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Entity Type Selection: Structuring for Long-Term Success

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A question we frequently hear from entrepreneurs and business owners is, “How should I structure my business for tax efficiency and business operations?” But one size does not fit all. The answer is dependent mostly on your goals for the company.

There are essentially four options to structure your business:

  • A traditional C-Corporation
  • An S-Corporation
  • A Partnership/LLC
  • A Sole Proprietor

Each entity has its own advantages and disadvantages regarding tax efficiency, types of owners and vulnerability of personal assets to creditors. Here’s a short rundown:

Sole Proprietorship
This is one of the simplest forms of business, but subjects you to the most risk. Owners have direct and sole control in the business making decisions. There is no separation of personal and business affairs. Raising capital may be difficult as banks typically depend on prior-year income to dictate the conditions of any loans, becoming stricter for businesses just getting started.

The tax return is filed with the business owner’s own personal return with a form Schedule C, mitigating the financial burden of filing a separate tax return for the business. Income is subject to the taxpayer’s ordinary income tax rates, with an additional 15.3% for self-employment tax (Social Security and Medicare) on the net business income. One-half of the self-employment tax is deducted to arrive at adjusted gross income on the personal income tax return.

Partnership/LLC
Partnerships can be as simple as a handshake between two entrepreneurs. A General Partnership gives all partners unlimited liabilities. A limited partnership requires at least one partner to manage the day-to-day activities, known as the General Partner, making them susceptible to unlimited liability. The remaining partners are passive investors with no part in management. Limited Partners still receive certain rights, such as voting about important issues.

An LLC requires more paperwork. You must file Articles of Incorporation and pay a fee with the state. LLCs must also file annual reports disclosing any changes in location, ownership or operations. LLCs are similar to a Limited Partnership as all partners receive limited liability.

If a member of an LLC dies or files bankruptcy, the LLC will dissolve. An advantage of a Limited Partnership is that a majority of remaining partners could vote to keep the business alive rather than terminate. Be aware that not all 50 states have a uniform treatment of an LLC. For example, some states limit the type of entities that may register as such, which can cause confusion for multi-state operations.

The form 1065 tax return is filed and partners receive form K-1 dictating their share of income or losses based on ownership percentages. Partners are provided guaranteed payments for services rendered or capital contributed rather than wages. Income is flowed through and taxed at the individual level at ordinary income tax rates.

For members active in day-to-day operations, the guaranteed payments and income from the partnership are subject to self-employment tax. General partners can use losses to offset other ordinary income. Any limited partner’s income will not be subject to self-employment tax, but is treated as passive. Passive losses may only offset passive income for tax purposes. Shareholders may take distributions in any manner partners agree.

S-Corporation
Incorporating as an S-Corporation becomes a bit more formal. Owners are required to file incorporation documents with their respective state, but not every state recognizes S-Corporation status. These states will tax the entity as a C-Corporation, meaning there will be double taxation. Shareholders are limited to 100 and they may only be U.S. citizens, U.S. residents and certain types of trusts.

S-Corporations are flow-through entities with income taxed at the individual level, but income retained by the corporation is not subject to the 15.3% self-employment tax like a sole proprietorship or partnership. Owners are required to take a “reasonable” salary based on the industry’s norm, with 2% shareholders being susceptible to taxability of various fringe benefits such as health insurance.

S-Corporations give shareholders limited liability, but also allows all shareholders to actively participate in the business. Owners are only liable for the capital they contributed into the corporation. It is important to separate personal and business assets so as to not “pierce the corporate veil” subjecting business debts to personal liability. Shareholders receive a form K-1 for their respective share of income and losses. Distributions, to the extent there are any, must be in proportion to ownership percentage to avoid termination of the S-corporation election.

C-Corporation
C-Corporations are similar to S-Corporations as the incorporation needs to be filed with their respective jurisdiction. Unlike other entities, owners’ personal assets are completely segregated from the assets of the corporation. Owners will typically take a salary as a form of payment. Form 1120 is filed and income is currently taxed at a flat 21% at the corporate level. Distributions are allocated to owners as taxable dividends. These dividends are taxed a second time at the individual level (double taxation). The tax rate depends on whether they are deemed ordinary or qualified; the maximum rate is 37% for ordinary and 20% for qualified.

With the incoming Biden administration, a new tax code change may be in the works. If implemented, the corporate tax rate of 21% will increase to a flat 28%. A minimum tax on corporations with book income over $100 million would also be incorporated. It would be structured similarly to an alternative minimum tax. This may make incorporating as an S-Corporation more favorable tax-wise depending on the threshold of income that would flow through to owners. The maximum individual tax rate would increase from 37% to 39.6%.

Weighing your options
A partnership must have at least two partners. A general partnership gives all partners unlimited liability, a limited partnership provides limited liability to all except at least one partner, and an LLC offers limited liability to all. Partnership entity type will be contingent on what capacity all partners are to be involved. Partnerships are more favorable for situations where you may not make consistent revenue, allowing you to take distributions as needed.

S-Corporations are more advantageous when revenue is more consistent. It gives owners the capability to take an annual salary, with distributions complementing any additional funds needed by the owners. A corporation provides the most division of personal and business assets as courts are able to “pierce the corporate veil” of S-Corporation, leaving shareholders susceptible to some type of limited liability.

Your choice of entity depends on your individual situation and plans moving forward. I would argue that most businesses begin as a sole proprietor — they have an idea and turn it into a profitable situation. Once they start buying assets and investing more into the business, it may be a good idea to incorporate as an S-Corporation. Soon enough, the company will be electing C-Corporation status and will be taken public with an Initial Public Offering.

All things being equal, it is important to have trusted advisors behind you at every stage of your business. At Magone & Company, our advisory services can help you select the best alternative based on your goals. We can also assist in implementing strategies to make the most tax-efficient choices.

Business Operations, 2020 Edition: Connecting in a COVID World

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The year 2020 has brought much confusion and turmoil as a result of the COVID-19 global pandemic. As the world went into lockdown, many businesses were forced to close in an effort to decrease the spread of the virus. Unfortunately, many local businesses had to shut down due to financial issues, while others were faced with a new challenge of how to maintain operations in the new age of social distancing.

Large companies such as Google, American Express, Microsoft and Airbnb extended work from home policies indefinitely, with Google extending its policy into 2021. However, not all businesses have the luxury or resources to follow suit.

Fortunately, companies can take advantage of some opportunities despite the current global climate. Below, we will focus on the importance of technology and a change in mindset, which could help businesses continue to grow as if the pandemic never happened.

Technology: An investment, not an expense
Technology is extremely prevalent in the modern workplace. Every day we converse with clients via phone calls and email. Some companies, however, still value their face-to-face communication with clients. Did you know that there are more avenues of technology that can keep people connected?  COVID-19 has given birth to a different means of communication. Since the pandemic, there has been a drastic increase in demand for video calls via platforms such as Zoom, Microsoft Teams and Skype.

Utilizing video calls can help companies maintain relationships with clients as well as build new ones. This is more than a simple telephone call; the use of the video function allows for more meaningful communication because you can read the body language of the client.

At Magone & Company, we’ve made it a point to engage in video calls for almost all our client meetings and are seeing great results. Clients are more willing to help us in performing our procedures since we’ve made an extra effort to be present in their business, even from behind a screen.

Gone is the time of technology being an expense; it is an investment in the business and relationships that cannot be overlooked.

Turning pandemic challenges into business opportunities
Look for opportunities in your organization to change delivery processes or business development strategies using technology. It’s one thing to have the technology, but now you must use it. Some companies may not feel comfortable with the use of video conferencing due to a lack of knowledge, or maybe they just do not feel it will have a positive effect on business.

In contrast, a transition to a more remote based work setting can have significant positive outcomes, such as reduced rental expenses or building operating costs. Reimagine your facility needs as well as your hiring needs. What skill sets are required? Geography may no longer be an impediment to hiring the perfect candidate, though you still need to be cognizant of the state tax effect of such a decision.

For Magone & Company, we’re winning new work outside of our geographic region despite having no offices remotely close to the client location. Our consistent use of video calls allows our employees to build positive relationships and also produce efficient communication to discuss our engagement progress, without ever stepping foot in the office. What was unimaginable in January or February of 2020 is now standard operating procedure — and it’s paying significant dividends.

Embrace the transformation
The year 2020 has taught us that life can change instantaneously. One of the key components to a running a successful business is being open to change. COVID-19 brought more change than most would have hoped for, however this did not stop businesses from assessing new avenues of success.

Restaurants suffered greatly from the imposed lockdowns, which caused owners to develop solutions to help mitigate the risk of closing. As a response, many establishments experimented with outdoor dining and curbside pick-up as a means to generated revenue flow. Others have gotten even more creative. According to an article from the Journal of Accountancy, one particular restaurant owner considered transforming a section of his establishment into a market for customers to buy food.

The same can be accomplished with your business with the right mentality. At Magone & Company, we saw an opportunity to establish a more prominent advisory practice in which we help our clients be better prepared to operate. This proactive, rather than reactive, approach has helped our clients to establish more efficient and effective business strategies. How can you reimagine your business to take advantage of possible opportunities?

Yes, this year has been rough and challenging; however, as outlined above, there is no need to panic. There are ways that businesses can restructure, recalibrate and execute successful business tactics. We have seen positive outcomes to continue to help our clients grow.

 

 

 

Can Client Accounting Services lead to increased efficiencies?

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 From increased visibility to enhanced financial controls, Magone & Company’s Client Accounting Services (CAS) were created to streamline your company’s accounting and finance functions and help you operate more efficiently.

But don’t take our word for it! Respondents to Bill.com’s 2018 Client Accounting Services Report say that CAS delivers measurable benefits.
 


What’s more, these benefits lead to hard-dollar CAS outcomes, such as increased profit (28%) and improved revenue (23%). 

Your financial needs are a moving target. So why lock into a hire who may not be able to keep pace? Our CAS team has the expertise to handle finance-related tasks at every level — for less than the cost of hiring a full-charge bookkeeper or staff accountant. 

With four levels of service — from bookkeeping and accounting to more strategic controller and CFO-level tasks — Magone & Company’s CAS services provide the financial skills, services and systems you need, without having to invest in expensive staff and technology infrastructure.

Is CAS right for you? Learn more or  call (973) 301-2300 for details.

Choosing the right entity for your small business

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If you’re thinking of starting a business, kudos to you! Starting a business can be an overwhelming experience in the beginning, but well worth it in the end.

Of all the decisions you’re going to make, one of the most important decisions that should not be taken lightly, will be the type of legal structure you will choose for your company, whether it may be a sole proprietorship, partnership, or corporate entity. This decision will definitely have an impact on your tax obligations, it will affect the amount of paperwork your business will be required to complete and process. It also has ramifications for your personal liability.

Before we get into the various business types, there are some considerations which lead to one business form over another regardless of tax advantages. For example, do you have foreign partners or investors, will you operate in various states, will you seek venture capital (if so, how soon)? These are but a handful of considerations that need to be considered. Let’s now look at the various business forms.

Types of business entities

Sole proprietorship is the most common form of business organization and easiest to operate. It is very simple to form often requiring only registering a Doing Business As (DBA) with the county courthouse. A mistake many owners make since this form of business is so easy to form and operate is they are lax in maintaining adequate books and records and frequently commingle business and personal expenses in the checkbook.

Tip – Open a separate checking account and pay yourself a draw. Pay business expenses from the business account and personal expenses from your personal checkbook.

Another consideration is this type of entity makes the owner personally liable for any and all financial obligations pertaining to the business. Think bankruptcy or liability from acts of your employees, such as an auto accident. I’m not referring to professional liability such as doctors, professionals are always held personally liable. Thought must be given to the nature of your business and potential for liability before selecting this form of entity.

Finally, adequate and accurate books and records are required, but the owner does not take a salary. The owner takes a draw and pays the federal, social security and state taxes assuming no employees via quarterly estimated tax payments. Keep in mind your draw is your “gross” pay check. This means you’ll need to estimate a reserve for income and social security taxes from each draw, no different than you would withhold taxes for an employee.

Tip –Establish a separate bank account for your tax liability and transfer the estimated amount for taxes to this account to establish a delineation between funds available for operations versus those earmarked for taxes.

A partnership consists of two or more people who agree to share in the profits and losses of a business. Similar to a sole proprietor, partners do not take salaries, but rather take guaranteed payments. The guaranteed payments are deducted from the net income, but included as partner’s compensation and subject to income and social security taxes.

Depending on whether a partner is a general partner or a limited partner, they may be held personally liable for the financial obligations of the business, absent personal guarantees. Many individuals form partnerships to avoid double taxation such as is the case with C-Corporations. Partnership tax law is one of the most complex areas of the tax code due to the flow-through nature of income, expenses, gains and losses. However, it’s useful when partners want flexibility in partner sharing percentages for income and losses.

Tip –Make sure you have a partnership agreement in place from the start. This can help you avoid heartache and expensive litigation if the partnership ever goes sour.

A corporation is a legal entity incorporated within a state. Many corporations are formed in Delaware, since most attorneys are trained in Delaware law and the law of their home state. The corporation is a separate entity, subject to federal and state taxation. Like a person, the corporation can be taxed and can be held legally liable for its actions.

Most venture capitalists require a corporate structure to facilitate investment and eventual sale, or public offering. In addition, there is the possibility certain officer fringe benefits and those of other shareholders will not be subject to tax as is the case with partnerships or S-corporations.

Tip –The key benefit of corporate status is the avoidance of personal liability, so long as the corporate veil is not pierced. Bes sure to work with a knowledgeable advisor to make sure you have the right documents and processes in place to take full advantage of corporate status.

The primary disadvantage is the cost to form a corporation and the extensive record-keeping (minutes, resolutions, etc). While double taxation is sometimes mentioned as a drawback to incorporation, the S corporation (or Subchapter S-corporation, a popular variation of the regular C-corporation) avoids this situation by allowing income or losses to be passed through on individual tax returns, similar to a partnership. Similar to the partnership tax laws, those applying to the Subchapter S-corporation are often quite complicated due to the flow-through nature of the income and expenses.

A hybrid form of partnership, the limited liability company (LLC), is very popular among new business owners and the legal community. LLCs offer personal liability protection for the owners, but for income tax purposes they are treated as a sole proprietorship if there is one owner or a partnership if more than one.

Tip –An LLC can elect to be treated as a corporation, but this is seldom done unless there are extenuating circumstances, for example foreign owners.

The foregoing is meant to provide a broad overview of the types of business entities a new business owner may choose. Each choice carries with it its own advantages and disadvantages based on your goals, so be sure to consult your CPA or other  trusted business advisor before making any decisions.

Need help talking through your options? Magone & Co. CPAs can help you make the decision that’s right for your needs and goals.

Thinking of expanding? Not so fast

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The driving force in many expansion plans is to generate higher sales, with the hope that profits, too, will rise.

But before making moves to buy new equipment, expand your plant or implement a new business idea, you need to grasp the profit angle.

In some cases, an expansion plan boosts sales but not profits. You wind up working longer and harder for nothing. You may think, “If we lose a little bit on each deal, we can make it up on volume.” That sounds good in theory, but may prove difficult in reality. To prevent problems, here’s a step-by-step guide.

  1. Fixed and variable costs. Break down your costs as either fixed or variable. Fixed costs don’t change over any reasonable time period while variable costs are related to sales. (The more sales, the more variable costs.)
  2. Contribution margin. This is what remains from sales after you deduct the variable costs. So if your product sells for $10 and your variable costs run $8, your contribution margin is $2. From that margin, you cover fixed costs and add to your profits.
  3. Breakeven. This is the amount of dollars and time it takes the contribution margin to match fixed costs. To calculate it, divide fixed costs by contribution margin. You don’t realize a profit until the contribution margin exceeds fixed costs. Until then, you’re in the red.

Once you calculate these factors, you’re ready to analyze the impact of expansion. Let’s say your company makes Belgian chocolates and sells them in quarter-pound boxes at $10 a piece. Your variable costs are $8, giving you a contribution margin of $2 on each box to cover fixed costs and provide a profit. Your fixed costs are $100,000, so you need to sell 50,000 boxes to break even.

If you expand, and fixed costs rise to $125,000, your contribution margin stays the same. Using the breakeven formula (fixed costs divided by contribution margin), you now have to sell 12,500 more boxes, or 62,500 total.

Have your numbers calculated? It’s a good idea to talk to your accountant about how cash flow, liquidity and profitability could change, depending on business conditions. But fundamentally, a solid grasp on these factors is critical to deciding whether you’re better off keeping the status quo or charging ahead with an expansion.

Why your business absolutely needs a budget

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Most business owners view a budget with utter disdain. They’ll use any excuse to not prepare a budget. Some of the excuses I have heard over my career:

“Who has time for that?”

“Our annual earnings don’t really change from year to year.”

“Sales are flat, why bother?”

Most business owners run their business based on the business’ history and the owner’s experience. Sometimes this works well, other times not so much. Remember the credit crisis of 2008? Our business clients who weathered the storm were the ones who had transparency into their business via a budget. They could model the effect it would have on their profitability and cash flow using their existing budget and adjusting their expenses or payroll accordingly.

So, why prepare a budget? As previously discussed, transparency into the effects business conditions have on cash flow and profitability. Another reason is to plan for growth, organic or merger. Growth creates its own challenges such as the need for financing. A merger needs to be modeled to attract possible financing. Yet another reason to create a budget is to see how pricing changes affect profitability.

What is a budget?

A budget is simply your estimated income and expenses for your business year, a pro forma document, meaning you’re using your knowledge to estimate the how you will see the year.  A budget typically reflects how your company expects to spend money in the future.

Let me say it again, it is your spend, meaning you have built into the budget hiring for growth, a new or larger facility, etc.  It will change as you move through the year and must be updated. I like to update each month of the budget with actual results, so trends can be spotted and profit and cash flow projections more accurate with the known adjustments. This is especially useful when communicating with a bank or investors.

How do I prepare one?

Depending on the size of the business the budget process can begin as early as August or September. If your business has a sales team, it is imperative you start with them. Have each sales person develop their sales budget by month and by customer. Do not just accept the numbers provided challenge them based on your expectation of reality, against their previous sales and the current economic environment. This will form the foundation of the entire budget.

Next, review your historical gross margin, listen to your sales team as to pricing pressures and project the gross margin. Finally, estimate your general and administrative expenses such as administrative salaries (accounting, HR, executives) insurance, utilities, rent, travel and entertainment.

Here again, you’ll reference history and change in operations and possible hiring patterns to estimate the expenses by month.  This becomes your plan for the year and if sales are not being obtained, or margin is lower than obtained, then changes will need to be made in personnel or expenses.

Of course, if you are satisfied with the ultimate operating margin, maybe nothing needs to be changed. The important thing to remember is this will hold your employees accountable to the plan, if you hold yourself accountable to developing, monitoring and taking action against it.

Where to start? Your accountant is a great place. Don’t have one? Fix that now and call Magone & Company at (973) 301-2300.