When you work with a tax planner to create a proactive tax strategy, deciding on your strategy is just the beginning of the journey. Even the best plan won’t translate to savings without an implementation strategy. One of the benefits of working with a Certified Tax Planner is that they can help you create a step-by-step implementation guide to make sure each task is assigned to someone and everyone is prepared to hit key deadlines.
One common but complex tax strategy is to form a new business entity. At first glance, this may seem like a major investment just to secure tax savings—but with a clear plan and a thoughtful strategy, this can be a streamlined process that makes a real impact on your final tax bill.
Forming a new entity for tax purposes involves ten basic steps:
1. Determine the appropriate entity type
The first big step in forming a new entity is deciding on the entity type. Your specific tax strategy will be the deciding factor here, since each entity type comes with its own tax benefits and its own limitations. For instance, if you currently have an S corporation that is not yielding tax savings, your tax advisor may suggest turning it into a C corporation. This strategy is called tax arbitrage, which is the process of benefitting from the way income, capital gains, and transactions are taxed in different entity types.
2. Determine the domicile
An entity’s domicile is its principal place of business. This decision will also largely be based on tax benefits. However, this requires more than simply choosing a state with no income tax, such as Delaware, Nevada, or Texas. In our digital age, many states have enacted laws for taxing businesses that are based in other states but sell digital products and services in their state. These are known as nexus rules. Once an entity makes a certain amount of sales revenue, they may be required to register, collect, and remit sales tax in the state where those sales occurred.
Other factors may come into play, such as the state’s creditor provisions. If someone gets a judgment against you (a court order demanding you pay a debt), these provisions can protect you from the creditor completely wiping out your monthly revenue stream. For example, California is a very debtor-friendly state, and Delaware has special provisions that allow a debt collector 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
The best case scenario if you are named as the owner of the entity is to set up a living trust. This prevents the taxpayer’s estate from having to go through probate and lose much of its value from taxation. You may also decide to make a child or a grandchild the owner of that commission corporation, depending on your tax strategy.
4. Work with a licensed attorney to open the entity
Relying on LegalZoom or a forms filing service may be tempting, but as tax professionals, we recommend working with an attorney. Many online legal services appear to simplify the process, but they use a boilerplate operating agreements and articles of incorporation (in the case of partnerships) that may be too generic to fully protect that entity. If a dispute between partners or heirs comes up in the future, having legal documents customized for you by an attorney will go a long way.
5-8. Follow these steps if applicable
Depending on your entity type, you may need to take action on the next four steps:
- Register as a foreign entity in operating state
A “foreign” entity in this context simply means your business is not registered in the state in question. Each state has slightly different rules for incorporation, so your team will need to do research on the operating state’s requirements.
- Apply for an EIN
Most entities will need an employer identification number (EIN). The exception is a sole proprietorship—businesses that do not have employees are not required to have an EIN, though it can still be wise to get one.
- Submit elections
If you have an LLC and want it to be taxed as a C 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 may still be able to follow the steps for a late election. You will not need to take this step if your LLC is taxed as a partnership or you are opening a C corporation.
- Apply for local licenses
Your business may need federal and local licenses and permits to operate. You can find more information on the Small Business Association’s website, and you will also want to do research on the rules in your particular county and municipality.
9. Establish books and records
Whether you are already working with an accountant or need to enlist help from your tax planner, you will need someone knowledgeable to set up books and records. Don’t make the mistake of skipping this step—if the IRS sees you didn’t so much as open a QuickBooks file for months after opening your business, this will send up immediate red flags in the event of an audit.
10. Set up monthly recurring journal entries (if applicable)
A recurring journal entry is a business transaction that occurs regularly, such as rent, payroll, or certain shared costs between multiple entities. If you have two entities operating out of the same address, you will need to have documentation showing you have properly allocated operating expenses, accounted for that accrual on a regular basis, and made timely payments. The IRS will look for all of this in an audit, so both companies need to have a clear paper trail.
Summary
Forming an entity can be a straightforward and effective tax strategy when you have a solid implementation plan in place. This is true whether you are looking to establish a sole proprietorship, partnership, corporation, or limited liability company. By breaking the process down into steps, making sure someone is assigned to each task, and setting clear deadlines, you can accomplish what is needed to realize those tax savings.
To receive expert assistance in navigating the entity formation process, reach out to a Certified Tax Planner today.
