CHAPTER
6

Strategies for the
Self-Employed

In This Chapter

• Sole proprietors, partnerships, corporations, and LLCs
• When others are involved
• Tax savings
• The importance of a buy-sell agreement

If you own a business, or perhaps are considering starting one, this chapter is for you. Your choice of entity, how you set yourself up to conduct your business, is important. It can impact the success of your enterprise tax-wise, and it can affect your estate, as you will see throughout the next several pages.

First we’ll look at how you might choose to set up shop (or office, plant, shopping mall kiosk, and so on). You have several choices.

Sole Proprietor

If you are the only owner of your business, with no partners or anyone else in the picture, you are the sole proprietor. This means you are personally responsible for your business’s debts and all its income (or losses).

A sole proprietorship is easy to set up because most states don’t require you to file any papers with a government agency. There are a few exceptions. For example, if you are opening a store, you need a retail merchant license; other professions might call for a local license. Someone like Harry, who is doing business as (abbreviated as d/b/a) Harry’s House of Wicker, may have to file a certificate stating his d/b/a name so his municipality knows who the owner of the store is. However, as a lawyer, I don’t have to obtain anything from my city or town hall to start my business. Many other enterprises don’t, either.

Of course, if you have anyone on your payroll, you must follow the reporting requirements of the Internal Revenue Service (IRS) and your state’s Department of Revenue.

It’s as simple to exit this kind of business as it is to set it up. Just take down your sign. You don’t have to file anything with any state agency saying you’re closing shop.

If you die while owning your business, that asset is treated like any other. It goes into your will and is passed on to whomever you choose. (That individual won’t be personally obligated for any business debt, but your estate will be. That means the debt will have to be satisfied before any distribution of assets is made to your heirs.)

Partnerships

Let’s say you and one or more associates co-own your business. If you haven’t incorporated, you probably are a partnership, whether or not you have a formal partnership agreement. A partnership is a recognized form of business ownership in which who owns what and how much is set out in the partnership pact, an agreement that controls each partner’s share of the profits/losses, assets, and management. If there is no agreement, each partner has an equal interest in those profits and losses and in management decisions.

Many states have created a variant of the partnership, the limited liability partnership (LLP), which permits the partners to avoid personal liability for business debts. Your partnership should elect to become an LLP if that option is available in your state.

Violet, Rip, and Mark have joined forces to become partners in a detective agency. They have no specific partnership agreement, but each has contributed $5,000 to set up the agency. Therefore, each partner, according to the law, has an equal share in the profits and losses and an equal voice in management decisions. Each has his or her $5,000 capital contribution on the partnership books.

This trio should have a specific written agreement, particularly if they want to divide profits/losses or management unequally. For example, let’s say Rip runs the partnership into $15,000 of debt by buying expensive disguises. Unless they have an agreement saying each partner is responsible for the debt he or she incurs, Violet, Rip, and Mark will have to contribute $5,000 to the partnership to pay off Rip’s $15,000 debt. With their equal partnership, it is not just Rip’s bill.

Let’s say the partnership’s net income for 2015 was $21,000, as reported on IRS Form 1065, “U.S. Return of Partnership Income.” Because each partner has an equal share in the profits, each will report $7,000 income on his or her individual tax Form 1040, “U.S. Individual Income Tax Return.”

When Partnerships Break Up

Our detectives might dissolve the partnership for several reasons: death or retirement of a partner, consensus termination, or involuntary termination by a court. Usually the latter involves bankruptcy.

In this case, Mark, while on a stakeout, chokes while eating a donut and dies. Because the partnership has no agreement, it has to terminate the business; pay its creditors; and distribute any balance left to Violet, to Rip, and to Mark’s estate.

A partnership agreement could have provided that the company would continue on the death or retirement of a partner. It also could contain clauses for the selection of Mark’s successor.

If you die while in a partnership, your partners are likely to buy out your share in the business, sometimes with periodic payments to whomever inherits from you. That comes from their having a buy-sell agreement, which I describe in detail later in this chapter.

Limited Partnerships

Also under the partnership umbrella is a limited partnership. This type of partnership involves two types of owners: general partners, who are personally liable for the business debts, and limited partners, who are not. The general partner runs the entity.

General and limited partners are taxed on the business income or may deduct its losses, subject to some tax restrictions.

Corporations

Many small businesses incorporate, often because incorporating makes the business, rather than the owners, liable for its debts.

A corporation is a separate legal entity, owned by its shareholders, with policy set by a board of directors and managed by the officers. You can elect to be the only shareholder, or you can sell shares to as many people as you want. The corporation is liable for its debts unless the shareholders personally guarantee a corporate obligation.

In most states, forming a corporation is fairly simple. You prepare a form called Articles of Incorporation, which you can get from your Secretary of State, and file the document with that office. If you are setting up a one-shareholder corporation, you can probably fill out the form yourself and obtain and prepare any other corporate documents needed. However, I advise at least having an attorney review your work to determine if it is properly prepared.

Mike and Sharon have decided to form a corporation as consultants for TV and radio stations. The Articles of Incorporation are filed, bylaws are drawn up, and the shareholder and board of directors’ minutes are recorded. The stock is issued: 49 shares to Mike and 51 shares to Sharon. Because Sharon has control of this business, Mike will probably want a contract detailing his employment and other rights in the corporation.

If you are terminating a corporation, most states require you to file an Articles of Dissolution form with your Secretary of State.

If you die while part of a corporation, your fellow owners will consult their buy-sell agreement, which I mentioned in an earlier section on partnerships and will describe in more detail shortly. Your share of the corporation is in stock, which is now considered part of your estate. The buy-sell agreement may require the corporation to buy a deceased’s share, perhaps with funding from a life insurance policy. Proceeds, of course, go to the deceased’s heir(s).

Limited Liability Companies

The limited liability company (LLC), which is a sort of combination of a corporation and a partnership, is the new kid on the block. An LLC is owned and managed by its members, who are co-owners. The LLC is established by Articles of Organization, which are similar to Articles of Incorporation, and run according to an Operating Agreement, which is somewhat like a partnership agreement.

There are two attractive features to an LLC:

• Members (owners) are not personally liable for business debts; the company is.
• Members are taxed like partners or S corporation shareholders, rather than twice-tagged on the profits (paying income tax at the corporate level and tax on dividends to shareholders), as a C corporation is. (S and C corporations are discussed in the following section.)

The members can manage an LLC like a partnership, with all owners involved in decisions. Or they can have an arrangement similar to a corporation, with a board of directors.

The LLC usually requires filing organization and dissolution documents with the Secretary of State.

Comparison of Business Entities

The following table can help you differentiate among the various ownership styles.

*Limited partnerships are not included in this table. LLP election avoids a partner’s personal liability for partnership debts.

Even More Tax Talk

I have mentioned some tax consequences in selecting a business entity so far in this chapter, but let’s take a closer look. Naturally, you will want to consider all the tax ramifications of setting up your organization.

S or C Corporation

Tax law allows small corporations (100 or fewer shareholders) to elect to be taxed as an S corporation (the S is a tax code designation). S corporation shareholders report business income (or loss) on their Form 1040, Schedule E, “Supplemental Income and Loss,” similar to partners. If there is no S election, the corporation is designated a C corporation, and its income taxed at the corporate level. (Dividends paid are reported by the shareholders.)

Your accountant or attorney can determine whether the tax status of S or C corporation is best for you.

Tax-Free Formation

Sole proprietorships, partnerships, and LLCs are formed without incurring a tax when established. Generally both S and C corporations may be formed tax free, but to do that, at least 80 percent of their shareholders must make capital contributions of property (not personal services).

Reporting to Uncle Sam

The sole proprietor reports income (or loss) on his or her Form 1040, Schedule C, “Profit or Loss from Business.” Partners and LLCs report theirs on Form 1065, “U.S. Return of Partnership Income,” and then each owner’s share of income (or loss) is reported on the 1040, Schedule E. Likewise, the S corporation reports its income on the 1120S, and the shareholder reports his or her share of the income on the 1040, Schedule E.

The C corporation reports its income (or loss) on Form 1120, “U.S. Corporation Income Tax Return,” and pays a tax on income. The corporation shareholder only reports dividends received, using Form 1040, Schedule B, “Interest and Ordinary Dividends.”

Partnerships, LLCs, and S corporation shareholders report passed-through income as the same “character”—in other words, ordinary income or capital gain—as its source. For example, capital gain created by a partnership is passed through to the partners as capital gain.

To sum up this mass of tax forms, only the C corporation—not its shareholders—pays its tax (except on dividends received). All other owners report and pay income taxes on their share of the entity’s income.

Why a Buy-Sell Agreement Is Vital

Whether you are nearing retirement or just starting out, you ought to have a plan for succession upon your death, disability, or that longed-for retirement. Your work is a valuable asset, probably more so as a going business than just the sum of its assets.

Every partnership, LLC, and multishareholder corporation should have a buy-sell agreement. This contract among the business owners usually restricts transfer of each owner’s interest and provides a procedure to purchase an owner’s interest upon death, disability, or other departure.

The agreement keeps ownership among the original owners, unless they want to allow in new people. The old group may be relatively compatible; a newcomer is an unknown quantity.

The agreement also provides a means of “cashing out,” or paying those who no longer want to own the company or who have become disabled. A buyout—perhaps through a life insurance policy—also can step in to pay the estate of a deceased owner for his or her share of the business or pay a disabled owner.

Usually the buy-sell agreement provides for annual payments to a retiring owner over several years.

If you and your co-owners do not have a buy-sell agreement, you are courting disaster, particularly if the death of an owner is involved. The deceased’s heirs may need money right away, which may not be available if he or she has not planned for that possibility.

Time for a Change?

Many owners select one form of ownership style, go on to do business, and forget about that setup. That’s not a good idea. That choice might still be the best one for the owner, but then again, maybe things have changed and now it isn’t. Decisions made initially in a business do not have to last forever. Indeed, some should be scrapped and revisited somewhere along the way.

A business is a living, evolving entity. Tax and business laws are constantly changing, too. If it’s your business, consult your accountant and attorney every few years to be certain the ownership style you have chosen is still the most beneficial for you.

April, for example, set up her umbrella sales corporation several years ago. At that time, her accountant and lawyer suggested she elect to be taxed as an S corporation, which was appropriate for her early years. Now the business has grown, and profits have increased dramatically. She must pay taxes on those profits, most of which she leaves in the corporation.

April may want to consider switching to a C corporation tax status because the corporation pays the tax on its income. In addition, the C corporation allows more flexibility in employee nontaxable fringe benefits, such as group term life insurance and medical insurance.

Will, Evan, Jeff, and Carl have gone the partnership route with their marina. They are concerned about personal liability for business debts, but they like the pass-through tax aspect of partnership. They might want to consider changing to a limited liability partnership, which eliminates personal liability while keeping the same partnership tax structure.

State business laws and tax laws, and federal tax laws, too, have become more flexible in allowing you to change from one entity to another. So always keep in the back of your mind the fact that there could be a better way of doing business.

Treating Yourself Well as the Key Employee

If you aren’t good to yourself, who will be? Let’s review some points to consider with a growing business.

The key employee is you, the owner. You can only improve your financial picture by either increasing your income or lowering your expenses. But you may be able to add more fringe benefits, many of which are tax free, and all of which can make a weary businessperson feel a little prosperous and coddled. Some will make your employees feel better taken care of, too.

Discuss the following “perks” with your accountant, who will be able to help you determine if you can afford them:

• Education assistance
• Business travel
• Business meals
• Medical and dental insurance
• Health or other club memberships for business purposes
• Business-related entertainment
• Help with dependent care—for employees’ children or parents they’re tending
• Tax-sheltered retirement plan
• “Cafeteria plan” of benefits (employees select what they want and can afford)
• Use of corporate vehicles
• Deductions for an office in the home
• Disability insurance
• Group term life insurance

When You Want to Sell

When the time comes to sell, your choice of entity will make a difference, in taxes and otherwise. Consider the following situations.

As a sole proprietor, you’re simply selling individual assets, and the classification of gain or loss depends on the nature of the assets. Capital assets like land create capital gain, and ordinary income assets like inventory create ordinary income.

An aside: For taxpayers in the highest bracket (39.6 percent), capital gain is attractive because for most assets, it is taxed at 0 percent for 15 percent bracket, 15 percent for 25 to 35 percent brackets, or 20 percent for the 39.6 percent bracket, depending on the taxpayer’s bracket. Ordinary income, however, may be taxed to the highest rate.

Partnerships and LLCs usually have some ordinary income to report in the sale of the business as well as capital gain.

Drew and Elsa are partners in a business selling artwork. The art is inventory, which results in ordinary income, while the building the partnership owns and sells at a gain is a capital asset. When the two sell their partnership, part of the sale will result in ordinary income, and part will be capital gain.

Corporate shareholders own a capital asset—their stock—so when that is sold, they have a capital gain.

Taking a Broad View

For your information now, and your plans for a future that might be years down the road, sit back and do a little thinking about these aspects of your work, keeping in mind what you have just read as well as the following suggestions.

Analyze the current status of the business Most have a life cycle for their owner: beginning, turning the corner, and maturity. The business likely will be less valuable and have significant debt at the beginning. When it turns the corner and starts becoming profitable, its value increases, although the debt may still be considerable if the business is expanding. The mature business is profitable and, thus, attractive to others.

Where is your business at this point? Ask yourself again when you are considering retiring or selling. And ask yourself when you are putting together an estate plan. What would happen to the business, and your heirs, if you were to die suddenly?

Consider the cash value of the business It could be at a stage where you may have few purchasers for it, and it also could be valuable only if you are able to run it. Again, you need life insurance and disability insurance to provide an adequate estate for your family. If purchasers are willing to pay its fair market value, and you are ready to retire or sell, less insurance may be needed.

Review your buy-sell and other business arrangements, if you have co-owners Your heirs may not want to continue owning a share of the business after your death, so a plan to “cash out” your interest upon death should be an ingredient of your estate plan.

If you have a family business, plan for an orderly transfer of ownership when you want to retire Your retirement funds might come from your withdrawal from the business. You may be able to restructure the business ownership to provide for a gradual withdrawal, with the minimum of adverse tax consequences.

Talk over all your prospective business moves with the appropriate members of your estate planning team, and certainly your accountant and lawyer.

Keep in mind that your will, trust, and other estate planning documents may be virtually useless if you haven’t considered how best to arrange your business to maximize your estate while minimizing taxes. That’s the bottom line. I’m afraid it gives you plenty of work to do, but it’s time and energy worth investing.

Finally, you’ll find suggestions specifically for physicians, accountants, attorneys, and other professionals licensed by the state and in business for themselves, and for those engaged in farming, in Chapter 14.

Also see the “Business Succession Planning Worksheet” on the book’s website.

The Least You Need to Know

• You have several choices of business entities from which to choose; study the legal ramifications of each carefully.
• Examine your pay and fringe benefits because you, the owner/employee, may be missing some tax-free benefits at little cost to you.
• If you and another person, or several other persons, co-own, sign a buy-sell agreement to protect you and the business.
• Always keep in mind your business’s current status and how it figures in a typical business cycle.