THE ACCOUNTING BONE’S CONNECTED TO THE…..

When it comes to business, just about everything is connected to Accounting. It’s the backbone to which other aspects of a business can be connected. It can also be construed as a framework in understanding a business’s position and performance.

One of the first tasks when starting a business is determining the business entity. The most misunderstood entity is the LLC or Limited Liability Company. I’ll leave the legal advice to the attorneys, but will offer some guidance in regard to understanding the accounting and tax side, from a broad perspective.

There is often an assumption that because a company title is followed by “LLC”, that the business is “Incorporated”. This is very misleading for accounting and tax purposes because an LLC does not always receive the book and tax benefits of a corporation. Legal documents are required for a business to be formally incorporated. The only true forms of incorporation for accounting and tax purposes are either the “S” Corp or “C” Corp.

To add to the confusion, while each of the basic four entities, (Sole-Proprietor, Partnership, “S” Corp, and “C” Corp.), can exist separately, they can also exist under the umbrella of an LLC. Confusing???  That’s why it’s best to discuss these options with professionals. It’s important to know how to protect your business investment, as well as your personal assets, and to know which accounting method requires the fewest tax forms and potentially has the least taxes.

The distinctions among these four entities for accounting and tax purposes can be found in section 3 on the form W-9, titled, Request for Taxpayer Identification Number and Certification. I use this form because it is widely known, specifically lists all the LLC options, and aides in defining the accounting process used.

When you receive a W-9, you are required to furnish a completed form. It is imperative to complete the Federal Tax Classification Section, by checking one of the options and furnishing other applicable information. The LLC line can be the most confusing so here’s a tip: if you are not one of the following three options–a Partnership, “S” Corp or “C” Corp, you are a Single-member LLC.

The first option, the Individual/Sole Proprietor or Single-Member LLC, is an entity owned by one individual. Contributions (investments) or draws (withdrawals) from the business funds are considered Owner’s Equity and are displayed on the Balance Sheet of Financial Statements. Don’t confuse Owner’s Equity with Net Income/Loss. Net Income/Loss (revenues less expenses) primarily determines the tax liability of the business, although the equity information is still required when completing tax forms.

For tax purposes, the Net Income/Loss of a Sole-Proprietor or Single-Member LLC business entity, flows through to the individual’s income tax returns on a Schedule C and is not taxed at the business entity level. Owners of sole proprietorships or single-member LLC’s must confine their accounting records to business transactions, and not commingle them with personal transactions or funds. If you are an LLC and not formed as a Partnership, “S” or “C” Corp, then you are a Single-Member LLC. You will check the Individual/sole proprietor or single-member LLC box only and NOT complete the Limited liability company line. (The W-9 form includes a note to this effect).

The next business model is the Partnership or Partnership LLC, either of which involves ownership of two or more individuals. This business formation’s equity section lists each partner’s equity (contributions and draws) separately. If you choose this option, you will check the partnership box, or if you are a Partnership LLC, check the LLC box and write a “P” on the designated line of the form W-9.

A Partnership (non-LLC or LLC form) requires that a separate tax form (1065) be processed and must be prepared prior to each partner completing his or her personal income tax return (1040). Therefore, this can be considered an additional expense, since two tax returns are prepared– the Partnership return and the Personal Income tax return. In a Partnership, income/loss from the business is passed through and taxed at the individual level, not at the partnership level. However, each state and/or locality may charge a fee for a Partnership or LLC Partnership entity. Again, check with your tax professional.

If you are related (for example, a husband and wife) and are filing personal income taxes jointly, you may want to consider any potential tax consequences prior to forming this type of partnership. However, don’t base your decision solely on this factor, because the legal benefit of this type of related party partnership could outweigh any additional accounting costs.

The third and fourth options of business entities are the Corporations. These entities are not considered Individuals or Partnerships, and they do not dissolve when the owner or partners pass on. A Corporation can continue business forever (it has no life). The equity section refers to the total stock value (shareholders shares). The same applies if either Corporation is distinguished as an LLC.

Both types of Corporations (“S” and “C”) require that a separate tax return (1120) be prepared for the business.  Additional corporation fees also may apply. Depending on the entity type, profits/losses may be taxed at the business level or flow to the individual shareholder(s). In the instance of an “S” Corp, two tax forms are required, because the business taxes flow to the shareholder(s) personal income tax return using a K-1 form. For calendar-year taxpayers, the ”S” Corp’s tax return (1120) is due by March 15th, because it produces the K-1 form which shareholders are dependent upon when preparing their personal income tax return. The same is not entirely applicable to the “C” Corp.

Check the applicable corporation box on the form W-9 if you are not an LLC. If you are designated as an “S” or “C” Corp, LLC, check the LLC box and enter the applicable letter (C or S) on the W-9 form. These companies are typically the entities rightfully using the term “incorporated”, and they require a higher degree of legality, formality, and accounting.

Changing from one entity to another should not be taken lightly; it requires a great deal of consideration. For example, recall the tax returns listed above that are required for each entity and individual. In a majority of instances, when one entity closes mid-year, acquires a new EIN number and forms a new business entity, a tax form is required for the business that is closing. Depending on the timing, this could mean more than one tax return during the same year for Partnerships or “S” Corporations, which could be costly. If planning can be timed for a year-end closing, it will likely be the least costly for accounting and tax returns.

As I stated at the start, the Accounting Bone is connected to … in this case…the Legal Bone. While it may be less costly to set up under one business entity vs. another, many factors need to be considered. Therefore, it is critical that you seek the advice from both an attorney and an accounting professional, before making a final decision.

This article is based on U.S. regulations and offers a broad analysis of accounting for various entities. I hope it provides business owners with a better understanding of the dependency of each area of expertise upon the other.

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