Just coming out of tax season I thought it would be a good time to discuss a couple of common items that cause issues at tax time. Many people do not want to pay an accountant to help them set up their business entity. And the internet makes it really easy for anyone to register a business. But there are a couple things you really should know before you mark the box to be a Corporation, or an LLC.
• If you are an LLC you cannot receive a wage. That’s right no payroll or payroll tax for you. But you can have a guaranteed payment and you can take draws to receive money from the company.
• If you want to be an S-Corp there are two ways to go about it. Register as a Corporation and elect to be an S-Corp. Or register to be an LLC and elect to be treated as an S-Corp for tax purposes. Both an S-Corp and an LLC and for that matter a Corporation have pros and cons to them legally but I am not an attorney so I won’t address them.
• If you are an S-Corp you MUST take a reasonable wage. Reasonable is a very big grey area and different accountants will have different opinions on what is reasonable. It would be helpful if the IRS would define reasonable but so far they haven’t provided much guidance.
• Either an S-Corp or an LLC will allow the owner to take dividends (if you are an S-Corp) or draws (if you are an LLC), but you must have basis in order for them not to trigger a tax issue. Basis in its simplest form is the amount of personal funds you put into the company to get it started plus or minus the earnings the company makes. Think of basis as “skin in the game”
A very common occurrence is for a new business owner to register himself as an LLC, take a wage and pay payroll taxes on himself for a very low wage and then take the rest of the earnings out in the form of draws. The wages and payroll taxes are not allowed for an owner in an LLC and will have to be corrected at year end. This can be a bit messy and costly to fix.
Now let’s say this particular owner put no funds into the company to start it and at year end the company has a loss. He thinks this is great and will reduce the amount of income his wife has made at her job. But he doesn’t have basis (no skin in the game), so the loss for the company is not allowed on his personal tax return and the draws he took have made his basis issue even worse because his basis is not only in the hole for the loss but the draws have caused him to be even further in the hole. It will take a really good year to get him out of the hole.
A little chat with his accountant before he registered the business and he would have been armed with all this knowledge and able to avoid these common pitfalls. So don’t treat your accountant like they have the plague, use their knowledge to help you and your business prosper!