Business Planning 101: Check-the-Box Regulation, the LLC, and the Manipulation of Employment Taxes

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By Marie V. Velazquez^*

According the US Bureau of Labor Statistics, only 44% of businesses survive the first 4 years in business.  Starting a business is no longer considered uncommon.  However, some individuals may not be familiar with the different business entities and which entity would suit their business the best. Some of those individuals might not even know that if they run a business and do not incorporate, they will default to a partnership or, if a single person, sole proprietorship.  If not given proper guidance, start up businesses could fail because of improper planning. Due to the unique tax and liability consequences associated with each of the different business entities, much attention should be given to these areas when forming a business.  Taking into consideration the structure of employment taxes is one of many aspects that a person should analyze before starting a business.

In general, “business planning involves the following three objectives: (1) minimization of income taxes; (2) limitation of individual liability; and (3) provision of flexibility and ease in operation.”¹  This paper first considers the different types of business entities available for an individual to chose from, leading up to the creation of the limited liability company (LLC).  Prior to the 1997 Check-the-Box regulations, business owners were confused about how the  LLC would be taxed for federal income tax purposes. The 1997 Check-the-Box regulation  clarified many of these questions on taxation.  The regulations allow both a single member LLC and multi-member LLC to chose how they wish to be taxed for federal income tax purposes. After a brief explanation of each of the business entities and how Check-the-Box works, the paper will then conclude with an analysis of FICA and SECA tax.  The FICA and SECA taxes are calculated differently for each business entity.  The choice of entity that the LLC makes under Check-the-Box will determine the amount of FICA or SECA tax owed.   This choice gives the LCC the potential to tailor their entity in a way which best suits their individual business needs.

I.  ENTITIES

Prior to the limited liability company, a start up business could only identify as a sole proprietorship, a partnership, or a corporation.  The sole proprietorship is a disregarded entity and income passes straight through to the owner while having unlimited liability.  A partnership is also a pass-through entity in which the partners are responsible for paying income taxes while retaining unlimited liability.  A corporation provides owners with limited liability, but a double tax is imposed.

Sole Proprietorship

The simplest business entity, used primarily by small family-owned businesses, is the sole proprietorship.  The sole proprietorship is formed without any formality and the costs in establishing and running a sole proprietorship are minimal.²  A sole proprietorship exists when an individual conducts business on his or her own, without the existence of any formal entity. For federal income tax purposes, a sole proprietor is a “disregarded entity” for income tax purposes.³   “Generally, when an entity is disregarded, its entity status under state law is ignored for federal tax purposes, and all of its assets, liabilities, and items of income, deduction, and credit are treated as the assets, liabilities, and tax items of the single owner of the disregarded entity.”⁴  Because the sole proprietorship is not viewed as an entity separate from its owner, all the taxable income, credits, and deductions of the business are reported on the owner’s individual tax return. The earnings of the business are only taxed once, and that is at the owner’s individual tax rate. ⁵ “The sole proprietorship provides an entrepreneur with an opportunity to own his own business without the formalities and expense of incorporation or the necessity of sharing control of the business with others.” ⁶

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