What are “business entities”?
Business entities are legal organizations that exist by virtue of state law. One way to view a business entity is as a separate person. The business entity carries on business activity on its own behalf. The owners of the business entity are representatives of the entity. Business entities benefit society by allowing individuals to aggregate their resources and efforts in furtherance of a business activity. The legal entity is essentially a bundle of contracts that provides for the rights and duties of the owners and employees of the business entity. Each individual state passes its own substantive and procedural laws regarding business entities. A business must choose its state of formation or organization. The home state may be the location where the business is headquartered or it may be any other state where the business organizes and establishes a registered agent. If the business wishes to carry on business outside of its home state, it must qualify to do business and register as a “foreign” entity doing business in the other state. Carrying on business is generally defined pretty broadly to include marketing or sales activity. A business may carry on the majority or all of its business in a state or states where it is registered as a foreign entity. The business entity must comply with the laws of any state in which it does business.
• Example: I want to form a business entity in my home state of New York. The rules prescribed by New York will govern the formation process. I want to also carry on business in Pennsylvania. To do so, I will register my business in New York and then register as a foreign entity doing business in Pennsylvania.
• Discussion: Think about major businesses within the United States. Can you identify five major businesses (Fortune 100 Businesses) within the United States and the state in which they are formed? Where is the headquarters located for each of these businesses?
• Practice Question: Martin is from Mississippi. He forms a business entity and begins providing chartered fishing services. He wants to expand his operations to Louisiana. Can you do that given that he is organized in Mississippi? How or why not?
What is the difference between a “closely-held company” and a “publicly-held company”?
Business entities are often categorized as either closely-held or publicly-held. These designations are not separate types of business entity; rather, they are classifications or defining characteristics of a given business. Generally, the distinction between the two classifications concerns the number of business owners and whether the equity ownership is sold on a public exchange.
• Closely-held Business – A closely-held business, as the name implies, is held by a smaller or more closely related group of individuals. It is often thought of as a smaller business, such as a mom-and-pop or family business. In truth, however, the closely-held status has little to do with the size or revenue of the business; rather, it simply means that the business is not widely owned by numerous, unrelated people. Another characteristic of the closely-held entity is that it is not traded on a public market.
⁃ Example: My wife, three friends, and I own a business that specializes in dog training and boarding. We are a closely-held business because all of the ownership is held by a small group of closely-connect individuals.
• Publicly-held Business – A publicly traded business is any business that is traded on a public exchange. This means that the company has gone through an initial public offering in which its shares were registered with the Securities and Exchange Commission and subsequently listed for sale to the public at large. A publicly-held or publicly-traded company is generally held, or capable of being held, by a large number of unrelated people.
⁃ Example: Elton’s business is growing rapidly. He needs to bring in additional capital to expand operations. He decides to undertake a public offering and list shares of his company for sale on a public exchange. Once listed for sale to the public, Elton’s business is now a publicly-traded company.
• Note: A closely-held business is a private business. It is unlikely that a business could or would undertake a public offering and remain closely held. The inverse, however, is not necessarily true. Private business entities are not necessarily closely held. Some private businesses are widely held by a large number of shareholders.
• Discussion: Some companies choose to remain closely-held instead of seeking a large and diverse set of owners. Other companies prefer to be widely held and often undertake a public offering as part of that effort. Can you think of reasons why a company would prefer to remain a closely-held private company versus a widely-held public company?
• Practice Question: Can you identify a very large closely held company that does business across the United States? Can you identify why the company is considered, “closely-held”.
What are the main types of business entities?
The main types of business entity discussed in this chapter are:
• Sole Proprietorships – The sole proprietorship is not considered a separate business entity, but it is the basis from which business entities are defined.
• General Partnerships – The general partnership is the most basic type of business entity. While the general partnership is commonly understood to be a legal business entity, some legal theorists do not regard the partnership as a formal legal entity.
• Limited Partnerships – This is a hybrid form of partnership that allows for a class of partner known as a “limited partner”.
• Limited Liability Limited Partnership – This is a hybrid form of partnership that allows professional practitioners to organize as partners with limited personal liability.
• Limited Liability Companies – This is the most common form of business entity in the United States. The reason for this fact is based upon the blend of informal and protective characteristics of the LLC.
• Corporations – The corporations is the oldest form of business entity. The corporation is generally divided based upon its tax status as C-Corporation, S-Corporation, and non-profit Corporation.
Some of the less-common types of business entity are the limited liability limited partnership (LLLP) and the professional corporation (PC). The LLLP is a special purpose entity generally used as part of special project, such as a real estate project. A professional corporation is a corporate form for small practitioner firms that is rarely used because of the unfavorable 25% flat corporate tax rate.
What are the main characteristics of a particular business entity?
There are numerous characteristics that make a business entity unique. The major characteristics of a business entity are as follows:
• Creation & Maintenance – The effort associated with forming and maintaining the entity;
• Continuity – The continuity or stability of the organization upon given occurrences;
• Ownership & Control – The ownership rights and control of those involved with the business;
• Personal Liability – The potential for personal liability of those involved with the business;
• Compensation – The compensation and division of profits among business owners; and
• Taxation – The taxation of the organization’s earnings and its distributions of profits to the owners.
This list is certainly not exhaustive; however, these primary characteristics provide a great deal of necessary insight for understanding and choosing a business entity.
• Discussion: Why do you think these are the primary characteristics of a business entity? Can you think of any other characteristics of the business entity that would be important to understand when selecting and forming a business entity.
What is “creation” of a business entity?
Creation of a business entity is the legal or procedural steps that one must undertake to bring the business entity into existence. There is a general dichotomy in the process or steps required to form a business entity.
Default Entity Status
Some business entities may arise by default without any formal procedural undertaking by the founder. That is, the business entity may arise simply by the parties undertaking some business activity with the intention of generating revenue or making a profit.
• Example: To form a general partnership, the only requirement beyond the physical activity of the founders is the subjective intent of the partners with regard to the responsibilities of each party and the allocation of proceeds (or losses) as they arise. Generally, in the event of dispute, a court will be charged with determining whether individuals carrying on commercial activity are a default general partnership. Notably, the sharing of losses is the greatest indicator of co-ownership of a business, as apposed to an employer-employee or contractor relationship.
• Note: In some cases, a court may determine that a business entity exists pursuant to the conduct or actions of the parties. Further, a court may recognize a partnership to avoid an inequitable result if an entity does not exist. This is known as “estoppel”.
Filing for Entity Status
Some business entities require a formal filing process through the state secretary of state’s office. This requires the filing of documents of organization in accordance with the procedural rules adopted by the state of organization. The amount of information and type of document(s) required will vary between states and depend on the type of entity. The general requirements for each business entity type are discussed along with that business entity.
• Example: Eric wants to form an LLC. He goes to the website for the Nebraska Secretary of State’s Office and downloads the necessary forms. He files the information sheet and articles of organization and pays the applicable fee. Seven days later he receives a Nebraska state certificate of organization for his LLC.
• Discussion: Most people do not realize the commercial activity by two or more individuals defaults to a business entity status under certain conditions. Can you think of any consequences that this may have for the partners and business activity? Hint: think about the characteristics of a business entity discussed above. These will help give you an idea of the potential consequences of being deemed a legal business entity.
• Practice Question: Eric is thinking about forming a business entity for his personal consulting practice. He has been consulting for several months and is bringing in Audrey, also a consultant, as a co-owner of the business activity. He and Audrey begin operating their consulting practice before filing the applicable business organization documents. What should Eric and Audrey known about their current business entity status?
What are the “maintenance” requirements for a business entity?
Maintenance of a business entity is summarized as the administrative steps associated with starting and carrying on business as a given entity form. It entails the process of filing documents, holding meetings, maintaining records, observing formalities, and reporting necessary information to regulators. The requirements for starting a business vary considerably between entity types. Businesses entities that require formal procedures to organize also require formalized maintenance procedures. At the most basic level, these entities require the owners to file statements each year (along with annual fees) with the Secretary of State’s office, to hold business meetings, to maintain records, and to report information to regulatory authorities. The state may require that an entity maintain certain records, such as meeting minutes and resolutions, ownership logs, capital accounts, financial statements, etc. The Federal Government may require that business entities file specific information related to taxation or securities issuances. State and federal reporting requirements can also be industry specific or based upon the company’s size or status as privately or publicly-held.
• Example: A group of friends and I form a corporation. We all vote and elect each of us as directors. We then appoint me as CEO. Our creation and maintenance requirements mean following the state-required duties for filing annual information and paying fees to the state. This could include voting as directors to approve our corporate documents. As CEO, I will be charged will filing those documents with the state.
• Note: Generally, default business entities require little or no maintenance to continue on as a business entity. These businesses arise simply through the conduct of those involved and do not involve the formalized procedure for maintaining their operating status. While there are few formal maintenance requirements for default entities, there are still numerous tax formalities to follow. The lack of formal maintenance requirements associated with default entities often causes the owners to fail to follow other business formalities.
• Discussion: Why do you think the government requires business entities to undertake these maintenance formalities? Why do you think it is important internally for businesses undertake formal maintenance? Which State and Federal agencies do you think the care about business maintenance? Hint: Think about taxation and securities law.
• Practice Question: Visit your state’s secretary of state’s website. Can you locate the information and filing required to form and maintain each type of business entity recognized by your state? How do these requirements vary between teach type of business entity?
What is “continuity” of a business entity?
The continuity of the business entity concerns the effect on the business of a major change in the ownership and organization structure. More specifically, this question addresses what types of conduct by business owners can cause the business to dissolve. Owners of a business entity must understand the stability and durability of the organization if or when an owner leaves the business. Managers are concerned with the stability of customers and suppliers and should make certain that changes in ownership or structure do not have unintended consequences on the business operations. The primary change affecting the status of a business entity is the death or dissociation of an owner. In some instances this occurrence may be grounds for the dissolution of the business. Another dissolution event may arise through a limitation on the transfer of ownership by any individual in the business. Such a scenario may effectively dissolve the business if one individual wishes to liquidate her interest.
• Example: Mary, Bob, and I start carrying on business as a general partnership. We do not have a partnership agreement. When Mary decides to leave the partnership, the default rule is that the partnership dissolves.
• Discussion: Can you think of any situations where a business has faced serious turmoil when a co-owner leaves the company? Passes away? Declares personal bankruptcy? What were the primary issues and what was the result?
• Practice Question: Mike and Bryan are partners in a business venture. They have a partnership agreement. Bryan passes away and his will leaves his interest in the business to his wife, Jane. What information do you need to know to determine the status of the business entity? Why?
What is the “ownership structure” for a business entity?
Ownership structure concerns the internal organization of a business entity and the rights and duties of the individuals holding a legal or equitable interest in that business. As owner of the business entity, it is important to understand how the ownership structure of a particular business entity is organized and what that means for the owner’s rights.
• Example: A shareholder, as owner of a corporation, has certain rights. These rights are distinct from those of members of a limited liability company. Further, within the corporation, a holder of preferred stock may have different rights than the holder of common stock.
• Discussion: Why do you think different types of business entity allow for unique ownership structures? Why do you think ownership structure is so important for business owners?
• Practice Question: Can you think of any situation where ownership of the business entity became an issue between the founders or co-owners of the businesses? What was the basis of the dispute and what was the outcome?
What is “control” over a business entity?
This questions concerns who has control over operations or authority to act on behalf of the business. Each business entity type has a default control structure and level of authority vested in individuals in those roles. In many cases the owners and managers of the business are the same people. This relationship becomes convoluted when there are owners who act as managers of the business and others who do not. The issue of overlapping ownership and control becomes increasingly important in closely-held business entities. Third parties dealing with a business entity want to be certain about the level of authority of the individual with whom they are dealing. Further, the business entity is concerned about its agents undertaking transactions that obligate the entity, such as taking out loans or entering into purchaser or sales contracts.
- Note: Recall from the chapter discussing agency law, the level of authority of individuals acting on behalf of a business entity affects the potential liability of the business for the acts of those agents. Business owners may undertake procedures to outline the role and authority of each member of the business. This is normally done within the business’s organizational documents. The title attributable to any owner affects the level of control and authority that she has. Failure to follow procedures to document the authority and control within the business can result in a default level of control or authority in a member of the business that is undesirable to the other owners. Further, a lack of formalized organizational structure can cause internal disputes that affect the operational efficiency of the business.
- Example: Owners of an LLC are known as members. I am a member of an LLC. If I am a member-manager of the LLC, I have the authority to carry on all operations and act on behalf of the LLC. If I am a not a manager of a member-managed LLC, I do not have the authority to act on behalf of the business.
- Discussion: Why do you think structure of control is an important characteristic of a business entity? Should business owners be able to change or modify a business’s control structure? Why or why not?
- Practice Question: Can you find a situation where an employee or agent acted on behalf of a business without authority? Can you identify a situation where the business was contractually bound by the actions of the employee that were not authorized?
What is the potential “personal liability” of owners of a business entity?
Generally, individuals are responsible for their own conduct. The rules of agency may make an individual vicariously responsible for the acts of an agent, if that agent is acting with authority or within the scope of her employment. Some business entities limit the liability of business owners for the actions of agents of the business. This means that the owner is protected from being held personally liable for the debts (contracts) or tortious conduct of the business’s employees or other owners. That is, the business owner does not risk losing her personal assets for debts created or tortious activity committed by the business or its owners. This business entity characteristic is a strong motivation for individuals to form a business entity to carry on their business activities.
• Note: It is important to remember that a business entity offering personal liability protection to its owners may forfeit that protection if the Secretary of State’s office or the court disregards the business entity. The Secretary of State may dissolve a business entity for failing to follow entity maintenance requirements. More commonly, a plaintiff who is suing the business may attack the business entity status in an attempt to “pierce the veil”. Piercing the veil is discussed further in the corporate governance chapter.
• Example: The owner of an LLC has two employees who deliver goods to customers. One of the employees accidentally crashes the company vehicle into a pedestrian. The pedestrian can sue the negligent driver and the LLC for damages. The driver may be personally liable for his negligent driving. The LLC may be vicariously liable for the employee’s tortious act, since it was committed when the employee was acting in furtherance of the business’s operations. The owner’s personal assets, however, may be protected from the reach of the plaintiff.
• Discussion: Can you identify any situations where the owner of a business has been held personally liable (either in contract or tort) for the actions of the employees of a business? Why was the business owner held personally liable despite the limited liability protections of the business entity?
• Practice Question: Bert is a member of an LLC. The LLC is managed by Victoria, who is also a member of the LLC. Victoria accidentally rear-ends Gayle while driving to meet a business client. If the plaintiff decides to sue for the negligent act, will Bert or Victoria potentially be personally liable?
How is an owner of a business “compensated”?
The owners of a corporation may be compensated in two primary manners. The acceptable method of compensation depends upon the type of business entity and the role that the owner plays in the business. Some business entities allow business profits to pass through the business directly to its owners. These owners receive either a percentage of the profits based upon their ownership percentage or a percentage based upon a special allocation of business profits that differs from their ownership percentage. Other business entities (specifically corporations) compensate owners by distributing dividends from business profits. Unlike flow-through profits, payment of dividends is generally a decision by the board of directors and does not represent all profits of the corporation. That is, the corporation determines the amount of any dividends paid to shareholders and may retain any percentage of profits within the corporation.
• Note: A corporate employee who is also a business owner must receive a reasonable salary for her services to the corporation. Otherwise, a portion of any share of corporate profits distributed as dividends will be treated as salary. This makes a difference in how the funds are taxed to the individual. An owner of any other type of business entity does not receive a salary and is compensated by receiving a distribution of profits.
• Example: I am a shareholder and CEO of ABC Corp. I will receive a salary for my services as as CEO, and I will receive a dividend if any are paid to shareholders. Corporate business entities (or business entities taxed as corporations) require that an owner who also serves as an employee of the business to draw a salary from the business. The salary is separate from any distribution of dividends.
• Discussion: Is it common for owners of a business to also serve as employees of the business? Are most owners of a business in the US employees of the business? Please explain.
• Practice Question: Frank and Judy are members of an LLC. Both Frank and Judy work in the LLC and each is a 50% owner. What other information do we need to know to determine how Frank and Judy are compensated?
How are business entities “taxed”?
Understanding basic taxation concepts as they apply to each entity type will give you sufficient background to understand the important tax considerations in a transaction by a given business entity. To understand taxation of business entities, it is important to understand personal taxation as well as business taxation.
Individual Taxation – Income
Individuals pay federal and state taxes on a percentage of their adjusted gross income (AGI) in a given tax year. AGI is calculated as an individual’s gross income, minus all deductions (either the standard deduction or itemized deductions) and the individual’s personal exemption. A person’s gross income is comprised of wages or other income, dividends, and investment interest, gains, dividends, rents, royalties, etc. Deductions are numerous categories of expenses that the state and federal government exempts from taxation. A person can either claim individual deductions, known as “itemizing deductions” or claiming a “standard deduction”.
• Note: The standard deduction in 2018 is $12,000 for single individuals. This changes for individuals filing jointly or as head of household. Prior to 2018, each taxpayer also had a personal exemption is $4,050. The personal exemption went away in 2018 with the increase of the standard deduction. The state and Federal Governments also allow various credits that subtract directly from the amount of income tax liability.
• Example: Each year I am required to tally all of my earnings from a number of sources. I then subtract all deductions allowed by the state and federal governments. If my individual deductions do not add up to an amount greater than the allowed standard deduction, I will subtract the standard deduction. This amount is my AGI. Calculation of my income tax liability for the year will be based upon this amount.
The income tax rates for wages and other income are tiered. All individuals pay a fixed percentage on the first several thousand dollars of their AGI, a fixed percentage on the next several thousand, etc.
• Note: The 2016 federal tax brackets for single individuals are 10, 12, 22, 24, 32, 35, and 37%. The dollar amount of income that fits in each bracket depends upon whether the individual files as a single taxpayer, married filing separately, head of household, or married filing jointly.
• Example: Assume the rates stated above apply. I am not married and file as a single tax payer. I make $30,000 in a year in wages. I take the standard deduction (and personal exemption if filing prior to 2018). Assuming it is 2018 income, my AGI is $18,000. The first $9,525 will be taxed at 10%. The remaining $8,475 will be taxed at a 12% rate. These two amounts are combined, and my total federal tax liability for the year is $1967.34. Note that this overly simplified example assumes that I have no additional deductions for state taxes, Medicare or Social Security payments that would reduce my taxable income amount.
Individuals also pay taxes on gains. Gains consist of value received and recognized when an asset is sold for a higher value than the owner’s basis in the property. Long-term capital gains (gains on certain assets held longer than 12 months) and dividends are taxed at different rates than other forms of gross income. Short-term capital gains are taxed at ordinary income rates. The tax rate for long-term capital gains and qualified dividends may also be tiered based upon income. While they are included in gross income, qualified dividends and long-term capital gains are subject to different tax rates from other sources of income.
• Note: In 2016, long-term capital gains and qualified dividends are taxed at 0, 15, and 20%, based upon income levels. The 0% rate applies to individuals with at total AGI of up to $38,600. The 15% rate applies to individuals with at total AGI of up to $425,800. The 20% rate applies to individuals with total AGI above $425,800.
• Example: I purchase a single share of stock in ABC Corp for $5. Six months later I sell the stock for $10. I have gains of $5. Because I held the stock for 6 months, the gains are treated like wages and taxed at that rate. If I had held the stock for longer than 12 months, the applicable tax rate would have been the applicable long-term rate.
Business Taxation – Income
Business taxation is more complicated than individual taxation. Business entities are either not taxed at all, or they are taxed at a corporate rate. If a business entity is classified as a pass-through tax entity, it does not pay income taxes. Rather, the business owners pay taxes on any business profits. Restated, the profits or losses from the business activity pass through to the individual and are reported on her individual income tax form. Businesses that pay taxes, such as businesses taxed under Subsection C of the Internal Revenue Code (“C-Corps), are taxed at the corporate rate. Like the individual tax system, the corporate tax rate is tiered.
• Note: The applicable tax rate for C-Corp is a flat rate of 21%. Prior to 2018, the applicable corporate tax rates are 10% ($0-50,000), 25% ($50,000 – 75,000), 34% ($75,001 -100,000), 39% ($100,001 – 335,000), 34% ($335,001 – 10,000,000), 35% ($10,000,001 – $15,000,000) , 38% ($15,000,001 – 18,333,333), and 35% ($18,333,333 & up).
• Example: I form an LLC. I can elect with the IRS for the business to either be taxed as a partnership or a corporation. If I elect to be taxed as a partnership, the LLC will be taxed as a flow-through tax entity. The business entity will not pay income taxes; rather, all profits or losses will flow directly through to me and I will report the income on my personal income tax return and pay the applicable taxes.
Business entities taxed under Subsection C of the Internal Revenue Code (IRC) pay income taxes on profits. Corporations taxed in this manner are known as C-corporations. These taxes are treated as an expense to the corporation. They are deducted, along with other expenses, to determine whether the corporation is profitable or has profits at the end of the tax year. Any distribution of corporate profits to shareholders is a dividend and is taxed to the shareholder at the applicable dividend rate. The shareholder reports those dividends on her personal income tax return.
• Note: A business taxed as a C-corporation is not required to distribute profits. These are known as retained earnings. A shareholder does not pay taxes on the income until it is distributed. In a pass-through entity, the business entity does not pay taxes. As such, owners of the business must pay taxes on the profits whether the profits are distributed or no.
• Example: I form a corporation and elect to be taxed under Subsection C of the IRC. The corporation brings in $12,000 and has expenses of $2,000 in the tax year. The corporation has taxable income of $10,000. The applicable tax rate is 21% on this amount, equaling $2,100. So, after taxes, the corporation has profits of $8,900. If the corporation decides to pay a dividend to me as the sole shareholder, I will report the dividend payment on my personal income tax return and pay taxes on the dividend amount. If, however, the corporation decides to retain all of the earnings and not pay a dividend, I will not be taxed on the profits. In contrast, in a flow-through tax entity, the business entity itself would not pay taxes. Rather, all $10,000 of profit (taxable income) would automatically flow through to me. I would report the entire amount on my personal income tax return and pay the applicable taxes.
• Discussion: Can you think of a situation where an individual would be subject to a personal income taxes on a portion of the money received from a corporation and subject to dividend taxes on other amounts of money received? Please explain.
• Practice Question: I am an employee and shareholder of ABC Corp. I draw a salary of $30,000 from the corporation. At the end of the year the corporation has a profit of $100,000. It decides to pay dividends to shareholders. Based upon the shares I own, I receive dividends of $1,000. In this scenario, what taxable income must be reported to the Federal Government?
Businesses that sell any sort of good are subject to sales and use tax. Sales tax is the amount that the merchant must charge to customers who purchase goods for use (rather than resale). Sales tax is generally a fixed percentage of the value of the good. Other taxes that accompany sales tax may also apply for specialty occupations, such as merchants selling luxury goods, hotels, and restaurants. The merchant must collect the tax from the customer and not simply pay the taxes from the proceeds of the sale. The taxes withheld must be deposited with the state’s department of revenue on a regular basis. The taxing state is the location where the good was sold. It does not matter the location where the seller is located.
• Example: I buy widgets from a wholesaler and then resale those goods to the public. Each time a customer purchase a widget for $10, I also charge the customer 6% sales tax. This means that the final amount is $10.60. At the end of month, I transmit all sales taxes collected to the state department of revenue in which I collected the taxes. This requires that I keep track of my location when I sold the goods and the location of the customer.
• Note: The sales tax rules become tricky when a retailer sells over the internet in state where she does not have a physical business or significant presence. Many states allow that, if the customer is located outside of the state where the retailer is located or has business operations, and the retailer ships the item to the customer, the retailer does not have to collect and deposit sales taxes. This can be a huge detriment to in-state retailers.
Use tax is a separate tax that is similar to sales tax and applies to the purchase of goods by individuals or businesses. Use tax is assessed when goods are purchased for use or consumption and sales tax is not paid on the item. This scenario may arise when a merchant purchases goods for resale, which is done free of sales tax, and then converts the item to personal use. Another common use-tax scenario is when an individual or business purchases a good in a state other than the state in which the goods will be primarily used, consumed, or located. If the sales tax assessed in the state of purchase is lower than the sales tax in the state where the goods will be used, consumed, or stored, the purchaser must pay the tax rate difference to the state where the good is used, consumed, or located.
• Example: Tommy decides to purchase a new truck. He lives in Wyoming but travels to Montana to purchase the truck. Montana has no sales tax; while Wyoming assesses a 4% sales tax. If he pays $30,000 for the new truck, he will owe use taxes of $1,200 to Wyoming, as that is the state where he will use the truck.
• Discussion: Can you think of a large corporation that actively negotiates exemption for state sales tax obligations for goods sold via its Internet service? Why would a state grant this business relief from collecting sales tax on items sold within the state? How do you feel about the assessment of use tax? What do you think is the reasoning behind this tax?
• Practice Question: Aragon is a large online retailer. It is headquartered in Kentucky but sells and ships consumer goods all across the country. In order to allow for rapid shipping, Aragon builds distribution centers in many states. Aragon ships to customers in State A, which assesses a sales tax, but has no physical presence in the state. Aragon also ships to customers in State B, which assesses a sales tax, but it has major distribution centers in State B’s capital city. Lastly, Aragon ships to customers who have PO boxes in State C, which does not assess sales taxes. These State C customers then take the goods with them for use or consumption in State D. What are the potential sales and use tax assessments in this situation?
Self-Employment and Payroll Taxes
Employers and employees who receive any form of compensation as part of their employment are generally subject to payroll taxes. Payroll taxes were authorized under the Federal Insurance Contribution Act (FICA) and are made up of Social Security and Medicare taxes. Employers must withhold these taxes from the compensation paid to employees. The employer then contributes a similar amount to that withheld from the employee’s compensation. The employer then deposits these funds with the Internal Revenue Service (IRS). These payments go to fund the Medicare program and the Social Security benefits that the employee will receive when she is eligible.
• Example: I go to work for ABC, Corp. ABC pays me a salary. Each pay period, ABC will withhold an amount of income, Medicare, and Social Security taxes. Medicare and Social Security taxes are known as payroll taxes. ABC will contribute an amount approximately equal to the amount of payroll taxes withheld from my compensation and then deposit those funds with the IRS.
Self-employment taxes apply to individuals who are self-employed or are owners of an entity taxed as a partnership. You can think of it as the employer and the employee are one in the same. As such, the self-employed individual is responsible for paying the employer and employee portion of the payroll tax.
• Example: Mary and I form a partnership. We both work in the partnership. As owners of a partnership, we do not receive a salary; rather, we receive compensation by splitting the profits of the business. We are considered self-employed, as we are owners of an entity taxed as a partnership. Mary and I will have to pay self-employment taxes equal to the portion of payroll taxes traditionally paid by an employee and the employer combined.
• Note: An employee must fill out form W-4 to provide necessary withholding information, which is then used to determine the amount of income to withhold. The withheld wages serve to satisfy the employee’s federal and state income tax obligations. In addition to payroll taxes, the employer will also withhold Federal Unemployment Tax (FUTA) and State Unemployment tax (SUTA) from the employee’s wages. She deposits all of the taxes withheld at regular intervals with the IRS or state taxing authority.
• Discussion: It is a common scenario where employers wrongfully treat employees as independent contractors. What is the benefit to employers in doing this? What are the detriments to the employee?
• Practice Question: Howard and Janet are the sole owner of Searchlight, LLC. Howard and Janet work in the business and Searchlight has one employee, Taylor. Searchlight is taxed as a partnership. What are Howard and Janet’s self-employment tax obligations? What are Searchlight’s payroll tax obligations?