Entity Structuring for Expanding Family Businesses
Owner-operator businesses usually start out as sole proprietorships, which is fine until your business starts to grow, and your family status changes. Life can throw your business a curve ball when you least expect it. Retirement, divorce, illness, even irreconcilable differences with a new partner or staff. Whatever life pitches, you should have a plan for possible risks and choose the right structure to protect both the business and your family. There are also important tax considerations!
Here are some insights into the choices you have regarding business structure:
Smaller owner-operator businesses are usually structured as sole proprietorships with no legal separation between the owner and the business. All properties and liabilities are in the owner’s name and the owner is liable for any legal or financial issues in the business. Startup and compliance requirements are minimal, and profits and losses are passed down to the owner and claimed on the owner’s personal tax form using Schedule C (Form 1040).
Here’s a common scenario: one day you get married, and before you know it your spouse and your children now work hand in hand with you. Your sole proprietorship is now a family business. What choices do you have?
1. The business can stay a sole proprietorship with your spouse and children hired as employees. You get a bit of a tax break because if one spouse is employed by another, the wages of the spouse are not subject FUTA, and wages of your kids under age are not subject to Social Security and Medicare taxes and not subject to FUTA if the kids are under age 21. WOW!
2. If you and your spouse run the business together while sharing both profits and losses, the business is now considered a partnership even if there is no formal partnership agreement. Business income and loss are no longer reported on a Schedule C, Form 1065 is now required.
3. Another option for a married couple owning and operating a business together is to elect treatment as a “qualified joint venture,” in order to continue filing as sole proprietors for federal tax purposes. In this case, each spouse must file a separate Schedule C to report their share of profits and losses.
There is no legal separation between the owner and the business in a sole proprietorship, so should the owner die, the business will terminate, and its assets will become part of the owner’s estate. The business does not necessarily get passed down to the remaining family members. A sole proprietor must include a provision in their will directing that the business be sold or a successor is appointed.
If a divorce between the sole proprietor and the spouse occurs, unless the spouse is a co-owner, there is no automatic sharing of the assets and the details are decided in the divorce proceedings.
In a partnership there is more than one owner. That could mean two spouses, two siblings or a parent and child. In a partnership the owners share legal, financial, and management responsibilities. Profits and losses are passed down to the partners, and each partner is equally taxed. For the family’s sake, be sure there is a partnership agreement in place. Without predetermined resolution methods, any argument over who works harder or disagreement about how to run the business can wreak havoc.
A partnership is like a sole proprietorship in the sense it has no legal separation from the owners. We highly recommend putting a buy-sell agreement in place for how to handle the business in the event of a partner’s death, retirement, divorce or departure.
C Corporations are legal entities separate from the owners. Owners and shareholders have a substantial amount of protection from personal liability and those operating the corporation are employees. Family members in the business are also employees and may also be shareholders. If the business wants to sell stock to raise money for growth, the C Corp structure is a good choice.
A corporation files its own tax return, IRS Form 1120. The corporation claims deductions for business expenses and a flat corporate rate of 21%. The disadvantage is the “double taxation” factor where the company is not only taxed on its profits but then the owners are taxed again when they receive dividend distributions which are taxed on their personal income tax return. There are compliance requirements and fees, but the advantages of tax saving deductions, liability protection and the ability to sell shares may make the C Corp worth it.
Incorporating a business involves filing Articles of Incorporation with the state. The corporation bylaws dictate how the company deals with divorces, deaths, succession and whether or not the company must stay in the family or can be sold to an outside party. There must also be rules on what happens to the shares in case of death, divorce, or company buy-out. Some family members may run the business and others may serve on the board. If the family corporation goes public, the board of directors governs decision-making. By creating bylaws mandating only family members can be on the board, a family can retain better control. Families can also decide to limit the number of shares going to non-family members.
The S Corp is a special election which allows owners/members to pass business income, losses, deductions, and credits through to their member shareholders for federal tax purposes. Shareholders of S Corps are then required to report the income and losses on their personal tax returns. Many family-owned businesses choose to elect S Corp status because of the treatment of employment taxes. Only wages are subject to self-employment taxes and other business profits can be distributed as dividends, which are only subject to income tax, but no payroll taxes are required. To elect S Corp status, the business must file IRS Form 2553 by March 15th, and meet ongoing filing requirements such as:
- Reporting financial activity (Form 1120S, Schedule K-1s for shareholders),
- Withholding federal income tax, Social Security and Medicare taxes from employees’ wages,
- Filing IRS Form 941 each quarter to report these withholdings, and
- Filing a Federal Unemployment Tax Return annually (IRS Form 940).
Family Limited Liability Company (LLC)
The LLC structure offers the liability protections of a corporation without the stringent compliance regulations. In a Family LLC, owners are called members and must be related by blood or marriage, and one family member acts as the managing member. LLCs are required to have an operating agreement which defines the rights related to ownership, decision making, transferring of assets and what happens in the case of divorce, death, retirement, etc.
LLC member’s personal assets are protected if the company gets sued or can’t pay its debts. An LLC is a pass-through entity, and all income flows through to members and is reported on their personal tax returns. The LLC can choose to be taxed as a C Corp or an S Corp. For example:
- The LLC taxed as a sole proprietorship or partnership will pay payroll taxes on all profits, so paying an immediate family member makes no difference to the owner’s taxes.
- The LLC taxed as an S Corp can decide to split up profits as wages and shares so only part of the profits is subject to payroll taxes.
- The LLC taxed as a C Corp with be double-taxed, profits taxed at the corporation level and then wages taxed.
Reach Out to Us: Let our tax professionals and business consultants help you choose the right entity for your family businesses to put you on a straight path to success. Contact us at 855-666-4201 or firstname.lastname@example.org. More info on the benefits of the C corp vs the S corp, and small business structuring for tax efficiency HERE: Harless Blog >