When I started my company in April 2009, I didn’t know much about business formation or the tax implications. Thank goodness I had a good friend and CPA who sat me down and told me everything I needed to know. If you’re starting a business, a CPA you know and trust is one person that should be on your personal board of advisors.
I created an LLC (limited liability company) and elected to be taxed as an S corp. All that means is that my business income is only taxed once and passes through to my personal tax return. In my experience as a business owner and a banker, a large majority of closely held companies are taxed as an S corp.
Many business owners purchasing or starting a business have significant savings in their 401k plan. So, utilizing these funds to start your company can make some sense, especially if the investment required is large. The ERSOP (entrepreneur rollover stock purchase plan) was born where an entrepreneur can rollover 401k funds to purchase stock of an existing business or create the initial stock in a startup business.
However, ERSOP companies are required to be taxed as a C corp. C corp taxation is double, once when the profit is made and once again when it’s distributed. This double taxation of earnings is significant, but in some cases may be the only option available.
I work with a business that used this method and it has worked well. However, distributions have been for taxes only. The company has increased in value since it was purchased. Now, the owners are looking at taking distributions and paying back their 401ks for funds used. Since the stock is repurchased at market value, they pay their 401k back a sizable amount over the original purchase price. With the 401k paid back, they can switch to an S corp tax election and avoid the double taxation.
With any tax issue, the best advice is to consult with your CPA to understand your options. However, in my opinion, the main reason to elect an S corp is to avoid double taxation of earnings.
Starting a business and understanding your financials can be confusing and frustrating. But you don’t have to do it alone. Let’s talk.