Starting a New Business
I haven’t cluttered your inbox with a tax update newsletter lately because, while a lot of tax proposals are floating around Washington, it is all posturing at this point. As things begin to jell somewhat, I’ll resume tracking legislation and report to you what is developing.
The Internal Revenue Service recently released a brief series of tax tips on starting a new business. With the economic and employment outlook still somewhat fluid, I have had several requests recently for help in setting up new ventures. I have put a little flesh on the bones of the Service’s tips and share them with you below:
- Ensure that the activity is truly a business rather than a hobby. For example, do the time, effort, and money you invest in the activity evidence a profit objective. Will you depend on profit from the activity as a reliable source of income? The IRS presumes that an activity is carried on for profit if it makes a profit during at least three of the last five tax years, including the current year (at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses). Early operating losses do not necessarily flag a venture as a hobby, but a continuing pattern of expenses in excess of income may indicate a more personal activity (unless, of course, you are in the automobile business).
- Choose the correct type of business organization for your venture. This typically requires both legal and tax advice. If losses or torts from the activity may subject your personal, non-business, assets to risk of loss, you will probably want a “limited liability” organization. This may be a corporation or a “limited liability company” (LLC). The form of business organization is a state law issue; with the exception of a regular “C” corporation, the choice of entity does not necessarily determine how the venture is taxed. A wholly owned LLC (or one owned only by husband and wife) offers limited personal liability, but is taxed as a sole proprietorship. A business organization with multiple owners is generally taxed as a partnership, but may elect to be taxed as a regular corporation (generally not advantageous). A state law corporation may elect under subchapter S of the Internal Revenue Code to be taxed much like a partnership.
- The type of business you operate determines what taxes you must pay and how you pay them. The primary types of business taxes are income tax, employment tax, and self-employment tax. Regular corporations are income tax paying entities and generally must pay their tax in quarterly installments. S corporations, partnerships, and most LLCs pass-through their taxable income to their owners and taxed at that level. There is no withholding on this income, so quarterly estimated payments are generally required. Businesses generally must withhold federal income tax from its employees’ wages. It withholds part of Social Security and Medicare taxes from your employees’ wages and the business pays a matching amount itself. A business pays federal unemployment tax (FUTA) from its own funds. There is no employee withholding for FUTA taxes. Self-employment (SE) tax is a social security and Medicare tax primarily for individuals who work for themselves (sole proprietorships, partners, and most LLC owners). It is similar to the social security and Medicare taxes withheld from the pay of most wage earners. LLCs pay employment tax on their non-owner employees; LLC owners pay SE taxes.
- All business ventures with employees, corporations, and partnerships are required to have their own employer identification number (EIN). Sole proprietorships and single owner LLCs with no employees may use the owner’s social security number as their EIN.
- Good records will help you monitor the progress of your business (particularly against your business plan), prepare your financial statements, identify source of receipts, keep track of deductible expenses, prepare your tax returns, and support items reported on tax returns. Regular corporations may use any 12-month period as their taxable year. All other types of business entities are typically required to use the calendar year as their taxable year.
These are only brief highlights of some of the federal tax issues to consider in starting a new business. State law and state tax schemes may also affect your choice of entity decision, based on the type of activity you will undertake. A well thought out business plan is a must. You should have it reviewed by experts for legal, accounting, financial, and tax issues. Operating your own business is challenging, exciting, and rewarding. If you are considering starting your own business, discuss these issues carefully with your professional team or visit my web site at www.phdcpa.com and call or email me.
Ronnie
Copyright 2009 Ronnie C. McClure, PhD, CPA