Type of entity to form
I strongly agree with the attorney's that you need to look at the formation of an entity from a personal liability standpoint, but there are also some tax consequences as well. A partnership and an LLC are both subject to self-employment tax on your personal return from the income generated from your business (carried to your personal return on a Schudule K-1). For example, if your business generates $100,000 in net income for a given year to be carried to your personal return as a passthrough activity, you will have to pay additional taxes for self-employment on $100,000. Obviously you get to deduct 1/2 of this amount as an adjustment to taxable income, but in most cases it increases your overall tax liability from 9 to 10%. The formation of a corporation poses a new set of tax consequences. First, corporate tax rates, depending on net income, can be considerably higher than your individual marginal tax rate. Second, any distributions from a corporation are not deductible from the corporations income for tax purposes (a balance sheet item) and are reportable as dividend income to you on your personal return. However, you can form a corporation under the laws of your state and elect to be a Subchapter S corporation under the codes of the Internal Revenue Service. The S corporation's net income is passed to your personal return as with LLCs and partnerships. However, this passthrough income is not subject to self-employement tax. The trick: you have to pay yourself a modest salary through your S corp to satisfy the IRS that you are paying some payroll taxes on your own behalf. However, the IRS does not specify how much to pay. I have found that the IRS will typically agree to an annual salary of somewhere between 20 and 30% of your annual net income from the corporation. The remaining 70 to 80% of the corporation's net income (if cash flow allows) may be taken as distributions. REmember, you are not taxed individually on the distributions, only the net income of the corporation. There are rules associated with the S-Corp, however, that must be considered. For example, you may not have over 75 shareholders. You should seek the advice of a good CPA and a good attorney prior to making the decision for your entity since your decision, in most cases, will be irrevocable (ie. you form an LLC...you cannot convert this to an S-corp without the transfer of assets, which opens a new can of tax worms). There are also issues to look at in the formation of any entity related to estate planning and forming trusts, which a good attorney should be able to help you with
One more thing about avoiding personal liability: keep in mind that the corporate veil (protection for personal liability from your corporation)does not protect you from your liabilities for payroll taxes!
Gregory L. Nowling, CPA
Comer, Nowling And Associates, P.C.
Indianapolis, IN
