Business Entity Choosing the form of entity under which a business will operate is the first important decision a business owner will make. The three variables to help you determine which option is right for you are business control, owner liability, and tax implications.
Forms of business entity are:
- Sole Proprietorship
-Limited Liability Company
Sole Proprietorship. A sole proprietorship has a single owner and is the most simple entity type. The benefits of the sole proprietorship are its ease of implementation and lack of regulatory requirements. It allows complete business control to a single business owner (proprietor). It requires the business owner to file a Schedule C (profit or loss from a business or profession) with their personal income tax filing. The proprietor personally assumes all liability and business risk, which can often be "transferred" through the purchase of liability insurance.
Partnership. The main difference between the sole proprietorship and the partnership is the number of business owners. Although quite easy to establish, it is a good idea to begin a partnership with a formal arrangement known as the partnership agreement. The partnership agreement sets forth the intent of the business owners in the event of a wide variety of business events such as the sale of the entire business, the sale of a single individual's holdings or the disposition of ownership in the event of the death of a partner.
Like the sole proprietorship, the partnership represents a "flow-through entity" where both cash flows and tax liabilities flow through to the business owners. The partnership provides its owners minimal protection from business risk.
C-corporation. Though often costly and time-consuming to establish and maintain, the C-corporation provides the greatest amount of liability and business risk protection to the business owner(s). Strict governmental regulations outline company structure, reporting, and disclosure requirements.
Corporations have unlimited lives with ownership rights passing to designated heirs upon the death of an owner. The corporate entity also has a great deal of income tax flexibility and can offer the broadest array of tax deductible benefits, but may also trigger "double taxation" of some corporate profits as they are taxed at the corporate level as profits and again, potentially, at the individual level as taxable dividends are paid to shareholders.
S-Corporation. The "S Corp" functions as something of a hybrid, assuming many of the best features of several other entity types. The S Corporation is a legal entity that offers owners the benefits of greatly limited liability, while allowing company profits or losses to flow directly through to the business owners for income tax purposes, thus avoiding potential double taxation. The legal requirements and costs associated with starting an S Corporation are modest, as are the regulatory requirements. There are limitations on the number of owners within an S Corporation, and a C Corporation may not be an owner.
Limited Liability Company. Like the S Corporation, the Limited Liability Company (LLC) combines many of the benefits of other entity types. In contrast to the proprietorship and partnership, the LLC provides its owners (or members) with limited liability for the debt and business risk associated with ownership. The LLC also avoids the "double taxation" of the corporation by functioning as a "flow-through entity" for income tax purposes.
Protecting Against the Loss of Key Employee The vast majority of small-business owners accept the wisdom of insuring the firm against the loss of its property values. We take care to insure the physical assets against fire, tornados and other disasters. Yet, protection from the loss a key executive may be far more important.
First, the probability of losing a key employee is far greater than a loss due to fire. It has been estimated that the chances of death of a key executive is 14 times greater at age 45, 17 times greater at age 50, and 23 times greater at age 55 than a loss caused by fire. Further, about one out of every three individuals dies in the working period of life with a consequent loss to his or her business.
Second, the loss due to a fire is temporary. Plants and factories can be rebuilt. Inventory can be replaced. The new building is likely to be more useful and valuable than the old one. On the other hand, a new hire may need several months or even years to become as productive as her or his predecessor. In fact, the deceased employee may prove impossible to replace.
Who Is Key? Every corporation has at least one key executive or an employee who makes a substantial contribution to the operation, profitability and success of the business. Any individual who has critical intellectual information, sales relationships, bank relationships, product knowledge, and/or industry contacts that may adversely affect profits in the event of their absence, may be considered key.
The Role of Key Person Life Insurance Although life insurance cannot ever fully replace the value of a key employee, it can indemnify the business for the financial setbacks that can occur. The proceeds from the life insurance policy can help ensure a smooth transition following their passing. Life insurance can provide the business with needed funds to keep the business running, to assure creditors that their loans will be repaid, to assure customers that business will continue operations, to cover the special expenses of finding, hiring, and training a replacement.
How This Strategy Works There is no particular form of agreement or special contract needed by the business to obtain key employee insurance on an executive or owner. However, the board of directors should authorize the maintenance and payment of the policy.
The applicant is the company. The application is signed by an officer of the business other than the insured party. Generally, the premiums will be paid by the business on an after-tax basis and are not deductible as a business expense. The business will be designated as the beneficiary and the insurance proceeds received upon the death of a key executive are not subject to federal income tax.
Qualified Retirement Plans for Small Businesses For the small-business owner, attracting and retaining valuable employees can be a daunting challenge. One way to make working for your business more attractive to current and potential employees alike is to implement a qualified retirement plan for you and your employees. Besides greater appeal to your workers, qualified plans can also provide you with numerous tax advantages, including:
- Contributions for all participants are 100% tax-deductible to the business up to certain limits.
- Annual contributions by the business are not considered taxable income to the plan participants.
- Capital gains and interest earned are deferred from taxation during the accumulation years.
- Income taxes are payable upon withdrawal.
-At retirement, favorable tax treatments may apply such as spreading payments over the participant's lifetime and special averaging formulas.
Non-Tax Advantages In addition to the obvious tax and employee hiring/retention advantages, there are many other, equally important, reasons to implement a qualified plan. For example, plan assets are creditor-proof. The assets of the plan are not subject to malpractice lawsuits or bankruptcy rulings.
These and other advantages combine to help improve morale as the participants realize that their company provides the mechanism to help secure their retirement.
Types of Plans The two most common types of qualified retirement plans are pension and profit-sharing plans. A business can also sponsor an IRA or SEP (simplified employee pension plan).
Pension Plans. There are three major types of pension plans -- defined benefit, money purchase, and target benefit.
- A defined benefit plan is one where the retirement benefit is determined by a plan formula - usually based on years of service.
- A money purchase pension plan is one where the plan formula specifies the percentage of each participant's compensation that will be contributed each year.
- A target benefit plan is a hybrid. It starts out as a defined benefit plan, which determines the benefit. Once the benefit is calculated, the plan converts to a defined contribution or money purchase plan.
Profit-Sharing Plans. The most popular type of profit-sharing plans is 401(k) plans. Elective deferrals amount to these plans are limited based on age, including catch-up provisions. Annual contributions to a profit-sharing plan are generally not required; instead, they can be discretionary each year.
Implementing a Cafeteria Plan in Your Business Internal Revenue Code 125 allows an employer to implement an employee benefit plan, which allows employees to select the benefit programs they prefer.
The plan offers the employee to choose from the "menu" of benefits available. It's sort of like ordering lunch from the restaurant - which is why the plan is referred to as a "cafeteria plan"!
Cafeteria plans, along with 401(k)s, are among the most popular employee benefit plans of the past decade. The tax benefits to the employer and employees far exceed the minimal required government reporting.
Cafeteria Plan Benefit Options
In general, the IRS allows the following benefits to be present in a Section 125 plan:
- Group-term life insurance (up to $50,000; amounts above that level of death benefit may be subject to Social Security and Medicare taxation)
- Accident and health plans
- Long- and short-term disability benefits
- Flexible spending accounts to save for health, medical, and childcare expenses
- CODA [401(k) plans]
- Dependent group life, accident, and health insurance coverages
Employee Tax Aspects
The plan essentially allows expenses that normally would be paid by the employee on an after-tax basis to be paid via salary reductions on a pretax basis. This allocated income will not be subjected to FICA or income taxes. The result is that taxable dollars have been converted to nontaxable dollars - thereby increasing the employee's take-home pay.
Employer Tax Aspects
Generally, employer contributions to a plan are income tax deductible. In addition, contributions on behalf of the employees, if such contributions are not included in the employee's income, are not subject to FICA (Social Security) or FUTA (Federal Unemployment Tax Act). This can result in significant savings to the company's bottom line.
The employer must file an annual information return (IRS Form 5500) stating plan participation, cost and business type.
An important point for the employee to remember is that there can be no claim of any unused benefits or contributions from one plan year to the next. This is known as the "use it or lose it" rule.
Many employees steer clear of these plans because of this rule. You have to decide up front how much to put in the plan and if you don't spend it all within a year, you forfeit the leftover amount.
Sounds risky - at least until you consider that the tax breaks are so powerful that even if you wind up forfeiting 20% of what you put into a plan, you'll still come out ahead.
For example, let's say you set aside $5,000 for medical expenses in 2007 and wind up spending just $4,000. At face value, you've lost $1,000. But consider: If you're in the 25% federal tax bracket and face a 5% state income tax as well as the 7.65% Social Security and Medicare tax, the $5,000 you put in the plan will save you more than $1,800 in taxes, leaving you $800 ahead. Put another way, you'd have to earn almost $6,300 to have $4,000 left over to pay those bills. Even if you forfeit $1,000, you still come out ahead. That's why it's wise to be aggressive in using flexible spending accounts.
Deferred Compensation In addition to providing qualified plans to employees, many business owners implement nonqualified alternatives in order to supplement retirement benefits. These selective benefit plans are generally offered to key employees and owners. One popular nonqualified benefit is deferred compensation.
Basically, nonqualified deferred compensation refers to an arrangement between an employer and an employee in which compensation for current services is postponed until some future date or the occurrence of a future event. The effect is to postpone taxation for the employee until compensation is received - usually at retirement or disability.
Types of Deferred Compensation Deferred compensation plans can be categorized several different ways. Plans can be:
- Funded or unfunded
- Forfeitable or nonforfeitable
- Defined benefit or money purchase
- They can also provide one or a combination of death benefits, disability benefits and retirement benefits.
Funded plans generally involve a trust fund or escrow account where the employer transfers money at a later date for its "promise to pay" deferred compensation. These are not very popular as the participant may be deemed to have "constructive receipt" of such funds and therefore inherits a current tax liability when funded.
IRS Revenue Ruling 60-31, 1960-2 CB 174, states that an employee's right to receive deferred compensation, backed during the deferral period solely by an employer's "naked promise" to pay, produces no currently taxable income for the employee. A deferred compensation plan is not regarded as funded merely because the corporation purchased and owns a life insurance policy or annuity contract to make certain that funds will be available when needed.
Rabbi Trusts One of the problems with a typical unfunded deferred compensation plan is that the employee has no guarantee that future payments will be made. If the employer defaults in making promised payments, becomes insolvent, or files bankruptcy, the employee simply becomes a general creditor waiting in line with all the other creditors hoping to recoup some of their receivables.
The rabbi trust protects an executive from an employer's future unwillingness or inability to pay promised benefits while retaining the benefits of deferred income taxation. The IRS has stated in a series of private letter rulings that an irrevocable trust or an escrow account can be established to fund a deferred compensation agreement as long as the assets placed into the rabbi trust remain subject to the claims of general creditors. If this condition is met, the employee will not be deemed to have "constructive receipt" of the assets, and, therefore, will not have received a current economic benefit. Hence, the employee will not be required to pay taxes until the payments are made at a future date.
The rabbi trust gives the employee security in knowing that the employer is, in fact, setting aside money to fulfill its obligation under a deferred compensation agreement.
Choosing the Right Continuation Plan for Your Business The death of a major shareholder in a closely held corporation can seriously interrupt the continuity and profitability of the business. Surviving shareholders must struggle with how to continue the company as a profitable business with the loss of a key player. Heirs must concern themselves with how to replace the income that the shareholder had earned and how to extract their inherited portion of the company value.
To reduce potential areas of conflict and realize a smooth transition, company owners should enter into an agreement while the parties are still living. This is called a buy-sell agreement. Stock purchase plans are generally arrangements through which shareholders agree to sell their stock interests in the event of specific triggering events such as death, disability, or retirement.
Plan Types Stock purchase plans are generally classified into three categories: stock redemption plans, cross purchase plans, and hybrid plans.
Under a stock redemption plan, the corporation agrees to purchase all or part of the stock interest of a shareholder. There are three approaches to stock redemptions - full redemptions, partial redemptions, and Section 303 redemptions.
In a cross purchase agreement, the remaining shareholders buy the stock interest of a single shareholder. They can either distribute the shares proportionally to what they had before the triggering event occurred or non-proportionally according to what is outlined in the buy-sell agreement.
A hybrid plan, or wait-and-see approach, gives the corporation the first chance to buy. If the corporation does not buy in within a specified time frame (for example, 90 days), the other stockholders have the option to buy. If that option is not exercised, then the corporation must buy the shares.
Many factors need to be considered when determining the best type of stock purchase plan to implement, cost factors, psychological factors, ease of administration, tax implications, and transfer for value rules to name a few. You should seek the advice of financial and legal counsel to help implement your plan.