Did you say I can avoid making a $100,000 mistake?

No, that is not a typo – Business owners frequently make a $100,000 Mistake and don’t even have a clue!

How is that even possible? I see it when people have gone for years in the wrong legal structure for their business, and it costs them big. You may think I’m exaggerating, but sadly, I’m not!

What If You Fall Short When Choosing a Proper Legal Structure?

If someone is in the wrong entity for their situation, it can easily cost them $10,000, $20,000, or even more every year.

After a few successful years in business, this adds up with the money, not in their pocket but going out that backdoor. They’re working so hard but wondering why they are successful but broke.

I see it often. Recently, Mark came to me, and after we worked together, he saved $25,000 per year, and now he can save that next year and every year after that. Connie came to me, and she could save $23,000 per year by restructuring. Renee had overpaid her taxes by $34,000 in the past two years because her business was not in the most favorable structure for her situation. And I could go on and on.

So you see how in just a few years of operating your business with the wrong strategy? It could easily cost you $100,000 or more in just a short time.

Picking the Right Entity Matters

Now you see why it is so essential for us as business owners to choose the best legal structure for our situation. When setting up your business, you have a choice of legal form. Yet, most people start and run their businesses without even a basic understanding of the choices they have that can make such a dynamic impact on their business and their finances.

Most of us don’t want to think about it; we want to run our business doing what we love. However, with the wrong choice of entity, we now know it can all run into the ground.

Many people don’t realize that what they’re doing is creating an effect on their situation, not by an intentional choice, but by failure to act, inaction, or neglect. Default is what happens when you fail to make a choice. The fact is, if you don’t make a choice, an alternative is made for you. And chances are that that creates something that is not likely to land in your favor, which I see happen as most of these defaulting entities are inappropriate for what is best for that individual situation.

A little education can go a long way. Bear with me as I explain some legal mumbo jumbo. I will put it, and it will be worth your while.

The Basics of Creating a Proper Business Entity

When you create a business, you create an entity. Even if you don’t think you did, It happens by default. Starting a business entity is a separate discussion from what you are naming your company, though people think it is one of the same.

We are focusing here on the legal structure as it affects your business.
But what is an entity?

According to Webster, in a business sense, it is an organization with an identity separate from its members.

You should be familiar with the most popular types of for-profit entities you will likely choose for your business structure.

These are:

• Sole proprietorship
• Partnership
• C-Corporation
• S-Corporation
• Limited liability companies (or LLCs)

There are advantages and disadvantages to all business structures. Understanding the complexities of these structures and the tax laws relating to each can be challenging.

What is best for your business even when you understand these variables?

It is not a one-size, fits-all choice. Before making your decision, evaluate the pros and cons of each entity type with a business professional to determine which structure makes the most sense for your unique business circumstance.

Sometimes, it is advantageous to have a combination of entities to align more pros to your advantage in your personal, financial, and business situation.
As a business strategist, I do many of these with great resolve. But for most of you here, you will appreciate me keeping it simple, at least for now. Just know that there are extended possibilities for situations that need expanded solutions. Let’s examine the legal structures you can choose for your business.

Sole-Proprietorship

A sole proprietorship is the most common and simplest form of business.

In a sole proprietorship, a single individual engages in a business activity without the necessity of a formal organization. A sole proprietorship is reported for taxes on Schedule C of your personal 1040 tax return. Moreover, it is subject to self-employment taxes on profits over $400.
As you learn about it, self-employment tax can be your number one tax-paying nightmare.

A sole proprietorship offers you no liability protection. Liability protection is more needed in some business situations than others. The higher risk of your profession, the more likely it is required. Consult with your attorney to see if your assets are covered.

Partnership

A general partnership is created when two or more people associate to carry on a business for profit. A partnership generally operates by a partnership agreement, but there is no requirement that the deal is in writing and no state filing requirement. A partnership is reported for taxes on a 1065 tax return, and partners receive a K-1for tax reporting.

It is considered a flow-through entity, meaning the partnership does not pay taxes, and the income flows through and is taxed on your tax return.

A partnership could be subject to self-employment taxes on profits depending on the business activity. A partnership offers no liability protection, which is not a significant problem for those with no assets to protect or a business that has minimal liability. However, always consult your attorney to see if you are at risk.

Corporations

Corporations are known as “legal fiction.” The government recognizes that individuals must take risks to begin a business.

Corporations are legal vehicles for individuals or groups to do business. To allow individuals to take those risks and not risk losing all their assets, the government has allowed for a business organization called a corporation.

A corporation is formed by a combination of legal paperwork and the actions of the business that make it compliant and qualify it to be recognized as a corporation.

Corporations are treated as separate from individuals for contracts, liabilities, and taxes. In short, the owners of corporations have limited liabilities using the cover of the corporation.

In other words, if one creates a corporation under most circumstances, the most they can lose is their initial investment in that corporation. Elections can be filed within specific windows to change how the corporation will be taxed.

C-Corporations

All corporations start as C-Corporations, and a C-Corporation is reported for taxes on an 1120 tax return. A C-Corporation pays taxes on its income and is not a flow-through entity.

A C-Corporation can have a traditional calendar year for its accounting and tax filings, but a C-Corporation has a unique option to select a different date range to file its taxes.

This election is called a fiscal year.

A fiscal year means instead of having a traditional calendar year of January 1st to December 31st, they can have but may choose a different starting and ending date for their tax year if they desire.

For instance, in my portfolio, I have a C-Corporation with a fiscal year that begins on July 1st and ends on June 30th.

Having a unique fiscal year can be more complicated, but it offers certain benefits in specific circumstances that make it worth the extra effort.

Now, it is helpful that you know this option exists, but at this point, you need not worry about it unless a professional recommends it.

S-Corporations

An S-Corporation is a C-Corporation that has made a special election to be taxed as an S-corporation by filing special paperwork to elect that with the Internal Revenue Service.

An S-Corporation is not a matter of state corporate law but an election made strictly for preferential tax treatment. It operates on calendar year only from January 1st to December 31st and does not have the fiscal year option as discussed with the C-Corporation.

An S-corporation is reported for taxes on an 1120-S tax return.
It is considered a flow-through entity and therefore does not pay tax itself; though there are penalties for not filing, they can be stiff.
The S-corporation’s income is included on the shareholders’ personal 1040 tax return.

Limited Liability Company or LLC

I feel that the LLC is the most misunderstood entity of all.
It is not a partnership or a corporation but rather a distinct type of entity that has the powers of both a block and a corporation.
The LLC has unique features that, when used properly, are excellent.

But it can also be very problematic when it’s not considered from all viewpoints. This seems to happen more times than not.

An LLC is not a recognized entity by the IRS. An LLC can be taxed in four different ways. If you call the IRS and tell them you have an LLC and ask what tax form to file, they cannot answer your question without more information; I have found that about 70% of LLCs are taxed incorrectly for the situation for which it was created. Though attorneys love them, I will rarely recommend an LLC.

We won’t get into the reasons here because my senses do not apply to everyone’s situation.

Suffice it to say that when this is the case, I am very opinionated on this subject, and usually, attorneys will agree with me when we have that professional discussion.

I will be delighted to debate the issue with you individually as it applies to your situation.

In the meantime, you need to remember two things:
One, check with the IRS and make sure your LLC is taxed the way you intended it to be.

Two, when you select a specific tax treatment, you must operate your company like that structure, or the IRS will disregard your tax election.

Avoiding the $100,000 Pitfall

When choosing your legal entity type, it is essential to have an educated involvement.

Do not follow the crowd or agree to a particular type without fully understanding why and asking the necessary questions.

Remember, if you don’t make an intentional choice, you may unintentionally make Uncle Sam your favorite charity — and he is not tax deductible!

Now you see, it’s relatively easy to make that $100,000 mistake and not even know it.

You ask, “How can I be sure to avoid it?”

The first step is to be aware of what legal entity you are now.
The second step is to educate yourself on the options and compare these to the ones which you currently are.

And the third step is to apply the correct choice to your life. Doing so will require the help of the right expert.

Professional Advice is a Life Saver!

Sometimes you need an attorney, and sometimes you need a tax expert or a business strategist, and sometimes a coach. But it can be costly to skimp on your professional advice.

My father would say, “Don’t be pennywise and pound-foolish.”
At the same time, make sure your expert is proactive in advising you. Beware that not all professional advisors are created equal.

Even with the absolute best advisor, none of them live your life. So, it is up to you to communicate your circumstances properly to them.
You must take a bit of ownership and educate yourself.

Do not accept everything they say as gospel. A second or third opinion may be needed.

And keep in mind, as your business grows, your structure may need to be adjusted. Consult with an expert whenever you have a shift in your business situation, personal situation, or income.

Hopefully, it is obvious to you that it is well worth ensuring you are always in the proper structure and for the best fit in your current circumstance.

Choosing the correct legal entity for your business is just one of many business red tapes you need to untangle. Call Business Untangled and learn how you can avoid costly pitfalls and put more money into your pocket!