The Basics of BUSINESS ENTITIES (Organizing the Farm Business)
Forms of BUSINESS ENTITIES Sole Proprietorship Partnership (Limited and General) Business Corporation (C, and Sub-S) Limited Liability Company (LLC)
BUSINESS OBJECTIVES Overall Business Plan Where are we going? What do we have to take us there? How can we get there?
Ease and Cost Capital Other Factors to Consider Taxes / Self-Employment Tax Risk Owner Involvement Transfer of Ownership Secrecy
Sole Proprietorship A business owned & operated by ONE individual.
Advantages of Sole Proprietorships Ease of starting and ending the business Being your own boss Pride of ownership Retention of profit No special taxes
Disadvantages of Sole Proprietorships Unlimited liability Limited resources Few fringe benefits Limited life span
2012 Family of Four Sample Problem Schedule F $ 65,000 Off-Farm Income $ 16,000 Standard Deduction $ 11,900 Health Insurance $ 9,800 Out-of- Pocket Med. $ 4,000
Personal Tax Consequences AGI ($65000 + $16000) $ 81,000 Standard Deduction $ (11,900) Exemptions (4 x $3800) $ (15,200) SE Health Ins. ($9800 x 100%) $ ( 9,800) SE Tax Ded. ($7984 x 50%) $ ( 3,992) Taxable Income = $ 40,108 SE Taxes($65000X.133x.9235) $ 7,984 Federal Taxes $ 5,146 Child Tax Credit $ ( 2,000) Total Fed & SE Taxes = $ 11,130
Sec. 105 Plans Self-employed farmers deduct health insurance, unreimbursed medical expenses 100% as business expenses. Spouse must be legitimate employee Proper employee records must be kept Proper tax forms must be filed W-2 & 943 Average savings in taxes for 2012 =+ $2,500
Tax Savings with a Section 105 Plan Farm($65000-$9800-$4000-$3000) $ 48,200 Off Farm($16,000 + $3000) $ 19,000 Standard Deduction $ (11,900) Exemptions (4 x $3800) $ (15,200) SE Tax Deduct. ($5920x50%) $ ( 2,960) Taxable Income = $ 37,140 SE Taxes ($48200x.133x.9235) $ 5,920 Federal Taxes $ 4,701 Child Tax Credit $ (2,000) Total Fed & SE Taxes = $ 8,621 Tax Saving ($11130-$8621) $ 2,509 Plus Iowa Saving on Medical $ 272
Partnership / Joint Venture An association of TWO or more persons who carry on as co-owners of a business for profit.
The Difference between General and Limited Partners General Partner Limited Partner A person who assumes full co-ownership of a business A person who contributes capital to a business but is not active in managing it
Advantages of Partnership / Joint Venture Pool resources Shared management Longer survival
Disadvantages of Partnership / Joint Venture Unlimited liability Informal arrangements Disagreements among partners Difficult to terminate Profits subject to Self- Employment taxes
Elements of a Partnership Agreement General information statements Capital contributions Contributions of labor & management Records and accounts Partnership income, expense, annual statement Partnership dissolution: business liquidation or continuation Miscellaneous provisions
Corporation A legal entity created by the state, whose assets and liabilities are separate from its owners.
Corporate Decision Making Shareholders Board of Directors Officers
General Powers of a Corporation Separate legal entity (sue & be sued) Continuity of life Make & amend Bylaws Hold interests in other entities Make contracts, borrow money, issue notes and other obligations Establish fringe benefit plans
TYPES OF CORPORATIONS Personal Holding Company (PHC) Personal Service Corporation (PSC) Controlled Corporation Sub- (Chapter) S Corporation Sub- (Chapter) C Corporation
Personal Holding Company 5 or fewer people own more than ½ the stock 60% of income comes from passive investments. Pay Corp tax + 39.6% on undistributed personal holding co. income
Personal Service Corporation Principal activity is the performance of personal services Taxed at a flat 35% tax rate
Controlled Corporation Multiple corporations owned or controlled by same interests. IRS can reallocate income/expense to any corporation if audited. Consolidated returns
Sub S Corporation Pass-thru tax entity No Self-employment tax only FICA Taxable benefits to shareholders Calendar year Common stock 100 Shareholders
C - Corporation Articles of Incorporation filed with Iowa Legal tax entity Unlimited shareholders No Self-employment taxes only FICA Fiscal year
Advantages of Corporations Limited liability More money for investment Business continuity Ease of ownership change Separation of ownership from management Tax-free fringe benefits (C-Corp.)
Fringe Benefits for a C-Corporation Qualified Retirement Plans Educational Assistance Program Meals & Lodging - In corporate cafeteria - Nature of business - Proximity to business - Condition of employment Flexible Benefit Plans
Flexible Benefit Plans Group-term life insurance premium cost Disability Income & Accident Insurance Health insurance premium costs Dental insurance premium costs Medical cost not covered by insurance Qualified dependent care costs Contributions to a qualified 401(k) plan
Initial cost Disadvantages of Corporations Extra paperwork Termination difficult Double taxation Capital loss restrictions Debt over Basis
Debt Over Basis Problem 1 2 3 4 5 Individ. Property FMV Tax basis Indebt. Jay W. various 926,000 473,000 540,000 John W. cash 37,000 37,000 0 Total 963,000 510,000 540,000
Disadvantages of Corporations Business more open to public Charitable contribution limitations No stepped-up basis of assets Accumulated Earnings Tax Children s wages subject to FICA Non-interest bearing checking acct. Built-in Gains Tax
Family of Four Considering Incorporation Schedule F $ 65,000 Off-Farm Income $ 16,000 Health Insurance $ 9,800 Medical Costs $ 4,000 Corp. Salary to you $ 30,000
Corporate Taxes if Incorporated $ 65,000 Problem Assumed $ (30,000) Wages Paid to New Employee $ ( 9,800) Health Insurance Benefit $ ( 4,000) Medical Expenses Reimb. $ ( 3,990) $30000x.133 (FICA) $ ( 3,000) Pension Plan Contribution ============== $ 14,210 Corporate Taxable Income ($50,000 top of Corporate 15% tax bracket) $ 2,132 Federal Corporate Tax @15%
Personal Taxes if Incorporated $ 16,000 Off Farm Income $ 31,695 W-2 (5.56% FICA corp. paid) $ 47,695 Adjusted Gross Income $ (11,900) Standard Deduction $ (15,200) Personal Exemption (4x3800) $ 20,595 Taxable Income $ 2,219 Total Federal Taxes $ (2,000) Child Tax Credit $ 219 NET FEDERAL TAX
Net Tax Saving of Incorporation $ 11,130 Personal Taxes if not Incorp. $ ( 2,132) Federal Corporation Taxes $ ( 219) Personal Taxes if Incorporated $ ( 700) Additional Corp. Tax Return Fee $ ( 150) Additional Accounting Fees $ ( 100) Attorney Fees (Annual Mtg.) $ ( 1,500) Set-up Fees $ 6,329 Tax Savings Yearly by Incorporation
20 Years after Incorporating $3000 Yearly Pension Contribution for 20 years = $104,158 @+ 5% int. = $434 / month income at age 66 for 20 years Social Security income on the $30,000 wage = $1460 / mo. + $779 for spouse = $2239 / mo. Social Security income if not incorporated = $1315 / mo. + $779 for spouse = $2094 / mo. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Tax Saving of the Corporation after 20 years = $219,738 ($6329 compounded at 5%) Tax owed at liquidation of the corporation & personal stock = $70,000 (if no plan) $149,738 corp. net / 20 years = $7500/yr. savings
Limited Liability Company Hybrid organization Avoids double taxation Owners called Members Must fail two of four tests if wanting to be taxed as a partnership a) Limited Liability b) Centralized Management c) Free Transferability of Interests d) Continuity of Life
Which Entity Should You Use? Only consider the C-corporation entity after thorough consultation with a competent tax advisor. If your primary concern is the availability of tax deductible employee benefits, seriously consider a C-Corp.
Which Entity Should You Use? If you place a high emphasis on reducing self - employment taxes, then an Sub-S corporation should be discussed with your tax advisor.
Which Entity Should You Use? If you rule out the C-corporation, the LLC, taxed as a partnership, is probably your best alternative. If your primary concern is achieving limited liability, seriously consider an LLC.
The Sole Proprietor Entity is BEST Selected When: Owned & managed by one person à YOU. Want simple and inexpensive to create & operate. Want less governmental filings and rules. Not concerned about raising outside capital or having personal liability. Report profit/loss directly on individual tax return.
The General Partnership Entity is BEST Selected When: Business is owned / managed by more than one person Want a structure simple and inexpensive to create and operate Partners want to report profit/loss on individual tax returns Not concerned about raising outside capital or about being personally liable for the obligations of the business
The Limited Partnership Entity is BEST Selected When: Partners are raising private money Don t want management involvement from outside investors Provide investors protection from personal liability but don t want the hassle of forming a corporation Partners want to report profit/loss on individual tax returns
The Limited Liability Company is BEST Selected When: All members (even just one person) want protection from personal liability Simple management structure in which all members manage Members want the option of reporting profit/loss on their own tax return or elect treatment as a corporation
The Corporation Entity is BEST Selected When: Business has become so profitable that you can save significant income tax dollars by keeping profits retained in the corporation A family business and want to start planning for the next generation of ownership or want to begin making stock gifts Want to limit your personal liability Business is large enough to benefit from centralized management
In Conclusion Individual situation and objectives Relevant characteristics for entity Seek advice from: attorney, accountant and financial advisor Evaluate choices Select a new business entity
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