Small Business Retirement Plan Credits

By Dan Ashburn

The SECURE Act brought many new tax breaks to help small businesses. The Small Employer Pension Plan Tax Credit provides businesses a credit for the start-up costs of implementing a new retirement plan for their employees. The Small Employer Retirement Savings Auto Enrollment Credit is a new credit for businesses who include and maintain an automatic enrollment feature in their plans. As always, there are certain requirements you will need to meet to receive these credits.

Am I eligible to receive the credits?

For both credits, you must be considered an “eligible employer”. An eligible employer is one that had 100 or fewer employees who received at least $5,000 in compensation for the preceding year, had at least one employee participating in their plan, and in the three prior tax years the same employees were not participating in another plan sponsored by the employer. The plan must also be an eligible plan, which include a SEP, SIMPLE IRA or qualified plan (like a 401(k) plan.

How much can I receive from the credits?

For the 2020 tax year and onwards, you can take the Small Employer Pension Plan Tax Credit for the first three years of the plan’s existence. The amount of the credit depends on several factors. To start, the amount of the credit cannot exceed 50% of all qualifying costs to set up the plan. These qualifying costs include any expenses for setting up and administering the plan and any costs incurred to educate your employees on the plan.

Beginning in 2020 the minimum credit is $500 and for every eligible employee you will receive a $250 credit, up to $5,000. Eligible employees must also be “non-highly compensated employees.” These are employees who received less than $125,000 in salary and owned less than 5% of the company. For example, if you have 15 employees you will be eligible for a $3,750 credit (15*$250=$3,750). If you have more than 20 employees you will max out the credit at $5,000, if 50% of your qualifying start-up costs are greater than the credit.

For the Small Employer Retirement Savings Auto-Enrollment Credit you must be an “eligible employer” and have an “eligible plan” as explained above. The business will receive a $500 credit for three years if they maintain an automatic enrollment feature in the employer-sponsored plan.

If you were thinking of adding a retirement plan benefit to your business, these credits will help you with the costs of setting up and implementing this employee benefit.  If you implemented a plan during 2021, be sure to discuss how these credits apply to your business with your CPA.  Please reach out to Snyder Cohn if you have any questions.

Tax Issues When Selling Your Home

By Darpan Patel

With mortgage rates near record lows and home prices soaring, you may be considering buying a new home and selling your existing home. Before you put your home up for sale, you should consider any tax implications to avoid any surprises. If you have owned the home for one year or less, the gain is taxed at your ordinary income tax rate. Otherwise, it is taxed at the more favorable capital gains tax rates. However, you may be able to exclude gain of up to $250,000 ($ 500,000 if filing as married filing jointly) if you meet the ownership and use tests discussed below.

  • Ownership Test
    To meet the ownership test, you must have owned your home for at least 2 years out of the last 5 years until the date of sale. For couples married filing jointly, only one spouse is required to own the home to meet the ownership test.
  • Use Test
    To meet the use test, you must meet the ownership test and have used the home as your primary residence for 2 years out of the previous 5 years. The 2 years do not have to be consecutive. As long as you’ve used it for 2 years (730 days) in the five year period as your primary residence you meet the use test. For couples married filing jointly, each spouse must have used the home as his/her primary residence for 2 years out of the previous 5 years.
  • Exclusion of gain
    As per IRC §121, you can exclude the gain (partially or all) from the sale of your home, if you meet both the ownership and use tests and avoid paying taxes on the gain to a certain amount. The maximum amount that can be excluded from your income is the first $250,000 of gain (or $500,000 if married couple filing jointly). Any gain in excess of the exclusion amount from the sale of your home is treated as a long term capital gain, given that you’ve owned the home for more than a year.

Other tax implications to worry about include tracking the cost basis of your home and realizing that a loss incurred from the sale of your home is not deductible as a loss on your income tax return. The cost basis of your home is the purchase price you paid, any closing costs on the purchase and sale, plus the cost of any improvements you made to the property. Maintaining thorough records of the improvements (invoices) and original purchase documents can help determine the accurate cost basis of the property. Additionally, if you used your primary residence for business purposes (home office or rental) there may be recapture of depreciation taken in prior years upon the sale.

If you are thinking of selling your home, you should speak with your CPA to determine if you are eligible for any gain exclusion and avoid any tax surprises.

Pass-Through Entities – Maryland Tax Filing & Payment Deadlines Extended by Comptroller

By Lorraine Sexton

New Maryland Form 511 – Pass-Through Entity Election Income Tax Return was released on Tuesday, June 29th. Tax preparers have been awaiting the release of this form, necessary due to Maryland legislation that was recently enacted allowing pass-through entities (partnerships and S-corporations) to elect to pay Maryland tax at the entity level and then claim the state tax deduction at the entity level. A few states have enacted similar entity level taxes in response to the federal $10,000 cap on itemized deductions for state and local taxes (“SALT”) for individual income tax purposes.

After releasing the form, the Comptroller of Maryland further extended the filing and payment deadlines for pass-through entity income tax returns from July 15, 2021 to September 15, 2021. Pass-through entities that file their 2020 income tax returns and pay any outstanding liabilities by September 15th will not be charged any late payment/filing interest or penalty.

The extension and waiver do not apply to interest or penalty charged on 2021 underpayment of estimated tax. However, pass-through entities that want to request a waiver of interest or penalty charged on underpayment of estimated tax, or late payment penalty and interest charged for returns filed after September 15th may submit their requests to PTEREQUEST @ marylandtaxes.gov.

Requests for an extension of time to file pass-through entity income tax returns beyond September 15th may be made using Form 510E. The extended filing due date would be November 15th for S corporations and October 15th for all other pass-through entities. However, the tax payment due date would remain September 15th.

Individual members of a pass-through entity whose returns cannot be filed until the pass-through entity files its return and issues the Schedules K-1 to members, may also request a waiver of interest or penalty by e-mailing their requests to PTEREQUEST @ marylandtaxes.gov.

While the implementation of the MD pass-through entity tax has been challenging to navigate, it brings significant benefits to MD businesses and their owners. Snyder Cohn can help you determine if there is a benefit from making this election to pay tax at the pass-through entity level. Contact us with any questions you have regarding your pass-through entity tax filings, including the new Form 511, the extended filing and payment deadline, and eligibility for the waiver of penalty and interest.

What Plan Sponsors Need to Know about Fiduciary Responsibility

By Chris Crouthamel

It is a common misconception among Plan Sponsors that contracting with their third party administrator to act as a trustee of the Plan abdicates their fiduciary responsibility to the Plan and allows them to take a backseat with respect to overseeing the day-to-day operations and transactions of the Plan. This is NOT TRUE! The Plan Sponsor is ultimately the party responsible for every aspect of the Plan’s operations and activity and it is the Plan Sponsor that would be liable for any penalties resulting from operational and compliance issues discovered and enforced by the DOL.

Who is a Plan Fiduciary and What are Their Responsibilities?

Anyone who exercises discretion or control over a plan or its assets is considered a Plan fiduciary. Plan fiduciaries can be one individual or a committee of individuals who have responsibility over the Plan and, in recent years, many more professionals who make investment-related recommendations to the Plan (i.e. investment advisors) are now considered to be fiduciaries of the Plan as well.

The following list outlines the many responsibilities of a Plan fiduciary:

  • Act prudently solely on behalf of the Plan and the Plan’s participants and their beneficiaries
  • Ensure the Plan Document is being followed
  • Ensure the Plan offers properly diversified Plan investments
  • Monitor the services and processes being provided by third party providers (i.e. custodian, recordkeeper, etc.)
  • Ensure the Plan pays only reasonable expenses
  • Keep participants updated appropriately with any significant Plan news or changes
  • Ensure the appropriate amount of bonding is in place for the Plan (required to have the lesser of 10% of the Plan’s assets at the beginning of the Plan year, or $500,000)
  • Offer education and training to employees about the Plan
  • Continue to keep current on changing laws and regulations impacting the Plan and its operations
  • Document your due diligence in these fiduciary responsibility areas (i.e. minutes)
  • File your Form 5500 timely with audited financial statements (if applicable)

Red Flags during DOL Audits and Enforcement of Audit Findings

Being selected for a DOL audit can have serious consequences for the Plan Sponsor. Plan Sponsors often think service providers will take the blame and suffer the consequences when compliance issues arise, but Plan Sponsors are ultimately responsible for Plan administration and operation and are thus open to suffering serious consequences if significant issues are found during an audit.

DOL audits primarily focus on the fiduciary issues discussed above, as well as reporting and disclosure requirements. These issues can mostly be found in the Form 5500 that Plans are required to file annually. Also, Plan participants or others tied to the Plan can file complaints against Plans, employers or service providers.

As mentioned above, the Form 5500 is a valuable resource for DOL investigators. Filing late or incomplete forms is likely to get investigators’ attention, but the DOL doesn’t stop there. Other major red flags the DOL looks for include:

  • Failure to file Form 5500
  • Failure to follow the Plan Document
  • Imprudent investments
  • Improper payment of expenses or compensation to fiduciaries
  • Prohibited transactions
  • Late remittances of contributions
  • Failure to maintain an ERISA bond

If compliance issues are found by the DOL, fines are levied accordingly. The failure to file a Form 5500 will cost a Plan Sponsor $1,100 for each day it is late with no maximum. Penalties for other compliance issues vary, but are significant.

How Can Plan Sponsors Avoid DOL Enforcement?

Given that Plan Sponsors are the ultimate fiduciary of the Plan, it is imperative that they act in the best interests of Plan participants and effectively carry out all of their fiduciary responsibilities. They must ensure the team of other fiduciaries and service providers are aware of the design laid out in the Plan Document and carry out the Plan in accordance with the Plan Document. There is no doubt that Plan Sponsors have many responsibilities to manage, but ensuring your Plan is in compliance should be a top priority. In certain cases, fines and other penalties can destroy not just the Plan, but the Company itself.

Snyder Cohn, PC provides audit services for employee benefit plans. Please contact us if you have any questions or need assistance in this area.

Paycheck Protection Loan Forgiveness Application Timing

By Tim Moore

Many business owners and their advisors spent an exorbitant amount of time during 2020 applying for a Paycheck Protection Program (PPP) loan. The first wave of this program kept many of these businesses afloat during the pandemic. For those businesses, now is the time to jump over the next hurdle – forgiveness.

Simply put, if forgiveness is not sought or obtained, PPP loans must be repaid over a five-year term at one percent interest. The period of time to apply for forgiveness extends beyond the point at which the loan must start to be repaid, but in most cases, it is advantageous to seek forgiveness before the loan payments must begin. There may be important reasons to wait, for example, coordination of the wages used on the application versus wages to be applied to the Employee Retention Credit.

For those borrowers that have not yet applied for forgiveness for their first PPP loan, the timing is important to avoid the need to start making loan repayments. According to the latest guidance from the Small Business Administration (SBA), the borrower may apply any time on or before the maturity date of the loan. If the borrower does not want to start making payments, it must apply for the loan forgiveness within 10 months after the last day of the maximum covered period. The covered period window of time, for this purpose, begins on the day the loan is disbursed and ends on the date exactly 24 weeks later. As an example, if a borrower receives a loan disbursement on May 28th of 2020, the date 24 weeks later is November 12th, 2020 and the date 10 months after that is September 12th, 2021.

There has been some confusion, since the law changed the rules for covered periods, that the 10 month period starts to run at the end of the covered period chosen by the borrower for the determination of covered expenses (those that create eligibility for forgiveness). That is not the case. For application purposes, the 10 months begins at the end of the maximum covered period that may be chosen, not the covered period actually chosen by the borrower. That allows for more time to apply without creating risk that payments must begin.

The turnaround time for loan forgiveness is less certain. By law, the lender has 60 days from receipt of the forgiveness application to submit it to the SBA, but SBA can take much longer to respond. Recent evidence of the period from application to notification of forgiveness puts larger loans at 90 or more days. For a borrower that is sensitive to the debt on its balance sheet or, for example, is looking to sell a business that took a PPP loan, there may be compelling reasons to start the application process sooner rather than later.

While we provided some basic information on the PPP Loan Forgiveness application and timing, it is important to understand that everyone’s situation is unique. Contact a Snyder Cohn associate to see how we can help you.

Ten Cybersecurity Steps We All Need to Follow

During the pandemic, given the increase in remote work, the importance of cybersecurity has only increased. Dealing with cybersecurity issues can seem daunting for both individuals and businesses, but we wanted to make you aware of some easy steps you can take to help keep your computers and devices secure.

  1. Load antivirus on your computers and devices (including tablets and phones) and keep the virus definitions up to date.
  2. Use a firewall to help keep malicious actors off your computer. Some firewalls can also block geographically, so you can block entire countries from access.
  3. Do not reuse passwords, and change them with regularity. Hackers know some people use the same password in multiple places. If you’ve ordered something off a website and that site is hacked with the hackers collecting passwords, email addresses, and usernames, the hackers will typically try to use those credentials on other sites such as banking websites, social media websites, email sites such as Gmail or Yahoo, and corporate networks, because they know some people use the same password in multiple places.
  4. Use two factor authentication (2FA) when possible. Factors are something you know, something you have, or something you are, and 2FA requires two of those things. Something you know could be your password. Something you have could be your cell phone. Something you are would be your physical characteristics (biometrics) such as your fingerprint or voice. For example, you could configure 2FA on your bank account where you would first enter your password, which would then trigger a phone call to your cell phone with a code you would enter to complete the login process. That way, if someone gains access to your password, they will also need your cell phone to access your account.
  5. Keep your operating system patched. As security vulnerabilities are discovered, patches are created and released to the public in the form of operating system updates. Most operating systems allow automatic installation of updates, so it is an easy way to keep your operating system patched.
  6. Have a process so that employees who leave the company have their network login rights disabled and are removed from your computer systems promptly. Do not forget to remove them from any portals, or cloud-based software packages that operate outside your network.
  7. Watch those email links! Bad actors are known for making malicious links look legitimate by giving them a familiar title, such as a banking website, but the underlying hyperlink goes someplace you would rather not be. Hovering your mouse over a link will show you the underlying hyperlink, but DO NOT CLICK unless you are confident the link is where you want to go.
  8. Just because an email says it is from a certain person does not make it so. When looking at an email, do not only look at the name of the sender but also look at their email address. The odds of your attorney Michael using an email address that starts with “Helen” and ends with a .edu extension are probably slim.
  9. If you receive an unexpected email attachment from a person, there is nothing wrong with picking up the phone and calling the person to ask if they sent it, BEFORE downloading and opening it. Attachments can have malicious payloads. Also, do not call the person using the phone number in the email. If a malicious person sent you the email, that phone number could go to them.
  10. Secure your devices. Crimes of opportunity happen in a flash. Leaving your laptop unattended on the seat of your car, or your phone on the table at Starbucks while you pick up your order invites crimes of opportunity.

Hacking is big business, so it will not be disappearing anytime soon. However, by being vigilant, and taking the steps we can, we can help reduce the odds of being one of their victims.

Ask Captain Codehead – Tax advice for people who think outside the box — and possibly the law

by Greg Yoder

Dear Captain Codehead,

I’m confused about the tax deadlines this year. It used to always be April 15, but then last year it was July 15, and now I’m hearing different things from different people. My brother-in-law told me that it was moved to May 17, but he also told me that the Earth is flat. Is he right?

–Timely Wannabe

Dear TW,

No. The Earth is an oblate spheroid, which basically means round. Glad I could clear that up for you.

My editor insists that I answer the part of your question that’s actually tax related. As of the time I’m writing this, the due date for 2020 federal individual income tax returns has been moved to May 17, 2021. But your first quarter estimates for 2021 are still due on April 15. Some other due dates have also been moved, but many haven’t. Also, each state gets to make its own decisions about whether and how far they want to move their own deadlines. The changes and inconsistencies would be enough to make me curl into the fetal position and refuse to leave the house, but I can’t do that. Mostly because I already did that a year ago and haven’t moved since. (I guess that means I should say that the Earth was round the last time I checked.)

Is May 17th the IRS’ final answer for this year? Maybe. My sources tell me that on May 1st, Commissioner Rettig will emerge from his bunker, and if he sees his shadow, we get six more weeks of tax season. So I guess you could pray for sun, but keep in mind that if he’s struck by lightning, we all get the rest of the year off, so…

Dear Captain Codehead,

If I have a reaction to my COVID vaccine, do I still have to file my tax return on time? If I were faking it (allegedly), how would the IRS know?

–Achoo

Dear Achoo,

Gezundheit. Now go wash your hands! (And file your return: the IRS knows everything.)

Your question, or some variation of it, is one of the most common questions we1 get here at ACC. So let’s run through what works or doesn’t work to let you file your return after May 17.

Works: I filed an extension and paid all tax due on or before May 17.

Doesn’t work: I didn’t file my return or an extension, but I totally meant to. The IRS wants you to know that they totally believe you. But they don’t care.

Works: I live in another country. Taxpayers who live abroad have until June 15 to both file and pay their taxes.

Doesn’t work: I was traveling abroad, and I got stuck in quarantine. The IRS wants you to know that they have the utmost sympathy for your situation. But they don’t care.

Works: I live in a federally declared disaster area. You will note that this one is tough to plan for. On the other hand, real estate in disaster areas is often dirt cheap (or cheap dirt), so there’s no reason why you can’t have a house in a flood plain, another on a fault line, and still another next to an active volcano. Captain Codehead would be remiss if he didn’t point out that moving to a federally declared disaster area is potentially more work than just getting your tax information to your accountant, but you do you.

Doesn’t work: I have teenagers, and my home could reasonably be considered a disaster area. The IRS wants you to know: this too shall pass. Also: they don’t care.

Works: Death. Technically, this doesn’t really work: your return is still due on May 17. But it’s somebody else’s problem, right?

Doesn’t work: The dog ate my tax return. The IRS would like to remind you to e-file.
Doesn’t work: The dog ate my computer. The IRS would like to remind you to back up your data frequently.
Doesn’t work: The dog ate my computer and all my thumb drives2. The IRS would like to offer its sympathy — to your dog. Also, it’s notifying the ASPCA, and your return is still due.

Dear Captain Codehead,

You’re my favorite superhero, so I was wondering whether you could give me your deets: origin story, alter ego, nemeses, weakness? What about super powers: is it true you can leap tall stacks of Treasury regulations in a single bound? Also, when is there going to be a movie, and who’s going to play you?

–Curious

Dear Curious,

Gosh, it’s nice to have fans; I can’t tell you how many emails I get from people who want me to be their kid’s godfather or who dressed up as me for Halloween3. Obviously, for reasons of security, I can’t reveal my alter ego, but your other questions are all answered in the film, which is coming October 15th to a theater near you. I will say that I got my dream cast: the early, nerdy, non-superhero version of me is played by Patton Oswalt, and the later, studly, superhero version of me is played by Zack Galifianakis! Or I might have that reversed: I wanted to attend an early screening, but my attorney advised me against violating the restraining order. Lawyers, what a bunch of killjoys, amirite?

HAPPY APRIL FOOLS’ DAY!!!!!

1And by “we,” I mean I.
2No animals (or thumb drives) were harmed in the writing of this column.
3Frankly, this is an extremely low-effort costume (especially during the pandemic: basically, you just put on sweatpants and forget to shave), but I appreciate the thought.

2021 Employee Retention Credit – As We Come to the End of the First Quarter

By Tim Moore

In the dynamic world of taxes, few areas have been more unpredictable in the last year than the Employee Retention Credit (“Credit” or “ERC”). One of the mechanisms created by Congress to help businesses and employees during the pandemic, the ERC underwent multiple changes since its introduction under the CARES Act in March of 2020. As we come to the end of the first quarter of 2021, it is important to understand how the Credit can benefit your business this year.

Eligibility for the Credit in 2021

To be eligible for the ERC in 2021, a business, which includes exempt organizations, will need to show either that (1) the business was subject to governmental orders that resulted in full or partial suspension of operations, or (2) the business experienced a 20% decrease in gross receipts during a calendar quarter compared to the same calendar quarter of 2019. Alternatively, a business can meet the gross receipts reduction by looking at 4th quarter 2020 compared to 4th quarter 2019.

Credit Amount

Employers with 500 or fewer employees can claim a credit for wages paid to all employees, even if those employees continue to provide services. The credit amount is 70% of the first $10,000 of qualified wages per employee ($7,000 credit per quarter for each eligible employee). Employers with over 500 employees are only able to claim the credit for wages paid to employees who are not working.

Congress Giveth and Congress Taketh Away

As with most tax benefits, there are collateral effects that are not immediately evident. The ERC has more than its share of such consequences. First, tax law abhors double benefits and, as a result, deductible wages (and associated health plan costs) are reduced by the amount of any Credit received.

Second, if the business also took out a PPP loan in 2021 (or still intends to do so) it must allocate the wages between the two benefits as you cannot use the same wages for PPP forgiveness and the ERC. It is important to keep in mind that while wages used to claim the Credit are reduced by the Credit received, those used as a basis for forgiveness of a PPP loan continue to be deductible.

Time to Take the Credit

After the American Rescue Plan Act of 2021 was passed, the ERC was made available for the 1st -4th quarters of 2021. The Credit can be taken on the business’ 941 filed each quarter, or on an amended 941-X if you are applying for the credit after initial 941 was filed. One of the most important features of the Credit is that it is “refundable”, which simply means that if the taxpayer has not paid in, or is not obligated to pay in, as much payroll tax as the amount of the Credit, it may claim a refund for additional Credit. That refund will provide much needed funds to the taxpayer to help cover wages and other business expenses.

Conclusion

This article focuses on the 2021 treatment of the employee retention credit, but please note that in January 2021 the Consolidated Appropriations Act opened up the employee retention credit for 2020 to businesses and nonprofits that had previously received a PPP loan. The 2020 rules for the employee retention credit are different than the rules for 2021, in that the credit is limited to $5,000 annually, per employee.

This is a brief overview of a tremendously complicated area of new tax law. Tax professionals still grapple with unanswered questions and gray areas in the rules. That said, the financial benefit of a proper application of the ERC can be the difference between survival and failure for many businesses and should be considered carefully whenever eligibility is even remotely likely. If you have questions on whether you are eligible for the Employee Retention Credit in 2021, please reach out to Snyder Cohn.

Qualified Improvement Property: CARES Correction

By Dustin Cutlip

The term Qualified Improvement Property, commonly known as ‘QIP’, originated with simplification in mind. However, through the years its application has been anything but simple.

Background and Definition

The Qualified Improvement Property classification was created as part of the PATH Act of 2015 as a combination and / or replacement to the old Leasehold Improvement Property, Retail Improvement Property, and Restaurant Property asset classifications. Qualified Improvement Property assets placed in service on or after January 1, 2016 were subject to a 15-year recovery life and eligible for accelerated bonus depreciation.

Qualified Improvement Property is defined as any improvement to an interior portion of a building which is non-residential real property, if such improvement is placed in service after the date such building was placed in service. There is no requirement that the improvement be pursuant to a lease and the improvements can be made to common areas of a building that are used by all tenants. However, Qualified Improvement Property does not include improvements attributable to building enlargements, internal structural framework or elevators / escalators.

Due to a drafting error in the Tax Cuts and Jobs Act of 2017 (‘TCJA’) the 15-year recovery life was not applied to Qualified Improvement Property. As a result, Qualified Improvement Property placed in service after December 31, 2017 became subject to a 39-year recovery life and was no longer eligible for accelerated bonus depreciation. It was widely known this was not the legislative intent of TCJA, but unfortunately that is how the law was written and applied.

CARES Correction

The Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 finally issued the technical correction to the Qualified Improvement Property definition that we were all waiting for. This correction retroactively reinstated the 15-year recovery life and eligibility for accelerated bonus depreciation for Qualified Improvement Property placed in service after December 31, 2017.

It is important to note that this taxpayer favorable adjustment to recovery life (from 39 years to 15 years) is not an optional change, it is required. Once the CARES Act was signed into law the 39-year recovery life for Qualified Improvement Property became an improper accounting method.

Call to Action

As a result, Taxpayers who have 39-year Qualified Improvement Property on their depreciation schedule need to take corrective action for tax years 2018 and 2019. Luckily, the IRS has provided some flexibility to make these corrections through the following options:

  • Filing an amended return(s)
  • Filing a change of accounting method – This would account for the change in the current year, rather than having to amend prior year tax returns.
  • Filing an Administrative Adjustment Request

It is important to note that a change in depreciation expense will likely interplay with other legislative changes under the TCJA and CARES Act, such as (but not limited to) business interest expense deductions, net operating loss rules, and excess business loss limitations. There is no one size fits all choice for Taxpayers. Careful consideration should be given to select a corrective method that will yield the most favorable tax outcome for your situation.

Please contact your Snyder Cohn advisor for more information on how these changes may affect your tax situation!

To C, or not to C: Choosing the Right Business Entity for your Startup

By Jacob Osburn

You have the idea for the “Next Big Thing.” You workshopped the idea with friends and, if you’re very brave, family, and now you are ready to go out and get some investors to make this idea become reality. Not so fast. Along with the seemingly endless amounts of decisions you must now make as a new entrepreneur, one will have a huge impact on the future of your company: What business entity should I choose?

The C-Corporation (C-Corp) is the go-to entity choice for many entrepreneurs. It provides liability protection to its investors, effectively limiting the risk of loss only to those amounts invested. Also, a C-Corp can offer many different types of stock to investors, including preferred shares which will allow these investors to get the first piece of the pie when dividends are paid or a return on investment is made. A C-Corp can also offer various types of compensation, such as stock options, in order to hire and retain top talent when actual liquid cash for higher salaries is not available. The major downfall of the C-Corp is that it does get hit with double taxation. First, any net income is taxed at the entity level and then the shareholders pay tax on the dividends paid out from the company. Double tax? No thanks. So, what is the alternative?

The S-Corporation (S-Corp) swoops in to save the day! It enjoys the same liability protections afforded a C-Corp but avoids double taxation by passing the items of income and loss directly out to the shareholder. Of course, the IRS would not allow this without attaching some strings, and those strings can feel more like anchors. An S-Corp is limited to only 100 unique investors, those investors must be US Citizens and cannot be C-Corps, or pass-through entities, and only one class of stock can be issued. All these factors conspire to make the S-Corp an almost non-starter if you are seeking large investors or venture capitalists. But before we go back to the C-Corp, there is another potential entity choice to consider.

The Limited Liability Company (LLC) is currently the most popular entity choice. They are as flexible as a C-Corp with their ability to offer different classes of membership and incentive-based compensation, while maintaining their liability protection. Also, they offer the pass-thru taxation benefit of an S-Corp without the restrictions on investors. There are a few key differences between an S-Corp and LLC when it comes to taxation. For instance, an S-Corp may pay and deduct salaries to its shareholders if they are reasonable and the income that passes thru is not subject to self-employment tax. Conversely, an LLC cannot pay salaries to its members and the income passed out is subject to self-employment taxes. So, maybe the LLC is the choice for you? Yet again, a venture capitalist will have something to say.

Venture capitalists (VCs) will almost exclusively require the companies they invest in to be formed as a C-Corp, for all the reasons noted above. Even though an LLC can provide many of the same benefits, the fact that the income is passed through to the owners is actually a detriment, as many VC’s are interested in investing in companies that will have some sort of liquidity event in the future. One option to help get your company off the ground is to form an LLC and then to convert to a C-Corp down the road when you start seeking larger investors or venture capitalists. This allows you to utilize the benefits of pass-thru taxation in the early stages of your business, and this conversion can be as easy as checking a box on your tax return (it is a separate form) to elect to be taxed as a C-Corp with the upside being that this conversion will most likely not be a taxable event as long as your assets exceed liabilities at the time of election.

We have only scratched the surface on entity choice. While we provided some basic reasoning and strategies, it’s important to understand that everyone’s situation is unique. Contact a Snyder Cohn associate to see how we can help you during this exciting and important time in your business’s life.