Is the entity you operate your pond construction or maintenance business as, costing you money? Although many of the tax law’s provisions apply to all business entities, some areas of the law specifically target each entity. Thus, choosing among the various entities can result in significant differences in federal income tax treatment.
There is also more to choosing the right structure for a pond-related business than taxes. Not only will the decision have an impact on how much is paid in taxes, it will also affect the amount of paperwork required for your business, the personal liability faced by the principals and, especially important in today’s economy, the operation’s ability to raise money.
The Tax Question
For tax purposes, the main forms of business enterprise are the regular, so-called ‘C’ Corporation, it’s pass-through small business cousin, the ‘S’ Corporation, a partnership, limited liability companies (LLCs) or a sole proprietorship. Of all business entities, however, it is the so-called regular or ‘C’ Corporation that takes the biggest tax bite.
The earnings of an incorporated garden pond business are actually taxed twice. First a corporate income tax is imposed on the pond supply, construction or maintenance operation’s net earnings and then, after the earnings are distributed to shareholders as dividends, each shareholder must pay taxes on his or her share of the dividends.
Naturally, a corporation can reduce, or even eliminate, its federal income tax liability by distributing its income as salary to shareholder-employees who actually perform valuable services for the corporation. Although this can reduce taxation at the corporate level, those who receive profits from a corporation in exchange for services must pay tax on the amount received since it is considered “salary” for tax purposes. Fortunately, there is some relief available to individual shareholders who currently benefit from the new, lower – and temporary – tax rate on dividends.
This scheme of taxation differs radically from that applied to S Corporations, partnerships, LLCs and sole proprietorships. These entities often referred to as “pass-through” entities, do not pay an entity-level tax on their earnings. Only the owners of these entities are taxed on their share of the entity’s earnings or personally benefit from any losses.
Going it Alone as a Sole Proprietor
The easiest structure is the sole proprietorship which usually involves just one individual owning and operating the pond business. The tax aspects of a sole proprietorship are especially appealing because income and expenses from the business are included on the sole proprietor’s personal income tax return.
Of course, as a sole proprietor, a garden pond professional must also file Schedule SE with Form 1040. Schedule SE is used to calculate how much self-employment tax is owed. And, don’t forget that quarterly payments of estimated taxes are due from self-employed pond professionals.
Naturally, there are a few disadvantages. Selecting the sole proprietorship structure means that the owner or proprietor is solely liable for the operation’s liabilities. As a result, a sole proprietor places his or her own assets at risk, subject to seizure to satisfy a business debt or legal claim.
What’s a Rich Best Friend for: Partnerships
If the pond business is to be owned and operated by several individuals, take a close look at partnerships. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the pond supply, construction or maintenance business and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners.
In a limited partnership, the general partner owns and operates the business and assumes liability for the partnership, while the limited partners serve as investors only; they have no control over the operation and are not subject to the same liabilities as the general partners. Obviously, unless many passive investors are involved, limited partnerships are not the best structure to use.
One of the major advantages of a partnership is the tax treatment it enjoys. A partnership does not pay tax on its income but “passes through” all profits or losses to the individual partners. Each partner is required to report profits from the partnership on his or her individual tax return. Even though the partnership pays no income tax, it must complete and file a partnership informational return, Form 1065.
Personal liability is a major concern for many contractors, especially those employing a general partnership. Similar to a sole proprietorship, general partners are personally liable for the partnership’s obligations and debt. Partnerships are also more expensive to establish than sole proprietorships because they require more extensive legal, and accounting services.
Incorporating but Not Protecting
Using the corporate structure for a pond supply, construction or maintenance operation is, as mentioned, more complex and expensive than for other types of business entities. The resulting corporation, however, is an independent legal entity, separate from its owners. As such, the corporation must comply with more regulations and tax requirements.
The biggest benefit for the owner of an incorporated business is the liability protection he or she receives. A corporation’s debt is not considered the debt of its owners. Although the courts are increasingly “reaching behind” the corporate structure, for the most part, a corporation’s debt is not considered to be a debt of its owners.
Another plus, is the ability of a corporation to raise money. A corporation can sell its stock, either common or preferred shares, in order to raise funds. Corporations also continue indefinitely, even if one of the shareholders should die, sell his or her shares or becomes disabled.
The corporate structure also comes with a number of downsides. A major one is higher costs. Corporations are formed under state laws, each with their own set of regulations. A corporation must also follow a more complex set of rules and regulations than other entities such as a sole proprietorship or a partnership. And, don’t forget another, major downside: the taxes paid by both the incorporated business and the owner/shareholder when profits are distributed.
Not Always Small S Corporations
An S Corporation is merely an incorporated pond business that has chosen to be treated as a partnership for tax purposes. It offers some appealing tax benefits while still providing its owners with the liability protection of a corporation. The income and losses of an S Corporation is passed through to its shareholders, and included on the shareholder’s personal tax return. As a result, there is just one level of federal tax to pay.
On the downside, S Corporations are subject to many of the same requirements that corporations must follow resulting in higher legal and accounting fees. The S Corporation must also file articles of incorporation; hold directors and shareholders’ meetings; keep corporate minutes; and allow shareholders to vote on major corporate decisions.
Another major difference between a regular corporation and an S Corporation is that S Corporations can only issue one class of stock despite the limit of having up to 100 shareholders. Experts say this can hamper the pond operation’s ability to raise capital.
No Limits to the LLC
While S Corporations remain the most-used separate entity for small businesses, the Limited Liability Company, or LLC, is a fairly recent phenomenon. An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations.
LLCs were created to provide business owners with the liability protection that corporations enjoy – without the double taxation. The earnings and losses of an LLC pass through to the owners and are included on their personal income tax returns.
Although it sounds similar to an S Corporation, the LLC has no limit on the number of shareholders. In fact, any LLC member or shareholder has a full participatory role in the business’s operation.
Like partnerships, LLCs do not have perpetual life. Some states stipulate that the business must dissolve after 30 or 40 years. Technically, a LLC dissolves when a member dies, quits or retires.
Despite its popularity and attractions, LLCs also have disadvantages. Since an LLC is a relatively new entity, its tax treatment varies by state.
The annual tax return provides one incentive to re-consider the options available to your pond business. Entities with more than one member can elect corporate status on the annual tax returns. Thus, an entity that is a partnership under state laws may choose to be taxed as a “C” Corporation, or as an S Corporation, for federal taxes by using Form 8832 (Entity Classification Election). Unfortunately, under those so-called “check-the-box” regulations entities formed under a state’s corporate laws are automatically classified corporations and may not elect to be treated as any other type of entity.
Changing circumstances, changes in the tax laws, and even the success of the pond business might prompt a reassessment of the form the business operates under. It makes sense to ensure you are using the best entity to provide your business – and yourself – with the most benefits and consistently lowest tax bill. To help in this decision-making process, professional advice is strongly recommended.