Formulating a tax strategy is just the first step in moving your clients toward tax savings. The best-laid plan will be useless without an implementation strategy. If you use a tax planning software solution like Tru Tax Planner, you will have access to ready-made implementation guides for even complicated tax strategies.
One often-used strategy that requires a complex implementation process is forming a new business entity. Our implementation guide will show you that there are ten basic steps to forming a new entity for tax purposes:
1. Determine the appropriate entity type
The biggest part of entity formation actually happens during the planning phase when you determine which entity type is best for your particular tax strategy. Each entity type comes with its own tax benefits and its own limitations, and you can leverage a tool like Tru Tax Planner to run projections and compare the possible tax savings. For example, say your client currently retains earnings in an S corporation but they are not seeing any tax rewards. You can run a projection to see whether it makes sense to convert this entity into a C corporation instead. This may allow you to get tax arbitrage—to benefit from the way income, capital gains, and transactions are taxed in different entity types.
2. Determine the domicile
From a tax perspective, where does it make sense for this entity type to be geographically based? “Domicile” is the official term for the principal place of business. Deciding on a domicile requires more thought than simply choosing a state with no income tax, such as Delaware, Nevada, or Texas. Especially in our digital age, nexus rules impact how businesses are taxed—once an entity hits a certain sales threshold, they may be required to register, collect, and remit sales tax in the state where those purchases were made. Nexus rules are only getting more stringent as digital products and services.
Other factors come into play when choosing a state. Attorneys sometimes recommend you select a state that has strong creditor provisions, so if someone gets a judgment (a court order that empowers a debt collector) against you, they cannot come in and wipe out your monthly revenue stream. California is a very debtor-friendly state, for instance. Delaware also has a strong charging order rule that helps protect people’s income so that a debt collector may be able to seize your ownership of an asset, but they cannot force you to liquidate that asset or redirect revenue.
3. Identify ownership of the recommended entity
Next, you will need to identify an owner, preferably through a living trust. This prevents the taxpayer’s estate from having to go through probate, which typically causes the estate to shrink dramatically via taxation. Depending on what we are trying to accomplish with this tax strategy—whether that’s income shifting, estate planning, or something else—we may decide to make a child or a grandchild the owner of that commission corporation. In any case, thinking through the tax implications of ownership is a key part of this process.
4. Work with a licensed attorney to open the entity
Going through an attorney is the recommended next step. While it may be tempting to rely on LegalZoom or a forms filing service, these services use a boilerplate operating agreement and boilerplate articles of incorporation (in the case of partnerships) that may be too generic to protect that entity down the road. In the event of a dispute between partners or heirs, the number one choice is always to work with an attorney.
5-8. Follow these steps if applicable
The next four items may not be necessary for every entity type, so you can start by collecting information on the needs of the taxpayer and do your research from there to determine if these steps are needed:
- Register as a foreign entity in operating state
Entities must be registered in each state they do business in—in this case, “foreign” simply refers to a business that is not currently incorporated in a certain state. You or someone on the taxpayer’s team will need to research the particular process in each operating state.
- Apply for an EIN
Most entities will need an employer identification number (EIN). Sole proprietors are not required to get one, but they may want one so if they hire any employees in the future, that task is already done.
- Submit elections
If you have an LLC taxed as a partnership or if you are opening a C corporation, you will not need to take this step. However, if you are going to have an LLC start being taxed as a corporation or if you want to form an S corporation, you will need to submit an Entity Classification Election. If the due date has passed, you should familiarize yourself with the late election procedure.
- Apply for local licenses
Most entities will need licenses and permits, both on a federal and local level, to do business. Start by checking the Small Business Association’s website for information on business activities that require licenses and permits. Be sure to also research the specifics for the county and municipality the business operates in.
9. Establish books and records
The taxpayer may have an accountant they are already working with or you may offer to help set up books and records as part of your services. Sometimes taxpayers have already opened multiple entities, but they never even opened a Quickbooks file for them, which will send up immediate red flags if the IRS conducts an audit.
10. Set up monthly recurring journal entries (if applicable)
Lastly, the taxpayer may need to set up monthly recurring journal entries for items like rent, payroll, and shared costs between multiple entities. For example, if a taxpayer has two entities operating out of the same address, in an audit the IRS will look for evidence of properly allocated operating expenses and documentation for how you are accounting for that accrual on a regular basis and when it is paid. Company One needs to be making regular payments to Company Two so we create that paper trail.
Whether you are looking to establish a sole proprietorship, partnership, corporation, or limited liability company for your client, you need to do more than list “form an entity” in your tax strategy. Establishing a new entity is a complex process that requires a step-by-step implementation plan. Be sure to walk the taxpayer through this plan and assign a person to complete each task and a deadline for that to be complete so you can maximize those savings.
To learn more about how to guide taxpayers through the entity formation process, sign up to become a Certified Tax Planner today.
