Dear Clients and Friends,
When one professional service provider or a group of professional colleagues decide to go into business for themselves, there are a host of significant legal and tax implications to consider. These range from choosing the best type of entity for the new practice, to setting up a qualified retirement plan, to taking advantage of year-end tax planning opportunities. This release highlights some key issues that are likely to affect professional startups.
Conventional wisdom says incorporating is a great idea because a corporation protects the owner's personal assets from business-related liabilities. As a result, many professional startups begin their lives as C or S corporations without much thought being given to the matter. However, conventional wisdom is wrong on two counts. First, incorporating generally will not protect a professional's personal assets from liabilities related to his own professional malpractice. Liability exposure in this scenario is a matter of state law, but generally no type of Liability Limiting Entity (LLE) will offer any protection. (The same may be true when malpractice is committed by another person who is under the professional's direct supervision.) Nevertheless, it's still advisable to set up an LLE to protect the professional's personal assets from other business-related liabilities, such as those caused by employees and by the malpractice of other persons. Second, there are some unincorporated LLEs that are suitable for professional practices. These entities are often more appropriate than corporations.
Here are the choice-of-entity options for professional startups.
Single-Member LLCs (SMLLC). For solely owned operations, all states now permit single-member LLCs (SMLLCs) for most types of professional practices. Under the federal tax rules, the existence of the SMLLC is ignored. It's treated as a so-called disregarded entity (unless an election is made to treat the SMLLC as a corporation, which will seldom be advisable). Therefore, an SMLLC used to operate a one-owner professional practice is treated as a sole proprietorship. The owner simply files Schedules C and SE with Form 1040. In effect, this is pass-through taxation in its most simple form. (Simple is good here!) Despite being invisible for federal tax purposes, the SMLLC still exists for state-law liability protection purposes, assuming applicable legal requirements are met.
Note: SMLLCs may be unavailable for certain professional practices under applicable state law and/or professional standards. Also, in a few states, SMLLCs are subject to entity-level state taxes. For example, Texas subjects SMLLCs, but not sole proprietorships, to the state's corporate franchise tax.
Multimember LLCs and LLPs. For professional groups, the unincorporated LLE options are multimember LLCs and Limited Liability Partnerships (LLPs). Both are now available in all 50 states, and both are treated as partnerships for federal tax purposes (unless an election is made to treat the LLC as a corporation, which will seldom be advisable). Therefore, favorable pass-through taxation applies. However, once again, LLCs may be unavailable for certain professional practices under applicable state law and/or professional standards. Also, in some states, LLCs and LLPs are subject to entity-level state taxes. For example, Texas multimember LLCs and LLPs are hit with the state's corporate franchise tax. LLPs are always treated as partnerships for both federal and state purposes, and they are expressly intended to be used by professional groups. With an LLP, however, the exact degree of liability protection offered by the entity is a key consideration. This is because some state's LLP statutes protect LLP partners only against liabilities related to the professional malpractice of other partners and firm employees (so-called vicarious liabilities). In most states, however, LLPs offer protection against essentially all of the firm's liabilities (similar to the protection offered by a corporation or LLC).
C Corporations. Setting up one or more professionals as shareholder-employees of a C corporation will typically maximize the availability of tax-advantaged fringe benefits for the ownership group. However, the taxable income of the corporation must be managed carefully to avoid the dreaded problem of double taxation. Typically, avoidance is achieved by "zeroing out" the corporation's annual taxable income via deductible salaries, year-end bonuses, and benefits provided to or on behalf of the shareholder-employee group.
Remember: C corporations that meet the definition of a Personal Service Corporation (PSC) are ineligible for the graduated corporation rate schedule. Instead, PSCs pay a flat 35% federal rate on all taxable income [IRC Sec. 11 (b X2)].
S Corporations. S corporations avoid the double taxation problem because they are pass-through entities (as are partnerships and LLCs). However, strict qualification rules must be met for a corporation to elect and maintain S status and thereby gain the advantage of pass-through taxation. These restrictions can make S corporations very unwieldy for professional groups.
Note: In contrast, LLCs and LLPs qualify for pass-through taxation with no muss and no fuss. The partnership tax rules, which apply to multimember LLCs and LLPs, are also much more flexible than the S corporation rules. Furthermore, from a liability protection standpoint, S and C corporations are identical. The only difference is how they are treated under the tax rules. For these reasons, S corporations are seldom advisable for professional practices.
Say the new professional practice will be operated as a sole proprietorship, or as an SMLLC treated as such for federal tax purposes, or as a husband-wife LLP, or as a husband-wife LLC treated as a husband-wife partnership for tax purposes. In these scenarios, the business can hire the owner's under-age-18 child as an employee, and the child's wages will be exempt from Social Security and Medicare taxes (collectively referred to as FICA tax in this discussion). [See IRC Sec. 3121(bX3XA).] In addition, there's no FUTA tax on the child's wages if she is under age 21. [See IRC Sec. 3306(c)(5).] In turn, the child can shelter up to $5,800 of her wage income (for 2011) from the federal income tax with her standard deduction. Thus, hiring the owner's child will deliver all of the following tax advantages:
The owner gets a Schedule C or E deduction for wages paid to the child, which yields the owner an income tax benefit that depends on his marginal tax rate and SE tax savings of either 13.3% or 2.9% for 2011 (15.3% or 2.9% after 2011 assuming the 2% FICA tax reduction is not extended).
The wage deduction reduces the owner's AGI, which increases the likelihood that he will: (1) qualify for tax breaks subject to AGI-based phase-out rules (such as the education tax credits and the $25,000 exception to the passive loss rules for rental real estate) and (2) avoid unfavorable AGI-based limitations (such as the ones that limit deductions for medical expenses and charitable contributions).
No FICA or FUTA taxes are due on the child's wages.
The child can often shelter most or all of her wages from the federal income tax with her standard deduction. Any unsheltered wage income is likely to be taxed at only 10% or 15%.
Hiring the owner's children can also make sense when the new professional practice will be operated as a corporation or in any other form that's not treated as a sole proprietorship or husband-wife partnership for federal tax purpose. In this scenario, the child's wages will be subject to FICA and FUTA taxes, just like for any garden-variety employee. But, the wages will be deductible on the entity's income tax returns, along with the employer's share of FICA tax and the FUTA tax. Also, the child's standard deduction will shelter some or all of her wages from the federal income tax. So the tax advantages are still substantial. The only catch is that the child's wages must be reasonable in relation to the actual work performed. This technique works best with older children who can deliver services worth more than the minimum wage. For example, some teenagers can function as junior computer consultants and be paid an hourly rate that reflects a high-skill level.
Professional practices can use cash method accounting for federal income tax purposes. This opens up yearend tax planning opportunities. Taxes can easily be deferred by: (l) postponing billings until after year-end and (2) accelerating deductible expenditures into the current year. Professional practices can also take advantage of the Section 179 deduction (up to $500,000 for 2011) and 100% bonus depreciation for 2011 by acquiring new business equipment and software and placing it in service before year-end. For practices run as C corporations, year-end tax planning primarily involves making enough deductible expenditures to "zero out" the corporation's taxable income each year to avoid double taxation. Generally, this is done by paying year-end bonuses to shareholder-employees. The bonuses must represent "reasonable compensation" when added to shareholder-employee salaries and any company-paid benefits. However, with a professional practice, proving reasonable compensation is seldom a problem, unless the corporation generates meaningful taxable income from the efforts of employees who are not shareholders or from other activities beyond the pure delivery of professional services by the shareholder-employee group.
Obviously, this discussion only scratches the surface, but you get the idea. Give us a call if we can be of service.
Daniel A. Kosmatka Donnelly , CPA, PFS, CFF
Dennis W. Donnelly, CPA, PFS
Michael R. Gohde, CPA, PFS
_____Check for Noncompete Agreements: If you previously worked as an employee, make sure you did not sign anything that prevents you from dealing with your former employer's clients who are now being counted on as revenue sources for your new practice.
_____Continue Your Health Insurance: It often takes time to find private health insurance at a price you are willing to pay. Unless your spouse can provide coverage through his or her employment, you should continue your existing coverage under your former employer's group plan by making a COBRA election within 60 days of the date your group coverage ceases. If the COBRA election is made within this period, coverage is extended retroactive to the date it would otherwise lapse (and you must pay the premiums back to that date). Generally, coverage is continued for 18 months at a cost of 102% of the cost to your former employer. The cost may be higher than you expect, but making the COBRA election assures you of continuing coverage while you look for replacement insurance.
_____Make Other Insurance Arrangements: Contact your property and casualty insurance company to find out what you need to do to insure any business assets and insure yourself against liabilities caused by your 'new business activities. Have a detailed discussion with your agent about issues such as whether you will have employees or independent contractors and what kinds of activities their jobs will entail. Are you insured against accidents that might occur in an office in your home? Many homeowner policies exclude coverage for business-related liabilities and provide only minimal coverage for business assets kept in your house. You should also make sure your liability limits are adequate in light of your new business activities. Some professional associations offer relatively cheap "umbrella liability" policies that provide excess coverage over and above your primary liability policy limits. You also probably need disability insurance to protect against loss of income if you become injured or disabled. Finally, you will probably want to replace any term life insurance coverage that is lost when you quit your job. The best deals are often through professional associations.
_____Arrange for Credit before You Quit: Even though you may have excellent credit, the change in your status from employee to being in business for yourself can make borrowing much more difficult-until you have a proven track record. If you have a foreseeable need to buy a new house or car or make other major purchases that will require significant borrowing, do these deals before you quit your job. If you are considering refinancing your home, do it now. Even if you don't think you will need the money, it is also a good idea to consider taking out a home equity loan or home equity line of credit now. This can provide some cushion if your business expenses tum out to be higher than expected or if revenues don't come in as quite as fast as you expect. (If it turns out you really don't need the money, you can always pay back the loan.) For the same reasons, arrange for a line of credit or overdraft protection at your bank. Again, do this before you quit your job. Strongly consider any other measures you can take to increase your borrowing power (including making informal arrangements with relatives), just in case you get off to a slower than expected start in your new business. You will have enough to worry about in the first few months-you don't need a cash crunch on top of everything else.
_____Conserve Cash: Before you actually quit your job and for the first few months after you go into business for yourself, minimize your cash outlays so you can build up a margin for error. In the early months of a new business, cash flow is often less than expected because of time spent in startup activities that don't generate any revenues and because at least some of the anticipated work fails to materialize. In addition, clients don't always pay as quickly as you would like. You may also have underestimated your expenses. The way to deal with all this is to (1) postpone spending money on things that are not strictly necessary (such as vacations) and (2) use your credit judiciously. Don't be afraid to put necessary expenditures on your credit cards in order to conserve cash. You can always payoff the balances as soon as cash flow permits. If you know youll need to purchase office equipment or furnishings, buy it on credit before you quit your job.
_____Understand the Liability Issues: Discuss state-law liability issues with a competent business attorney. Ask your tax adviser to participate in the conversion, because legal and tax issues are interrelated.
_____Choose Your Business Entity Wisely: The question of what type of legal entity (corporation, Limited Liability Company, etc.) is best for your new business also depends on both legal and tax considerations. Your attorney and tax adviser should both be involved in helping you make the choice-of-entity decision. Get Startup Tax Planning Advice: Often, what you do (or dont do) when you begin your new professional practice can help or hurt your tax situation for an extended period. For this reason, you should seek up-front tax advice about the following issues (this is not an exhaustive list):
Avoiding double taxation if your business will be incorporated.
Installing a retirement plan and other tax-favored fringe benefit programs for the owner(s).
Avoiding unnecessary employment or self-employment taxes.
Making critical federal income tax elections in the first year of business (such as elections to amortize startup costs, immediately deduct the cost of new equipment, and use the cash method of accounting).
Implementing various other strategies to minimize taxes on both you and your business entity. Important: Don't assume you can wait until the end of the year (or even worse until tax return filing time) to handle all your tax planning needs. By then, it may be too late to benefit from all the potentially available tax breaks and avoid all the tax pitfalls. This advice is especially important if your new practice will be run as a corporation because transactions between corporations and shareholders almost always have tax implications. These should always be assessed ahead of time rather than after the fact.
References: IRC Secs. 11(b)(2), 3121(b)(3)(A), and 3306(cX5). Subscriber Note: This Tax Action Memo was written by Senior Manager, Robin Tuttle Christian, CPA. Ms. Christian is Managing Editor of this publication as well as a coauthor and contributing editor of several PPC publications.