I want to bring solutions to people within our community around The Villages, FL. I run Blue Heron Bookkeeping, a bookkeeping and accounting firm, which focuses on helping those who run businesses within our community. I want to give back time to owners so they can focus on their product. I also want to reduce costs to owners, making it more advantageous and easier to scale out the business. This, in turn, allows them to provide greater value to the community.

There is a lot to focus on when it comes to starting a business and setting up the business for success. While creating your business plan and market research, entrepreneurs usually miss out on creating their accounting plan. By “accounting plan”, I am not talking about your bookkeeper or how you will perform your accounting, I am referring to the organization type your business will operate under and what the impacts of that type is on your cash flow. There are many other important factors of the accounting plan we will discuss in future articles.

Best practices currently push most small business owners to file and operate as a Limited Liability Company (LLC). Many people understand that the LLC provides a shield for you as an owner so that business operations do not put your personal possessions at risk. This shield exists so long as you are not found to be negligent and you practiced good faith in your business. After forming the LLC, there are additional options you have which often are not considered properly.

For the following, I recommend finding an expert who explains how income is divided in each of the organization types. The organization type affects more than your short term tax payments. The organization type also affects adding equity partners into your business and whether your goal is to sell the company. The following organization types are available to almost any for-profit business:

Sole Proprietorship

• This designation is for a business which has one owner and is the easiest business to set up. In a sole proprietorship, there is no barrier between the owner and the business which means the owner is liable for all interests in the business.
• A sole proprietorship makes the owner recognize income for the year on their personal tax return as taxable income. The owner must pay social security along with medicare taxes on both the employer and employee sides. Business income and expenses are reported using a Schedule C. Deductions are reported through Schedule C and then reported on your tax return 1040 as income.
• Based on the little amount of cost and paperwork associated with starting a sole proprietorship, this designation is often best for small businesses which will likely keep one owner rather than multiple owners.
• Make sure a portion of the income you make from the company is set aside to pay taxes. I usually recommend setting aside 25%-30% depending on other income you have away from the business and how much it costs you to make revenue within your company. I tell all my clients, “The money you made so far is not yours unless you spend it all on the business”.

Partnership

• This designation is for a business which has multiple owners who have contractually agreed to operate together. There is no separation between owners and business therefore owners are liable and taxed at an agreed upon percentage of distributions. Capital investment without substantial operational capacity is also allowed within a partnership and requires additional documentation to remove certain liabilities from those “limited partners”.
• Partnerships, similar to sole proprietorships, cause the owners to recognize income from the business on their personal income tax return. Instead of reporting income in whole on each tax return, a partner will report only the percentage of income that they have agreed to share within the partnership. Similarly, this works for losses as well. If a partner has agreed to assume 60% of liabilities and revenues, they would then report 60% of the gain or loss of the partnership on their tax return. This process is performed through Form 1065 and transferred to a K-1.
  • Through a partnership capital gain treatments are allowable.
  • For partnerships who wish to take on capital or strategic partners, a limited partnership may be the right option.
• Partnerships are also easy to start-up and are best for formal agreements between companies and individuals along with situations where limited partners are involved.
• Partnerships are similar to proprietorships in that you should set aside revenues you make from the company to pay for taxes. I usually recommend 25%-30% should be set aside if you are unsure of your effective tax liability rate.
• When starting a partnership, make sure you fund the business up front or in large increments. Tracking the amount of money you, personally, have put into the business will allow you take advantage of any losses you may have in the business for the future.

Limited Liability Company(LLC)

• An LLC allows an owner to separate themselves from the liabilities which exist in a business and establishes a barrier between the two for operating issues which may occur. An LLC provides this protection so long as members in the LLC perform, in good faith, operations of the business without being negligent. LLCs are taxed based on the designation the LLC wishes: Disregarded Entity, Partnership, C Corporation, or S Corporation.
• LLCs, due to the ability to take on the characteristics of any other option for organization, have a wide variety of choices. Make sure your business files the appropriate paperwork after filing the LLC organization to ensure the LLC is taxed properly at the end of the year.
• As LLCs have been created to shield assets of owners, in the vast majority of situations it would be advantageous to establish an LLC for your business and then elect the taxable nature of the business.

C Corporation (C Corp)

• A C Corp provides a separate legal entity whose ownership is issued through “shares”. By creating a C Corp, you must establish how many shares will be issued and apply ownership to those shares. Though ownership interests are more complicated to establish, sale of ownership is often much easier and continuity through death is well defined. C Corps are divided between public and private corporations, both of which hold very different standards.
• The tax structure of C Corps is often more costly to owners but provides large incentives if you properly plan the tax implications. C Corps themselves are taxed at a specific rate, any distributions made to the shareholders are also taxed at the shareholder’s rate. This is called “Double Taxation” and it typically causes shareholders to have a higher tax rate when combining the corporate tax rate and the personal tax rate. The upside to the C Corp taxation is that money which sits within the corporation and is not distributed to the shareholder does not get taxed through the shareholder.
• C Corporations are best for people that wish to keep profits inside of the business rather than paying taxes annually for income recognized. C Corps can hold their earnings as “retained earnings” which are taxed at the corporate rate and further invested into the business.
• With C Corps, you must treat yourself as an employee of the company. It does not matter if you own 2% of the company or 100% of the company. You must also pay yourself a fair wage based on your duties and responsibilities. Non-compliance can create large tax issues in future years.

S Corporation (S Corp)

• S Corporations, as their name suggests, are corporations that provide as a separate legal entity. They establish a barrier between owners and the business for operating issues. S Corps are unique in that they can only be owned by individuals who are residents of the US and it caps ownership at 100 distinct members. You must also pay employees and operators of the S Corp a “reasonable wage” even if they are owners.
• S Corps function as flow-through entities where income from the corporation is taxable to the owner in the year in which the business made the income. Single owner S Corporations are very similar to a sole proprietorship. Similar rules apply to multi-owner S corporations.
• An S Corporation is best for companies that hold domestic operations and are owned by individuals living in the United States. Based on the ability to pay owners a “reasonable wage” rather than classifying all income as wages, you can potentially save money through not paying self-employment taxes on residual business income. Keep in mind, in this structure, each owner is an employee of the S corporation. Though you own the company, make sure you compensate yourself fairly and competitively as if you did not own it.

As you start your business, your organization type can dramatically change your future decisions. Once operations begin and ownership becomes more complicated, changing the organization type can be costly. Plan ahead and understand your future vision for your company. Lack of planning will likely be costly. Hopefully this was a useful dialogue to help you understand the critical steps of organizing your business prior to beginning your business journey. As always, feel free to reach out if you have any questions or would like to discuss your bookkeeping or website needs.