Custom harvesters who operate as sole proprietors may think there's little reason to change to another business structure.
But there are two reasons to reconsider the sole proprietorship, says Gregory Anderson, a certified public accountant with a large agricultural practice. First, you may get sued and lose not only your business, but also your house and other personal assets. All it takes is an accident while moving machinery. Second, you may be paying too many taxes.
“People wonder why they can't get ahead,” says Anderson, of Manitowoc, WI. “One reason is the wrong choice of business structure.”
To help sort through business structures, Anderson offers these explanations.
The sole proprietorship is simple to use, but personal assets are at risk from a big legal judgment. And health insurance premiums aren't deductible as a business expense, although they are deductible on individual income tax returns.
This distinction might seem minor. But counting health premiums as a business expense reduces the income subject to Social Security — a 15.3% tax bite. (General partnerships function roughly the same way.)
The limited liability company limits exposure of personal assets from legal judgments against the business. Assets such as home, cars and personal investments are protected — but it's not absolute protection.
The C corporation shields owners against personal liability from legal judgments in most cases. It can also save taxes over the sole proprietorship, especially for operators in high tax brackets. That frees up cash to put back into the business.
Here's how it works. Let's say the owner is in the 27% tax bracket. If he's a sole proprietor, for every $100 profit, he pays $42.30 in federal taxes and Social Security. That leaves $57.70 for his personal use.
But let's say the owner wants to raise cash for new equipment. Operating as a C corporation, he can retain profits for the business instead of distributing them to himself as income.
For C corporations, the first $50,000 of retained income is taxed at 15% instead of 27%. And corporations don't pay Social Security. So for every $100 of profits, $85 are available to put back into the business.
In addition, health insurance premiums are fully deductible as a business expense, saving Social Security taxes. (Note: if you pay less into Social Security, you'll get less when you retire.)
But C-corporation status could subject income to double taxation. First, profits are taxed at the corporate level, then owners must pay taxes on any distributed dividends. That's one reason some operators don't incorporate. But as a practical matter, says Anderson, ag businesses almost never pay dividends.
The S corporation also offers personal liability protection. But there are big differences between C and S corporations. You can't use an S corporation to provide deductible health insurance to yourself if you hold more than 2% of its stock. But the S corporation offers a big advantage if you lose money. Losses can be used to offset income from other sources, such as investments, pension income, or a spouse's salary from an in-town job.
You can switch back and forth between C and S corporate status, choosing the one that benefits you in a given year. But not at the last minute. Consult your accountant for deadlines in choosing C or S status.
Anderson offers other advice:
Consult an accountant or lawyer versed in agricultural tax law before choosing a new structure.
Be flexible. The business structure that works best now may not work best down the road. Tax laws change. Moreover, the structure that works when you're starting out may not serve well when you're preparing for retirement.
Think twice before putting real estate into the assets of a C corporation. If you do, you'll be subject to double taxation if you later sell the land. You'll first pay capital gains taxes and then pay individual income taxes on what's left.