Business Entity Selection

One important consideration when starting your business is determining the best legal structure of your business. Your selection of legal structure will affect operating efficiency, transferability, control, the way you report income, the taxes you pay, and your personal liability.

Here is the comparison of some of the basic considerations while selecting one of the five most common structures for your business entity:

  Sole Proprietorship(SP) Limited Liability Partnership (LLP) Limited Liability Company (LLC) S Corporation C Corporation
Limited liability No Yes (for LPs only) Yes Yes Yes
Perpetual life No No Yes Yes Yes
Eligibility Physical persons No limitation No limitation (Limited if “S” election is made) U.S. citizens or permanent residents No limitation
Maximum shareholders Single owner Unlimited Unlimited members 100 Unlimited
Minimum ownership 1 2 or more 1 in many states 1 1
Ownership by other corporate entities N/A Yes Yes No Yes
Classes of stocks No No No Yes Yes
Flow through entity N/A Yes Yes (if treated as SP, Partnership or S Corp) Yes No
Double taxation No No No(unless treated as a C Corp) No Yes
Tax flexibility Medium Medium Highest Medium-high Low
Federal tax forms 1040 (Schedule C) 1065 1040, 1065, 1120S or 1120 1120S 1120

The choice of a legal structure can be complicated and errors can be costly. In addition, current tax laws make it difficult to change your legal structure after you begin operating. Making the right decision before you open for business is very important.

Consult with a CPA who can help you decide what type of entity and structure is best for your situation and type of business, explain how business structure affects your organization’s bottom line, and file the necessary paperwork to start your business.

LLC vs. S Corporation – Which One Is Better?

The main similarity between Limited Liability Company (LLC) and Subchapter S Corporation (S Corp) entity types is that they both allow the benefits of limited liability protection and pass-through taxation. However, both these entity types have their unique set of advantages and disadvantages that you should be aware of, while deciding which one of the two types is more beneficial for your unique circumstances.

An LLC offers ease of creation, less restrictions on ownership structure, and fewer reporting requirements and corporate formalities. An LLC allows profits and losses to be shared among its members in a manner other than member’s pro-rata ownership in business. Also, a single-member LLC is permitted to report business activities on owner’s personal income tax return rather than filing a separate tax return. A couple of potential downsides of an LLC in comparison to an S Corporation is that you may potentially pay more in employment taxes, and there are some restrictions regarding whom you can sell your business ownership interests to.

An S corporation has restrictions as to who can be an owner and the number of owners there can be. An S corporation requires its profits and losses to be shared in proportion to each shareholder’s ownership in business. In addition, an S Corporation is always required to file a tax return, regardless of income or loss. Shareholders of an S Corporation are required to pay estimated taxes on their income from S Corporation on their own returns. A couple of potential benefits of an S Corporation in comparison to an LLC is that you may potentially pay less in employment taxes, and there are generally no restrictions regarding whom you can sell your business ownership interests to.

The biggest consideration in deciding between an LLC and an S corporation is employment taxes.

An LLC owner is considered self-employed and not required to withdraw a salary. An S corporation shareholder, on the other hand, is not considered self-employed, and is required to withdraw a reasonable salary for his/her time and efforts devoted to the business. In essence, an LLC owner pays self-employment taxes on all profits distributed to him/her, whereas, an S corporation shareholder pays self-employment taxes only on the reasonable salary he/she is required to withdraw. S corporation profits, net of the reasonable salaries paid to the shareholders, are not subject to self-employment taxes.

IRS does not provide specific guidelines as to what is considered as reasonable salary. It is the responsibility of taxpayer to determine that. Factors considered by the courts in determining reasonable salary for employees or officers of an S corporation include duties and responsibilities, training and experience, time and efforts devoted to the business, dividend history, amounts that comparable businesses pay for similar services, etc.

In the end, there is no single right answer to the question as to which one is better – LLC or S corporation. The answer depends on your unique circumstances. Consult your CPA to weigh pros and cons of each entity type and select the one that is best for your situation.

8 Steps to Setting Up Your Payroll System

If you have at least one employee or if you are a self-employed owner of an S Corporation, setting up your payroll system can help you streamline your ability to stay on top of your legal and regulatory responsibilities as an employer. It can also help you save time and protect you from incurring costly Internal Revenue Service (IRS) penalties.

Before setting up your payroll system, make sure you have secured an Employment Identification Number (EIN), aka Employer Tax ID, from the IRS. The EIN is necessary for reporting taxes and other documents to the IRS. Also, check and secure if your state is one of those states that also requires State/Local IDs in order to process taxes.

Here are 8 steps to help you set up a payroll system for your small business:

  1. Know the difference between independent contractor and employee: Whether the person working for you is considered an employee or an independent contractor determines how you withhold federal and state income taxes, withhold and pay Social Security and Medicare taxes, and pay federal and state unemployment taxes.
  2. Take care of employee paperwork: New employees must fill out Federal Income Tax Withholding Form W-4, and its state equivalent if your state requires it, and return it to you in order for you to then start withholding the correct federal and state income taxes from their pay.
  3. Determine pay period: Setting up a pay-period (monthly or bi-monthly) is sometimes determined by the state law with the most favoring bi-monthly payments. The IRS also requires that you withhold income tax for that time period even if your employee does not work the full period.
  4. Document employee compensation terms: As you set up payroll, consider other payroll related items such as how you track employee hours, if you pay overtime, how you handle paid time off, etc. Don’t forget that other employee compensation and business deductibles, such as health plan premiums and retirement contributions, will also need to be deducted from employee paychecks and paid to the appropriate organizations.
  5. Choose a payroll system: Payroll administration requires a great deal of attention to detail and accuracy. Typically, you have two options for managing your payroll – in-house, or outsourced to a local accounting firm or online payroll service provider. Regardless of the option you choose, you — as the employer — are responsible for reporting and paying off all payroll taxes.
  6. Run a payroll: Depending on which payroll system you choose, in-house or outsourced, you will either enter payroll information in a payroll software yourself, or give it to your accountant.
  7. Keep records: Federal and some state laws require that employers keep certain records for specified periods of time. For example, W-4 forms must be kept on file for 3 years after an employee is terminated.  You also need to keep W-2s, copies of filed tax forms, and dates and amounts of all tax deposits.
  8. Report payroll taxes: There are several payroll tax reports that you are required to submit to the appropriate authorities on either a quarterly or annual basis. Check the IRS’s Employer’s Tax Guide for all federal tax filing requirements and the Employer’s Tax Guide for your state for their specific tax filing requirements.

Employment Tax Basics for Small Business Owners

As an employer, in addition to paying your employees salaries, you are also responsible for withholding certain taxes from their gross salary, matching some of the taxes withheld, and paying other taxes from your own funds. To comply with the IRS and state laws, you must then report and deposit these taxes on certain forms and, on, or before certain due dates.

Here is a list of federal and state employment taxes:

Federal Employment Taxes

  • Federal Income Tax: Employers generally must withhold federal income tax from employees’ wages. Use the employee’s Form W-4 and withholding tables to figure out the withholding amount. You must deposit your withholdings; the requirements for depositing vary based on your business and the amount you withhold.
  • Social Security and Medicare Taxes: Social security and Medicare taxes are also known as FICA taxes. Employers generally must withhold a part of social security and Medicare taxes from employees’ wages and pay a matching amount themselves. Use the employee’s Form W-4 to figure out how much FICA taxes to withhold. You must deposit the FICA taxes you withhold. For 2016, the employee tax rate for social security was 6.2%. The social security wage base limit is $118,500. The employee tax rate for Medicare is 1.45%.
  • Additional Medicare Tax: Beginning January 1, 2013, employers are responsible for withholding 0.9% Additional Medicare Tax on an employee’s wages and compensation that exceed a threshold amount, based on the employee’s filing status. You are required to begin withholding Additional Medicare Tax in the pay period in which it pays wages and compensation in excess of the threshold amount to an employee. There is no employer match for the Additional Medicare Tax. 
  • Federal Unemployment (FUTA) Tax: Employers report and pay FUTA tax separately from Federal Income tax, and social security and Medicare taxes. You pay FUTA tax only from your own funds. Employees do not pay this tax or have it withheld from their pay.
  • Self-Employment Tax: Self-Employment tax (SE tax) is a social security and Medicare tax (aka FICA taxes) primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most employees.

State Employment Taxes

  • State Income Tax: Employers generally must withhold state income tax from employees’ wages. Use the employee’s Form W-4, or state-equivalent of Form W-4, and withholding tables, to figure out the withholding amount. You must deposit your withholdings; the requirements for depositing vary based on your business and the amount you withhold.
  • State Unemployment (SUTA) Tax: Employers report and pay SUTA tax separately from State Income tax. You pay SUTA tax only from your own funds. Employees do not pay this tax or have it withheld from their pay.

Employers must deposit and report employment taxes on specific forms and, on, or before certain due dates. At the end of the year, you must prepare and file Form W-2 to report wages, tips, and other compensation paid to an employee. Use Form W-3 to transmit Form W-2 to the Social Security Administration.

DIY Bookkeeping for Small Startup Entrepreneurs

Most small startups can neither afford, nor do they need, a full-time or even a part-time bookkeeper given the size of the business, and the amount of daily business activities during the early stage. If you are one of such small startups, it is important for you as a startup entrepreneur to understand what bookkeeping activities are involved in your business, and learn how to perform many of these activities yourself.

A few preparatory items to take care of before you start doing your own bookkeeping –

  1. Subscribe to an online small business accounting software (QuickBooks, Xero, etc.) and find a local accountant who can help you setup your chart of accounts and beginning account balances, and train you for 3-4 hours on how to use the software for most common bookkeeping activities in your business.
  2. If you are required to run a payroll, outsource it to a local accounting firm. It will cost you between $50 and $100 per pay period if you have less than 10 employees.
  3. Retain a virtual bookkeeper for only 3-4 hours a month to catch and fix your bookkeeping errors, if any, and “clean up” your books at the end of each month.
  4. Read a book on bookkeeping basics if you have time and interest to do so.

Now you are all set to do bookkeeping on your own. Here is a list of most common bookkeeping activities for most small startups, broken down by week, month, quarter, and year.

Daily bookkeeping tasks

  • Check your cash position against the bills coming due in next 30 days
  • Enter customer orders
  • Enter vendor orders

Weekly or bi-weekly bookkeeping tasks

  • Enter customer invoices and vendor bills
  • Enter deposits and payments
  • Enter payables and receivables
  • Enter payroll data received from your accounting firm
  • Deposit Federal payroll taxes and withholdings (if a semi-monthly depositor)
  • Pay any bills due
  • Follow up on any past due receivables
  • Review inventory reports
  • Keep copies of all invoices sent, all cash receipts (cash, check, and credit card deposits), and all cash payments (cash, check, credit card statements, etc.).

Monthly bookkeeping tasks

  • Deposit Federal and state payroll taxes and withholdings (if a monthly depositor)
  • Report and pay any retirement benefits withheld from employee paychecks during the previous month
  • Pay and enter sales tax and other state taxes (monthly filers only)
  • Review A/R and mail reminder invoices as needed
  • Review A/P to find any missing or past due bills to be paid
  • Enter principle and interest on any loan payments
  • Reconcile all bank and credit card accounts. Click Here to learn how to reconcile a bank statement
  • Work with your virtual bookkeeper to “clean up” your books
  • Create monthly P&L and balance sheet statements and compare with budgets and forecasts

Quarterly bookkeeping tasks

  • Pay any balance due on all quarterly payroll reports
  • If FUTA exceeds the threshold for annual filing, pay FUTA tax
  • Reconcile payroll liability accounts against quarterly reports
  • Deposit Federal and State payroll taxes and withholdings (if a quarterly depositor)
  • Pay and enter sales tax and other state taxes (quarterly filers only)
  • Review quarterly P&L and balance sheet statements
  • If you pay estimated taxes, make your quarterly payment

Annual bookkeeping tasks

  • Pay and enter FUTA tax and reconcile all payroll liability accounts for the entire year
  • Pay and enter sales tax and other state taxes (if an annual filer)
  • Verify and update employee withholding and address information
  • Update year-end inventory and capital assets in the books
  • Review status of any owner loan accounts
  • Renew your business registration and licenses, and review your client and vendor agreements
  • Prepare materials for CPA

Since your books were “cleaned up’” each month by your virtual bookkeeper, it will take your CPA less time (hence lower fee) to prepare your year-end financial statements and tax returns.

Protecting Corporate Veil

Many owners of incorporated business entities believe that their personal assets are protected against the debts or obligations of their business, no matter what. While limited liability is one of the principal characteristics of business entities, simply incorporating a business is not enough to protect against personal liability. Once a business is properly incorporated as a separate legal entity, business owners must operate their business as such and follow all the required corporate formalities throughout its existence in order to create a shield, known as “corporate veil”, against personal liability.

Courts across the country recognize a doctrine known as “piercing the corporate veil” which most often arises in connection with a creditor’s attempt to hold corporate shareholders or LLC members personally liable for the debts of their business entity. Courts are likely to allow the piercing of corporate veil and hold the business owners personally liable, if the business entity is found to be simply the “alter ego” of the owners, or when owners disregard the required corporate formalities to the extent that the business entity is no longer distinguishable from its owners.

Here are some practical tips to reduce the likelihood that the corporate veil of your business entity will be pierced:

  1. Make sure your business is incorporated correctly.
  2. Have a separate bank account for your business on its name.
  3. Do not commingle or freely transfer funds between your business account and your personal account, or between your parent company and its subsidiaries.
  4. Do not pay your personal expenses out of the business checking account.
  5. Capitalize your business adequately.
  6. Do not hold the business assets in your name. Hold them in the name of your company.
  7. Do not provide personal guarantees.
  8. Sign contracts and other legal documents as an agent for your business entity. Do not simply sign your name without reference to your business entity.
  9. Observe required corporate formalities such as conducting shareholder and Board of Directors meetings after giving proper notice, keeping minutes of the meetings, issuing stock certificates, etc.
  10. Follow formalities regarding loans to shareholders; have them properly authorized and documented, have arms-length interest rate and terms, and require repayment.
  11. Do not pay loans from shareholders before unrelated creditors.
  12. Make the type of your business entity known via business card, website, invoices, letterhead, etc.
  13. Do not let Parent Corporation control a subsidiary’s operations. Have separate officers and directors for each.
  14. Timely file the annual report with the Secretary of State.
  15. File corporate income tax returns.

Basically, if a court cannot separate what belongs to your business from your personal belongings, and if you cannot provide any proof that all the required corporate and other formalities have been followed, it may be deemed that you are acting more like a sole proprietorship than as a corporation or an LLC, and therefore, you may lose your limited liability protection. Consult with a CPA or an attorney to ensure that your corporate veil is strong. 

“Am I Required To File An FBAR?”

Say you are a United States person who owns or has signature authority over financial accounts outside the United States, and the aggregate amount in those foreign accounts exceeds a reporting threshold amount during any day of the calendar year. In such cases, you are required to report these foreign accounts to the office of Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of the Treasury, by filing the Report of Foreign Bank and Financial Accounts (FBAR).

  • United States person: United States person includes: (1) U.S. citizens (including minor children) (2) U.S. residents (3) Trusts or estates formed under the laws of the United States (4) Entities, including but not limited to, corporations, partnerships, or limited liability companies, that are created or organized in the United States, or under the laws of the United States.
  • Foreign financial accounts: Foreign financial accounts include bank account, brokerage account, mutual fund, trust, cash value of insurance policies and annuities, or other type of foreign financial accounts in a foreign country. The physical location, not the nationality, is considered when determining whether a financial account is a foreign financial account.
  • Aggregate amount threshold: As of 2016, the aggregate amount threshold was $10,000. If the aggregate value of all foreign financial accounts exceeds this threshold amount at any time during the reporting calendar year, you are required to file an FBAR. The foreign currency amounts are converted to U.S. dollars based on the Internal Revenue Service (IRS) exchange rates.

The annual due date for filing an FBAR is April 15 with automatic maximum 6-month extension up to October 15.

Those required to file an FBAR, who fail to properly file a complete and correct FBAR, may be subject to civil monetary penalties. Taxpayers, who have not filed a required FBAR and are not under a civil examination or a criminal investigation by the IRS, and those who have not already been contacted by the IRS about a delinquent FBAR, should file any delinquent FBARs and include a statement explaining why the filing is late. The IRS will not impose a penalty for the failure to file the delinquent FBARs if the following conditions are met:

  • Income from the foreign financial accounts reported on the delinquent FBARs is properly reported
  • Taxes are paid on your U.S. tax return, and
  • You have not previously been contacted regarding an income tax examination or a request for delinquent returns for the years for which the delinquent FBARs are submitted.

Taxpayers with specified foreign financial assets that exceed certain thresholds must report those assets to the IRS on Form 8938, Statement of Specified Foreign Financial Assets, which is filed with an income tax return. Those foreign financial assets could include foreign accounts reported on an FBAR. The Form 8938 filing requirement is in addition to the FBAR filing requirement. To learn whether you are required to file an FBAR, IRS Form 8938, or both, Click Here.

Consult with your CPA to determine whether you are required to disclose your foreign financial accounts, and if so, whether you need to file an FBAR, IRS Form 8938, or both.

Operating Your S Corporation

After your business is allowed to be treated as an S Corporation by the IRS for tax purposes, it is important for you to observe certain corporate formalities and meet specific reporting requirements. This is for you to maintain your S corporation status in good standing and continue to receive the asset protection and tax benefits afforded by the S corporation status.

Here is a list of some of the tasks throughout the year to operate your S corporation properly:

  • Draft and follow bylaws: Bylaws are the rules for the operation and interactions between shareholders. You will need a set of bylaws to show the IRS that your S corporation is distinct from the shareholder as an individual. You should know what your bylaws require, and comply with them before taking any action. 
  • Hold meetings: Generally, S corporations are required to have at least one meeting of stockholders and one meeting of the board of directors each year. Elect directors and officers, issue stocks, and adopt bylaws at initial shareholders meeting.
  • Keep minutes: Draft minutes from the meetings and file them in your corporate book. It is important you hold meetings and keep minutes even if you are the only shareholder in your corporation.
  • Create a stock ledger and a corporate book: A stock ledger is a document that keeps records of the issuance and transfer of all shares, the names and addresses of all current shareholders, the number of shares held by each shareholder, etc. A corporate book houses all corporate documents including your bylaws, meeting minutes, and notices.
  • Setup payroll: S corporation status requires shareholders to determine and withdraw a reasonable salary. Shareholders are required to pay estimated taxes on their income from S corporation on their own personal tax returns. Setup your payroll system to file quarterly payroll reports and make deposits.
  • File tax returns: S corporations are required to file an annual corporate tax return (Form 1120S) even if there was no business activity during the year.
  • File annual reports: This is an annual filing required by the secretary of state to update the information on file for your S corporation. An accompanying fee is required to be paid on an annual basis.

S corporation can be a powerful tool for asset protection and tax savings. However, it comes with additional corporate formalities and administrative costs. Operating your S corporation can be time-consuming and maybe even a distraction from your focus of growing your business. Ask your CPA to help you operate your S corporation properly and handle most of the procedural work.

6 Things to Consider While Selecting a Small Business CPA Firm

For most small businesses, it is more cost-effective to outsource their bookkeeping, payroll, accounting, and tax service needs, to an outside accounting firm than it is to hire the required in-house staff for the same. The key is to find the right accounting firm.

Here are some of the things to consider while selecting a small business CPA firm:

  1. Is the firm specialized in serving small businesses like yours? A CPA firm specialized in serving small businesses is likely to understand and address the challenges unique to small businesses more effectively than a CPA firm that is not. In addition, such a CPA firm is likely to be efficient and agile in serving your needs as its services, processes, and operations are likely to be built just to serve small businesses.
  2. Does the firm have expertise in areas relevant to your needs? Understand your needs first before seeking a solution. For example, if your internal staff handles your accounting and bookkeeping but you need outside help for certain types of taxes, then hire a CPA firm that is expert in those types of taxes, preferably in your industry. If you want to setup a retirement plan for yourself and/or for your employees, hire a CPA firm that is also a financial advisor.
  3. What credentials and licenses in accounting and finance do the firm employees have? Most highly-recognized professional credentials in accounting and finance, such as CPA, CFP, CFA, PFS, EA, etc., have requirements for continuing education and compliance with their standards. This is to ensure that the professional is not only knowledgeable about the subject matter, but also that his/her knowledge is the most up-to-date one. It’s always wise to hire professionals with the highest professional credentials in the field of your needs.
  4. What is the firm’s client callback policy? One of the main reasons to hire a small local CPA firm is the ease of access. Ask whether they have a policy of returning client’s calls within 24 hours and addressing their queries within 72 hours. Also, find out whether they will be available over the weekend for an occasional urgent situation.
  5. Is the firm also skilled in preparing personal tax returns and providing other personal finance services, if needed? Most small businesses are flow-through business entities whereby their business profits and losses flow through their personal tax returns at the year-end. Therefore, as a small business owner, you need a CPA firm that has experts in not only accounting and business taxes but also in personal finances. Such CPA firm applies a holistic view to your finances in devising optimal tax strategies.
  6. Does the firm have a strong referral network for your other professional service needs? For many small businesses, their CPA is their most trusted source for many great referrals. You should be able to count on your CPA for reliable referrals for your other professional service needs such as legal, financing, banking, investment, and insurance. Once you hire the right CPA firm, it should become your primary source for other reliable professionals.

As a small business owner, your CPA should be your most trusted advisor for both your business as well as your personal financial service needs. Do your due diligence while searching for a CPA firm that is right for your needs.