um, have restrictions on the entity type that they can choose. But then you kind of look at how many people are involved, work, that what their income levels at, um, how, how big a goals do they have? Are they going to be needing to raise a lot of money in the future? Is it a closely held entity? Um, Just kind of evaluating all those things and getting the full picture of where they're at now and where they plan to go in the future kind of helps paint that initial picture of, of what the best route is. Awesome. So what if a client has already created. You know, an LLC or corporation, you know, cause they just needed to get started, you know, get that big account, get the EIN and all that. And then they come to you after the fact, um, you know, what do you do or what can you do, uh, after the fact when the entities already been created, uh, to help make sure they're in the right vehicle. Yeah. Sometimes, um, you know, they've been operating for a few a few years and they're, and they're going well. And that's usually a place where we can provide some value in looking at does make an an S selection makes sense. Um, you know, if they have an S selection, you know, revoking that and going go into the corporate route, does that, does that make sense? Um, or maybe get it treated like a partnership, um, and sometimes there's situations where. You kind of look at where they're at and what's going on and think it might just make more sense just to start over. I mean, there might be a quick and easy exit strategy there and start scratch, start from scratch and, and, and build it up again with the right, you know, the right footing, the right entity structure to accomplish their goals. Yeah, totally. I mean, I absolutely, uh, you know, uh, agree with that. And you know, one of the things that I've told clients before is, you know, if you have the LLC, if that's what you started with, cause that's usually the easiest to form the most flexible, you know, we might just kind of wait right. To see what your numbers start looking like, because you might want to make the selection. If you get to a certain, uh, you know, net income number. Okay. Uh, but you may not know that because you're just starting out and there's a lot of unknowns out there. But as long as we're tackling that before year end, you know, we can run the payroll needed to make a retroactive S election, all that sort of stuff. So there's definitely some fluidity in this, you know, that, I think it's, uh, good for, uh, entrepreneurs to understand that it's not just a static decision you make once that you're done with, uh, it can be more of a fluid situation. Um, but yeah. Putting that aside, you know, what are the main types of entities out there that our listeners should be aware of, specifically entrepreneurs? What entity types should they be looking at? So the few that we're going to focus on are the sole proprietor, uh, the partnership, both limited partnership and general partnerships, um, LLCs escorts, all the way up to C corpse. Well, let's start with maybe the lowest hanging fruit. The easiest one here. Tell us about a sole proprietorship. How does one go about setting one of these up? Very simple. All you do is go out and start a business. Start generating revenue, start selling, widgets, start consulting or coaching or whatever, whatever it might be. Um, there's no, there's no formality to it. As soon as you. You know, go out and start generating revenue. You've essentially become a sole proprietor and you've you've started, started a business. So who would you typically recommend this entity type to? A lot of times it's. I mean, nowadays you see a lot of folks who are doing stuff online, whether it's selling, selling widgets, like I mentioned, or, um, you know, maybe it's somebody who has a, you know, a day job and they start doing something on the side. Um, whether that is. Consulting type type work or advising or something or physically selling something. But they're not really sure if it it's a real business. Um, and they're not sure how it's gonna, how it's gonna take off. They just had an idea and they acted on it and they started making some money. Um, those are, those are kind of the ideal people who would fall into this sole proprietor realm. And so it's probably safe to say too, that this might be an area where you want to get an attorney involved to really see if there's any exposure, you know, liability-wise for whatever business they're in to make sure that they're not totally unprotected and unshielded from their personal assets. Is that, would you say that's fair? Yeah, I would agree. Um, one of the things you generally recommend is at least some sort of umbrella insurance policy to help out, um, just to protect their own personal assets. Right. So dovetailing into, you know, that liability, uh, discussion, you know, what are some of the pros and cons of being a sole proprietorship and, you know, really, as it relates to, you know, how it compares to other entity types out there? Well, like I mentioned, the pros, one of the pros is that it's easy to set up. You just go out and you start, you start generating revenue, you start doing business and, um, you get a hundred percent of that revenue, right? Uh, you also get to make all the decisions and you know, when you are 100% in charge of what's going on, um, the cons with being a hundred percent in charge, you are on your own. So sometimes, you know, you don't have partners to lean on and, and, and people to go to when you, when you have questions within the business. Um, and also you being taxed at, at an individual rate, which can get above that corporate rate. Um, sometimes it's, it's hard to find funding and loans. People aren't going to invest necessarily in a, in a sole proprietor, like they would in, in a corporation. And sometimes banks can be a little leery of lending to a sole proprietor. Um, there's really no separation between you and the business, which, which can be a con if, if, if things were to go, where to go South. Gotcha. So really, you know, because there is no separation there. If it goes South, you've got no legal entity shielding you from liability, correct? Yep. Gotcha. And so what are some of the common recommendations that you have for your sole proprietor clients? One of the things is I would, I would at least set up a DBA, which is doing business as, um, some sort of name that you can, that you can go buy. It just, it just comes off better if you are, if you're able to do that, um, I'd also go ahead and get an EIN. So you don't have to give out your social security number, uh, when you're working with people and, you know, Getting payments, making payments, stuff like that, just having that EIN makes it. So you're not floating your social security number around there. Um, that's kind of the main stuff. And, and the other thing is the insurance that umbrella policy is, is something at the very least I would recommend having awesome. Justin, are you taking notes here? Yeah. I mean, obviously this is, this is stuff that's way over my head. No, I'm not a sole provider right now. I'm, I'm, I'm more focused on the LLC route because that's obviously what. You guys recommended? I would, I should be set up as. Right. So that's a perfect segue. So let's talk about partnerships, which an LLC is a form of a partnership. So some of the common, uh, partnerships out there are the GP, which stands for general partnership and LP, which stands for limited partnership, LLP, which is a limited liability partnership. And as you mentioned, Justin, the LLC, which is a limited liability company, all of these entity types, and there are more of these, but they're all partnerships. Um, and so they're all. Pass through entities. Um, so which partnership types is it most important for our listeners to understand? So a general partnership, a GP, um, basically, you know, it's kind of like a sole proprietor. It's unincorporated, but there's two people they're out there on equal footing, um, that they equally share the, the income and they're responsible for the liabilities and the debts. Both of them are going to be active in the, in the partnership. As opposed to an LP, a limited partnership, um, usually have a silent partner there. So maybe somebody who, you know, has contributed capital cap into the partnership and a general partner in there who is more active as far as day to day and running the business. Um, the limited partner is limited and you know, they're responsible and their share of the debts and the liabilities. Um, So, if that were to go South, they kind of have kind of have an out there. Um, and then the LLC is, you know, there's more work upfront to set this up. It is a legal entity. I mean, you go ahead and you create a legal name that you file the articles of organization with the state. Um, have an operating agreement. There's some annual periodic reports that are required. Usually you want to get an attorney involved when you're setting up an LLC, just because it is more formal. This is for the folks that have that idea and they've. They've grown the business and it is going well. And they just want to get a little bit more protection. Like the name says limited liability. There's, there's more protection for them personally and their assets, um, while running their business. So outside of the initial formation, you know, some of the formalities that go along with that, and some of the things you have to do that, you know, may cost you time and or money. Um, Why would someone choose to be a general or a limited partnership as opposed to an LLC? I think they would, they would stick in that general or limited partnership realm because they're not, not quite worried about things going South. I mean, maybe it is just a venture and they're seeing how it's going. And if things do go South, they say, Oh, okay. I lost my money and they're not necessarily worried about someone on the outside coming in. So that liability protection of an LLC. Is is something that, that is beneficial for, for setting up an LLC, right. And also, you know, in certain States, California being one of them, an LLC has got to pay that minimum franchise tax of $800, which every entrepreneur in California loves. Um, whereas, you know, at least the general partnership, uh, does not have that. So there are, you know, some things too, and I think it goes to your point about, you know, how serious they are about the business and where they're trying to take it. So talk to me a bit about pass through income. How does it work and how do distributions of cash from the partnership factor into all of this? So pass through income is the, the income that flows from the business to the individuals for tax purposes. So, I mean, if you have an LLC, um, and you generate generate revenue, ultimately the LLC is not taxed and that revenue. And that income ends up being taxed at the individual level. So for example, you have a partnership LLC. In the first year of operations, they have taxable income say a hundred thousand and there's two partners. Um, one 60% owner, one's a 40% owner, regardless of the distributions. One partner's gonna end up with$60,000 of taxable income and the other will have $40,000 of taxable income. And that's going to flow through their personal return and that's where they're going to pay the tax. Um, so if they both took $50,000 in distributions, then the 60% partner would end up having 10,000 left in their after tax account known as their basis in the company to pull out in, in later years tax-free and the 40% partner then would have exceeded their basis by 10,000, which would mean they would actually have a $10,000 capital gain that they would have to recognize beyond the 40,000 that we just mentioned. Gotcha. Quick question. Quick question on that. So in that situation, the PR the, the fit, uh, the 60% owner that got 50 grand, he's actually paying taxes that year on his 60% ownership. Is that correct? Even though he only was distributed 50,000, correct. Got it. And so this can, you know, be a little bit of a thorn for people. Like I didn't get that money, you know, and why should I pay tax on it? Unfortunately, that's just how it works. But there is something called a guaranteed payment, which can kind of help work around some of these inconsistencies between, uh, the income, your tax on versus the money that you actually receive from the partnership. So Eric, how exactly. Do these differ, you know, these guaranteed payments differ from distributions. And also how might the partners in the previous example have used guaranteed payments, devoid having their capital accounts diverted. Right? Um, yeah. So guaranteed payments are different than distributions would diff distributions are, you know, Earnings that the company has, that are distributed out tax free to the partners or distribution or excuse me, guaranteed payments are, you know, something they've agreed upon. Whether it's somebody who's in there actively work. And, and, uh, there's, they're saying we're going to guarantee you this amount of money. Um, regardless if we make money this year, if we lose money this year, and then that guaranteed payment is treated as an expense. On the business side. So it reduces the income. And then on the individual side, they, they will have income based on that payment coming to them. Right. I think it bears mentioning that guaranteed payments are really the only one way to take salary, uh, from a partnership, um, you know, as opposed to a W2 or 10 99, if you are an owner providing services for the company. Uh, I think a lot of people, uh, get tripped up on this and they think, well, I should just be paying myself via W2, but if you're an owner, uh, of that partnership, you're actually not supposed to do that. I mean, what's the downside of taking money via guaranteed payments as opposed to just taking distributes. So one of the main downsides is it's going to reduce your qualified business income deduction, QBD, um, that goes down. So in that previous example where you had a hundred thousand dollars of income, um, if you were to take. You know, those $50,000 distributions and make them guaranteed payments. Now, all of a sudden your income is zero. Um, and your QBI deduction would be zero as well because you didn't have any income. And he think about QBI and the deduction 20%. Um, that's I mean, granted, you have to have income, which is going to be taxable, but getting that deduction is beneficial. 100%. Yeah. I mean, we actually have had a number of taxpayers, uh, restate their operating agreement, you know, to get rid of that, uh, guaranteed payment aspect and, um, you know, make sure that their compensation is coming in the form of profits distributions for that exact reason. So, uh, you know, when people talk about attacks, distribution from their partnership, what are they referring to and why is this a good provision for companies to consider. A tax distribution from the partnership is when the partnership kind of has an agreement that says, you know, you're gonna get a K one that shows this amount of income, and you're going to have a personal tax liability based on that. And regardless if you see cash or not to help cover that liability. So the tax distribution comes in and they say, well, look at that. And maybe that's, you know, 30 35% of what that income is. We'll distribute that cash out to you just to help cover that tax liability. Gotcha. And so at least from what I've seen, you know, that's, that's a provision for companies that are trying to keep as much, you know, capital within the company as possible, but you know, just don't want to, uh, put their, their investors in an adverse tax situation. Hey, this is chase Berkey, CEO of dark horse CPAs. If you're an entrepreneur and investor, a co-founder or someone who just has a complicated tax situation, you should absolutely consider reaching out to a dark horse CPA like Eric KCStat. In fact, if you like what Eric's talking about today, You can actually reach out to him directly at Eric at dark horse dot CPA. And that's Eric with a K unlike most firms where you'd end up working with lower level staff members. If you engage with Eric, he will be your CPA, the one you call, email and meet with for all of your taxes. And you can find your very own Darcor CPA on our website. We'll be able to see their areas of expertise. Just go to dark horse dot CPA slash team. And once again, that's Darkhorse dot CPA slash team to find a CPA that will help you understand your taxes and how to minimize them. I'd like to talk about, you know, the entity type that is probably most entrepreneurs favorite and any type. Um, at least maybe the most popular one that we see. Uh, and that is the S-corporation. So why exactly is this entity type so popular? The S corporation, uh, offers more asset protection similar to, uh, the, the C Corp, um, but still provides the pass through income, um, that, that people like while avoiding that double taxation situation that the C Corp is get into. Um, they can, you know, they can sell stocks so they can easily attract shareholders and, uh, up to a hundred, um, and one big difference between a partnership and that, and the S-corp is that they're not subject to the se tax, the self-employment tax. Gotcha. And that's just on the pass through income portion, correct? Correct. Gotcha. So, uh, does a business form an S corporation with their secretary of state? No, you make an S selection, um, through the IRS, there's a form 25 53 that's that's filed with the IRS to make that selection. Gotcha. So what if someone wants to make an S election after they've created their corporation or their LLC? That's totally fine. Um, we see that quite, quite a bit, um, where they have an LLC that's been operating for a few years and you know, we'll sit down and work with them and say, if you were to make this selection, this is what your tax situation looks like. If you keep going as you are, this is what it looks like and kind of evaluate that situation. And it's not something that needs to be done upfront or else it's lost forever. You can, you can revisit that and make an S election down the road. Right. Yeah. I mean, so long as they don't file as a different entity type, um, you know, then typically they'd be precluded from making that election, at least for that tax year. But if they haven't filed returns, then that is definitely open to them. So how exactly is an S-corporation similar and different to a partnership? Well, they're similar. They both have that pass through income to the owners and they, they both get the QBI deduction, deduction, qualified business income deduction. Um, Well, the difference is, is like I mentioned, the no self-employment tax, which can be, which can be very advantageous. Um, as an escort, the distributions out to the partners must be pro-rata. So you can't just kind of decide to, you know, give one partner this amount and then another partner, a different amount that's not in line with, with our operating agreement. Um, And, you know, you have to pay yourself wages as a, as a, the owner of the S-corp. You have to pay yourself. What's referred to as a reasonable wage. Right. We see people get both of those items wrong all the time. You know, when it comes to the pro-rata distributions, they might be given the main shareholder, a distribution, and then, you know, screwing up with the math to catch everyone else up. Uh, so we see a lot of people run a foul there. Um, and also, yeah, with that officer compensation, you know, that salary that you need to pay, uh, the, you know, officer, the owner operator, a lot of people get that wrong, you know, because, uh, you know, a lot of people have been told, well, if you do 50% of your. Taxable income. Uh, and you run that through his W2. You're good. And that's unfortunately too simplistic. There's many more variables that the IRS would consider, uh, in terms of whether you met that provision, but what's the downside. If they're not following, uh, you know, some of these requirements, well, yeah, they could lose their S election and then they would revert back to, you know, the, the entity structure that they had before. Right. So, How exactly then does an S-corporation compared to a C corporation. So I can compare it to a C Corp. They're both separate legal entities. The liability protection is greater there. So shareholders aren't personally liable for the debts of the company. Um, a lot of times the both have directors and officers, um, one of the. Differences with a C Corp is they don't have that limit on the number of shareholders at a hundred. Um, they can have different classes of stock, which you see a lot where, you know, different maybe with the court, different rounds of investors they'll have different classes of stock. Um, and then, like I mentioned before, the, the double taxation that the C Corp and sort of faced with isn't, isn't there for the escorts. Right. So if you're going to get double taxed as a C corporation, you know, why would a company opt to be a C corporation? If it could otherwise qualify as an S Corp? The main reason is, you know, the number of investors you can. I mean, the capital that you can raise and is much greater when you go the C Corp route, just because there's, there's not a limit on, uh, on, you know, a hundred shareholders. So you can, you can really expand and grow. And ultimately if you, if you wanted to go public, that would be the route you need to go. Right. And there's also an argument to at least under our current tax code, which could be changing. Uh, we can reference episode one of the podcasts talking about Biden's tax plan on that one, but currently at 21% maximum corporate tax rate, you know, the argument could also be made that if you're just trying to reinvest profits back into the company, uh, that the. Most advantageous vehicle to do that is a C Corp, uh, because you don't have that potentially much higher level of tax, uh, at the individual level. And, you know, I think the other thing that our listeners really should take into account is what happens to the state level, you know, cause the California, they're going to tax an LLC, an S-corp a C Corp differently. Uh, so you need to take that into consideration here. So an LLC, you're going to pay taxes on your gross receipts. I'm an S corporation you're going to pay tax on 1.5% of your net taxable income. And the C corporation is going to pay, you know, about 8.8%, uh, tax to California. So there are some pretty significant differences, you know, in terms of, uh, how the state can tax these different entity types. So specifically with California, if you're a high revenue business, low margin, you know, you're probably going to want to be either an S or a C Corp, you know, to lower your taxes there because the LLC is going to tax you business, your gross receipts, which in California, That can get up to, you know, North of $12,000. Uh, whereas, you know, if you have low margins and S-corporation, you're going to pay 1.5% tax California, you're going to pay 8.84%. So, you know, ultimately that is a huge consideration that everyone needs to take account. Uh, you know, when you're deciding on your entity type, because the state taxes are still very real thing. So chase, as we're wrapping up here, I had a question as you guys were talking, you know, I've heard that a lot of. C corpse, our Delaware C corpse, you know, w w what does that mean? Why, why does so many companies choose to, to create their business entity in Delaware, as opposed to some other state, or even the state that they're operating in? Right. I mean, some people think it's a tax reasons. Like if I'm a California entity and I register or create my entity in Delaware, you know, do I get to skip out on some of the franchise tax? Uh, the answer is no, you still have to register as a foreign entity in California. However, you know, the real reason that. Delaware corporations are so popular is really because of the amount of case law that's out there. Uh, you know, specifically just the laws, uh, surrounding, uh, you know, investors' rights and just how the business operates, uh, you know, from a shareholder perspective. So when it comes, you know, to a investor, you know, investing in a company, you know, especially serial investors, uh, you know, they're gonna. Have a preference to invest in a Delaware entity because they are familiar with how the law works there. They know what their protections are. They aren't going to be, you know, blindsided by some, you know, state specific, nuanced law that they weren't aware of that puts them in an adverse position. So really it's just about uniformity of, you know, law, you know, it's ultimately going to protect their investment. Got it. Okay. Well, that was a good, good little podcast. Ton of info there, right? Oh man. Now, how do you guys feel? I mean, I feel like I just got knowledge dumped on me and I also feel very fortunate that I'm working with you guys because I would have gone, you know, into a spiral trying to figure this out on my own. And I know I'm a small, small business and you know, I'm not, I'm not qualified yet to figure out whether or not I need to be a C Corp, but it sounds like most, most small businesses as a default. If you're kind of operating on a, on a smaller scale, especially if you're an army of one, like me, you know, LLC taxed as an S Corp is kind of the way to go. If you can, if you can manage it, if you're a bigger company that needs to get larger investors coming in over time, it sounds like it's more of a C Corp. Yeah. Yeah. So, I mean, you know, really when we see people start as a C Corp, it's, you know, they are immediately looking to attract significant capital, uh, you know, but I would say the lion share of small businesses out there are like yours, where, you know, you start off with. You know, just an owner-operator maybe a handful of employees. Um, you know, and you're just trying to find the most tax advantageous, uh, vehicle, you know, uh, until you grow to a point where you need to consider some other things and cross that bridge when you, when you get there. Um, yeah, but I mean, Ultimately, you know, it's just really about what your trajectory is and kind of where you're, where you're at at this moment in time. And like I was mentioning earlier, you know, S corporations are really just the, lion's share of a lot of small businesses, uh, because of that self-employment tax, uh, element there. So, yeah. Anyways, um, Eric, thank you very much. Um, and as mentioned on our commercial, if you want to get in touch with Eric, uh, for your. Tax services, tax advisory, tax preparation, tax resolution, you name it. He is available. His email is Eric and that's Eric with a K at dark horse dot CPA. And now for the disclaimer, the content in the proceeding podcast should not in any way be construed to be tax advice. All tax laws are nuanced in. Those are applied to each unique situation differently. There'll be a dummy higher CPA. Preferably a darker CPA.