Entity Selection for the Small Flower Farm Business
There are many areas of business and tax that I see misunderstood in my course of business as an accountant. There is none more than how the various entities available for selection work operate and benefit the business owners.
During the proverbial “Tax-Season,” I spend most of the beginning of the season working with new clients and talking them through the process of selecting the type of entity and which would be best for them. Unsurprisingly, I usually have the exact same meeting the next year going over why they selected that entity, how to operate it and how it benefits them.
Warning: This is a very complex topic that takes awhile to grasp. That is why, even after all that I am about to say, I recommend that you meet with a licensed professional (CPA or Attorney) in your area and discuss with them what they recommend for your unique situation.
To be able to work through the process of selecting an entity for your business, you first need to identify what it is that you are hoping to achieve through the setting up of said entity. This is unfortunately the most misunderstood and the area surrounded by urban legends, so to speak.
By and large, the most important aspects to consider for a small business flower farmer are liability protection and tax handling.
This isn’t to say that there are not other important and impactful features to consider but these two by far bear the greatest weight in you decision making process.
What are Liability and Tax Handlings?
Let’s briefly go over what Liability Protection and Tax Handling are.
Liability Protection: This protection does not absolve the owner form any and all wrong doings of the entity as some would think. Liability Protection is most simply put as a separation between the entity and the entity’s assets along with the business owner (owners) and the owner(s)’ assets. However, if the delineation between business and personal assets is not clearly defined in the operation of the business, this protection can be quickly overcome in litigation and be made null. Additionally, Liability Protection does not hold up in instances of gross negligence on behalf of the owners.
Tax Handling: Each entity has its own individual ways of being taxed or passing on the income to be taxed by the owner, and even from that point, has different taxes the income is subject to. The most significant, and often overlooked tax, is self-employment tax. This isn’t per se a traditional tax but rather two mandatory withholdings of both Social Security and Medicare. We will explore the tax handling of the three main types of entities further on, in limited detail. The tax handling area is so large that you could create business on helping other people with this…
State Versus Federal
Before we get into the pros and cons of the main entity types, there is one other piece that we need to talk about first: State Vs. Federal
With every entity, there is:
The actual formation and recognition of the entity that is filed with the State that you are setting up the entity in
The way that the entity is taxed/elected to be taxed with the Federal Government.
This is a very hard concept to grasp if you have never had experience with business entities before.
Just because you have set up a LLC or a Corporation with your State (for the sake of this blog, we will be calling it a “(state) Corporation”), doesn’t mean the Federal Government knows you exist or how you would like the be treated for tax purposes, if you have an option on said treatment.
There are a lot of entities that you can choose from in your state to be and every state has their own list of such entities which can be different from any other state.
However, there are four types of entities that are common among all states, those being:
Sole-Proprietors
Partnerships
Limited Liability Companies
Corporations.
Now, this is where we are going to. get in the weeds some, let’s tackle it one at a time.
Sole-Proprietorship
A Sole-Proprietorship is a single person doing business. Some states, including mine, don’t really require anything more than a state business license for you to operate as one. Sole-Proprietorships are, at their core, the simplest entity that you can be. It is also the simplest entity to operate. However, this simplicity comes at a cost in terms of tax and its ability to adapt to your business as it grows.
Tax Handling: Income and expenses are reported on a Schedule-F on your Individual Income Tax Return, aka. Form-1040. The net income generated by the business is subject to self employment tax (15.3%) and also subject to ordinary tax (bracketed).
Liability Protection: None
Partnership
A partnership is essentially two or more sole-proprietors working together.
Tax Handling: Everything that holds true for a Sole-Proprietorship holds true for a Partnership, except, that your income and expenses are reported on a Schedule-F that is reported on a Partnership return aka. Form-1065. You don’t pay tax with the Partnership return, instead, your portion of profit or loss is reported on your Form-1040 by way of a Form-K1.
Liability Protection: None
Corporation
A Corporation is an entity that is recognized on its own independent of its owner (Shareholders). Compared to a solo-proprietorship, there are a lot more requirements for operation including: annual list of officers filings, Federal and sometimes State tax returns (depending upon what state it is in), handling of profits and other such items. There are also two types of corporations that you can choose between when it comes to filling your federal tax return, C-Corps and S-Corps.
Tax Handling:
C-Corp: A C-Corp is the default status for corporations when it comes to filing a Federal tax return. They are considered to be double taxed, as there is one tax that is paid within the corporation (on Form 1120) and there is a second tax that is paid by Shareholders when dividends are distributed. The current corporate tax rate is at a maximum of 21% and dividends are tax at capital gains rates to a maximum of 20% (at the time of writing 2023).
S-Corp: A S-Corp is an elected status that an election has to be filed with the IRS to be recognized. The favorable part about a S-Corp is how it is taxed and how money can be distributed from them. Just like a partnership, a S-Corp does not pay tax at the entity level (Form 1120-S). Earnings are distributed out, based upon ownership, and taxed at the individual level on a Form-1040 by way of a Form K1. The unique part is that its profits are not subject to Self Employment tax as a Sole-Proprietorship or Partnership profits are. This alone is the greatest benefit of a S-Corp and can save its shareholders thousands of dollars. One note, Officers of the S-Corp are required to be paid “Reasonable Compensation” by the S-Corp by way of wages. This is the same wages that are paid to employees and the pay is subject to FICA withholdings, thus paying into Social Security and Medicare (Self Employment tax).
Liability Protection: Both C-Corps and S-Corps have liability protection.
Limited Liability Company:
Now heres where things get complicated!
A LLC is only a LLC with the State that it is registered with. However, with the Federal Government, the LLC may elect to be treated as one of four different tax types. By default, if the LLC only has one owner (Member) then it will be taxed as a “disregarded entity” or just a simple Sole-Proprietorship, reporting its activity on a Schedule-F. Also by default, if the LLC has more than one owner (Member), then it will be treated as a Partnership and will file a Form 1065 tax return.
Oh but it doesn’t stop there!
A LLC may elect to be treated as a Corporation and report its activity on a Form 1120 and if it really wants to get crazy, it can make a second election to have that elected Corporation choose to be treated as a Subchapter-S Corporation aka. S-Corp.
As you can see things just got pretty confusing.
The main thing to understand about LLCs is that you are just setting up an entity that is independent from the Owners and affords them Liability Protection. It is the responsibility of management to determine what would be the best tax treatment with regards to Federal tax law and to make the corresponding election.
Liability Protection: Yes.
Asking 2 main questions to determine entity selection
At this point you’re either scratching your head with more questions than what you started with or you might find yourself thinking “if an LLC can be anything why make anything but an LLC?”
Ok, so I’m going to try and make it easy by providing basic scenarios and common solutions.
First, one last disclaimer: You will in every way be better served by working with a local professional (CPA or Attorney) to help you choose your business entity. So much more goes into selecting one that I haven’t even begun to scratch the surface on in this blog. Additionally, this does not constitute legal advice and is only the analysis of hypothetical scenarios. With that being said, let’s get to it!
There are two questions to be asked:
1. Does the business need Liability Protection or not?
If a business owner has a lot of personal assets that they don’t want to risk and if they feel that their exposure to risk will be higher than average (for a flower farmer) opting for Liability Protection can be a great choice.
2. How much “Net Income” will the business be producing? This will take a guess or knowledge from prior year(s) experience(s).
In this area, what we are really concerned with is: if the business will be generating a Net Income greater than about 60k-70k a year. This will be our break-point in determining whether the business owner would like to be taxed as a subchapter S-Corporation.
Let’s look at some scenarios based upon how these two questions are answered.
Don’t need Liability Protection and Net Income is less than $60K
If a business owner doesn’t feel as though they need the Liability Protection and they won’t have Net Income above $60k, then it is common to skip an LLC or a Corporation and opt for a Sole-Proprietorship.
With the added complexities with operating an LLC or a Corp, along with the added cost of running them, the cons would outweigh any potential benefits of them. The beauty with a Sole-Proprietorship is in its simplicity and almost carefree nature about them. Yes, you will have the added taxation with regards to Self Employment tax but in the first couple to few years; most new business profit is not recognized and the loss can be used to offset other sources of Ordinary Income without worrying about Basis Limitation like you have to with S-Corps. More on that later.
Want Liability Protect and Net Income is less than $60k
What if the business owner doesn’t think they will make too much money but still want Liability Protection? The common recommendation is to still be a Sole-Proprietor but by way of being a disregarded entity in an LLC. A Single Member LLC is by default a disregarded entity that files its taxes on the same Form that a Sole-Proprietor does. The only difference is that the LLC would list its “EIN” aka “Tax ID” on the Form Schedule-C.
This structure would afford the business owner asset protection while also bringing in the ease of being a Sole-Proprietor. However, the one big downside to this setup is that the business owner would be incurring the Annual List of Members fees to the Secretary of State. This isn’t horrible but I feel it’s best to cut cost wherever possible.
Why pay for it if you don’t need it?
When Net Income is over $60k
If a business’s income is over $60K-$70k, it is typically highly encouraged to create an LLC that files as an S-Corp with the Federal Government.
Even if the business owner doesn’t feel they need the Liability Protection, to get the tax savings that an S-Corp provides, they have to set up either an LLC or a (state) Corporation with their Secretary of State.
Why an LLC and not a (state) Corporation in this scenario?
Honestly, in the state of Nevada where I live, an LLC has less annual fees with our Secretary of States office that a Corporation does. Why pay more for something if the cheaper option affords that same benefits? Also, as long as the business is going to stay small and it’s not going to be looking at large growth, like massive expansion growth, a (state) Corporation with the Secretary of State is overkill.
You made it!(almost…)
Well, I’ve laid it out for you and that’s all there is to it, right?
No.
One more thing… or two.
An LLC is a great entity to set up for a growing business, and if annual Secretary of State fees weren’t an issue, setting one up can be ideal, even if the business isn’t profitable.
The thing about an LLC is that it can grow with you as your business grows. In the first beginning year, an LLC can file as a Sole-Proprietor but as the business grows and the income grows, it can be ready for you to make a couple elections that will changing your tax status to an S-Corp, to take advantage of the tax savings.
If money isn’t that big of a concern, consider setting up an LLC from the beginning.
Lastly, I didn’t talk about one big area that will affect most of the people in the United Sates: State Tax!
Each the scenarios provided are lacking State tax and fee considerations, as all states have different taxes and fees.
That being said, you have to do your own research on the fees and taxes for your own state, or make it easy on yourself and hire a professional.
I know this can be a brain blowing topic! I attempted to present it in a fashion that shed as much light on it as possible without overwhelming.
Until next time, we are looking forward to helping you hand blooms soon.
- Graham & Jessica
If you have any questions, please leave them in the comment section below and I will do my best to answer them or update the blog to reflect them.
As there is so much that needs to go into making the right decision for each person and their business, I will not be able to answer specific questions related to individuals own scenarios.