Retirement plans for business owners

As a business owner or self employed individual, there are options available for funding your retirement in addition to those options which are available for anyone with earned income, such as traditional and ROTH IRA accounts.  The most common types of retirement accounts for business owners are SEP-IRAs and 401K plans, which will be reviewed in detail in this article.  For information on additional options available, please see this article on defined benefit pension plans for small business owners.

SEP-IRA retirement plans

A SEP-IRA account is the same as a traditional IRA in most ways.  The only substantial difference is that with a SEP-IRA, the participant can contribute up to 25% of compensation, or $54,000 for 2017 ($60,000 for persons ages 50 or older), whichever is lesser.  This could end up being substantially more than the contribution limit for a traditional IRA account, depending on the compensation of the participant.  In order to be eligible to establish a SEP-IRA, you must own a business (this includes being self employed).  If you have any employees, they are eligible to have a SEP account as well, and must be included if they meet certain criteria (worked for the business for 3 of the previous 5 years, attained age 21, and had at least $600 in compensation.  These requirements can be made less restrictive in the SEP-IRA plan document).  SEP-IRAs have the main advantage of being easy and relatively inexpensive to administer.

401K retirement plans

A business owner, including a self employed person, has the option of establishing a 401K plan for his or her self and employees.  The participant can contribute 100% of compensation, up to the limit ($18,000 for 2017 plus a $6,000 “catch-up” contribution if age 50 or older).  The business owner can also make a non-elective contribution of up to 25% of compensation.  The rules related to the non-elective contribution are a bit more complex for a self employed individual but are in the same general range.  401K plans are in general a bit more time consuming and costly to administer than SEP-IRA plans, however they have the main advantage of having larger contribution limits than SEP-IRAs.  They also allow the participant to take loans against their 401K balance, something which is prohibited by the IRS rules pertaining to IRAs, including SEP-IRAs.

 

Business structure – LLC, Corporation, Partnership or Sole Proprietorship

Which business structure you choose for your small business is an important decision from an operational and administrative perspective as well as from a legal and tax perspective.  It is important to review your individual situation with the appropriate advisers.  We will provide an overview of some of the most common business structures here.

Corporation

A corporation has numerous advantages.  A corporation is typically formed by filing articles of incorporation with the relevant state authorities. A corporation has directors, officers, and shareholders. Shareholders have a representative ownership interest in the corporation, and are able to exercise their rights by voting their shares. Directors are elected by the shareholders, and the directors appoint the officers, who manage the corporation on behalf of the shareholders. In most cases shareholders are shielded from personal liability related to the activities of the corporation. Corporations can be taxed as either a “C” corp or as an “S” corp at both the federal and state level. A C corp files its own tax return and pays its own taxes, whereas an S corp for the most part is taxed by passing its income through to the individual shareholders.

C corporation – taxation overview

Corporations, which are organized and filed under state law, can elect to be treated as either a C corporation or an S corporation for federal tax purposes. Corporations typically must have officers and directors who supervise and direct their business activities. Each corporate structure has advantages and disadvantages related to taxation and shareholder composition. We will provide a very basic overview of the C corporate structure here.

C corporation earnings are subject to corporate taxes at the federal level. A corporation must file its own federal tax return, and must pay its own taxes. Corporate taxes are levied at a progressive rate according to the corporation’s total earnings. An exception to this is the personal service corporation, whose earnings are taxed at a flat rate regardless of total income.

When corporate earnings are distributed to shareholders via dividend payments, the shareholders are taxed on the income received as a result of these dividends. As a result, these earnings are taxed twice: once to the corporation and again to the shareholder. This is frequently referred to “double taxation”, and is a major disadvantage of the structure of c corporations from a taxation perspective.

Advantages of c corporations include an unlimited number of shareholders as well as minimal restrictions related to the composition of these shareholders. This is in contrast to S corporations, which have more stringent rules. For example, S corporations can not have more than 100 shareholders, and those shareholders can only be U.S. citizens and residents, and must be natural persons.

In certain cases, non dividend distributions can be made by a corporation to its shareholders. This would occur, for example, in the case of a liquidation of the corporate assets. Such distributions would be treated as either return of capital or capital gains to the shareholder, depending on the circumstances.

S corporation – taxation overview

As discussed previously, corporations, which must be filed under state law and have both officers and directors, can elect to be taxed as either an S corporation or a C corporation at the federal level. We discussed the basics of C corporations previously. Here we will discuss the basics of S corporations and their advantages and disadvantages related to taxation, shareholder composition, and stock classification.

S corporations are considered pass through entities from a taxation perspective. Accordingly, the S corporation itself does not pay any taxes on its earnings, but instead passes those earnings (and gains) directly through to its shareholders. The S corporation must file its own tax return, however typically there is no tax due at the corporate level. As the income is passed though, the shareholders are responsible for paying taxes on their share of the income. This is a major advantage of the S corporation structure as there is no “double taxation” as is the case with C corporations.

S corporations have several disadvantages, however, mainly related to restrictions on the composition of their shareholders and classification of their stock. An S corporation can have a maximum of 100 shareholders, and these shareholders can only be natural persons who are U.S. residents. A married couple would count as a single shareholder. Additionally, S corporations can only issue one class of stock, and economic interests must be allocated proportionally in relation to ownership interest. Voting rights may be allocated disproportionately, however.

Limited liability company (“LLC”)

A limited liability company is a business structure which is comparatively simple and easy to administer.  Limited liability companies are formed by filing articles of organization with the relevant state authorities. LLC’s have members who possess ownership interest in the LLC, and managing members supervise, manage, direct and operate the LLC. In general, LLC formation and administration is less complex than that of a corporation.  The simplicity of formation and administration and flexibility of tax status are some of the main advantages of the LLC structure.  LLCs must elect whether to be taxed as a C corporation, S corporation, partnership, or sole proprietorship (in the case of a single member LLC).

Limited liability companies typically utilize what is known as an operating agreement to designate the ownership structure and relationships between members as relates to capital accounts, earnings and management of the LLC.

The main disadvantages of the limited liability company structure as compared with a corporate structure relates to the entity’s lifespan as well as issues related to raising capital. For example, a corporation will continue in perpetuity upon death of one of its shareholders, while an LLC will typically be dissolved. Corporations, in particular C corporations, are advantageous for raising capital in that their shares can be registered and the company can become publicly traded. This is typically not the case with LLC membership interests.

Another advantage of a limited liability company when compared with an S corporation relates to shareholder composition. An S corporation has numerous restrictions on shareholder composition as relates to the number of shareholders and the nature of those shareholders. An LLC, on the other hand, has few of such restrictions. LLC shareholders can be unlimited in number and can be individuals, corporations, partnerships, and other LLC’s.

Partnerships

A partnership is a business arrangement where the individuals or entities involved share in the profit and loss of the business. Unlike a corporation, and depending on the particular structure of the partnership, partners may or may not have liability related to the business activities. Earnings and other gains are typically passed through to the partners who are then responsible for reporting these gains on their individual tax returns. Similarly, expenses, assets and liabilities are assigned to the partners.

A major advantage of a partnership is that the income passes through to the partners and is thus taxed only once. This is on contrast to a c corporation which, as discussed previously, is subject to taxes once at the corporate level and again at the shareholder level, resulting in “double taxation”.

In one structure, known as a limited partnership, there are two types of partners: limited partners and general partners. Limited partners do not actively participate in the business activities of the entity and are not liable for the activities of the partnership to any extent that exceeds their ownership interest. General partners are typically responsible for managing the business activities of the entity and are subject to liability. This is in contrast to an LLC, where both the managing members and non managing members are typically protected from liability in most cases.

There are other partnership structures, including limited liability partnerships and general partnerships, which will not be discussed in detail here.

Sole proprietorship

A sole proprietorship is a small business structure where the business owner has no legal entity to separate his/herself from the business. The business is operated under the business owner’s name or a trade name and the business owner is personally responsible for the debts and obligations of the business. This is in contrast to a corporation or a limited liability company, which is separate and distinct from its shareholders or members and typically provides some amount of liability protection to the owners and operators.

A sole proprietorship may or may not have its own employer identification number (EIN). As EIN is required in certain circumstances, for example where the proprietor wishes to hire employees.

While a proprietorship may have a trade name, such a name does not create any legal distinction between the business owner and the business.

Due to its being indistinguishable from its owner, a proprietorship does not file its own tax return. Instead it typically reports business income and expenses on schedule C of the business owner’s personal tax return.

The main advantage of a sole proprietorship is simplicity and ease of formation and administration, while its main disadvantages are lack of protection from liability as well as limited ability to raise capital.

Tax deductions for small business owners

As a small business owner, you are able to take numerous tax deductions against your business income.  How these deductions are taken will vary depending on whether your business is structured as a sole proprietorship, corporation or partnership.  This article will restrict the discussion to the sole proprietorship situation, which includes single member LLC entities which have elected to be treated as sole proprietorships.

Pension plans for small business owners

Defined benefit pension plans provide an excellent option for small business owners looking to save for retirement.  Similar to SEP-IRA’s and 401K plans, business owners can use these plans to save in a tax deferred manner.  The advantage of these plans is that they allow for larger contributions for the business owners, and are therefore ideal for highly compensated owners or partners of small businesses.  The disadvantage is that they are more time consuming and costly to administer than many of their alternatives.  Contributions to defined benefit pension plans are typically tax deductible to the business, and earnings grow tax deferred until they are withdrawn or paid out.  Unlike a SEP IRA or 401K plan, contributions must be made every year.  The contribution amount is based on a number of factors including age, compensation, retirement age, and assumed rate of return on pension assets.  If the business has employees, they must typically be included in the plan.