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Uncle Steve's Tax Corner

A Business of Your Own is Still the Best Tax Shelter Around

One of the most important decisions to make is what legal form your business should take. Each form of doing business has its own tax consequences. The most common forms of business to select from are: sole proprietorship, partnership, limited liability company, and corporation.

SOLE PROPRIETORSHIP
AN UNINCORPORATED
BUSINESS WITH ONLY ONE OWNER

TAX ADVANTAGES

• Losses incurred in starting up the business are deductible on the owner’s personal tax return. These losses can be used to reduce the owner’s taxable income from other sources.
• There is no double taxation. Income of a regular corporation is taxed twice... first, the business pays corporate income tax on its profits, and then the shareholders pay personal income taxes on the dividends they receive. The income of a sole proprietorship is taxed only once, to the owner on his personal income tax return.
• Income is taxed at individual income tax rates which are lower than corporate rates (C-corporation).

TAX DISADVANTAGE

• Income tax cannot be deferred by retaining profits in the business. The income is taxed to the owner, whether or not s/he takes the money out of the business.

MAJOR DRAWBACK

• The owner of the business has unlimited personal liability for the debts, obligations, and lawsuits of the business.

PARTNERSHIP
Operates like a sole proprietorship but has more than one owner

TAX ADVANTAGES

• The partnership agreement determines each partner’s share of income, loss, deductions and credits. These items are passed through to the partners to be reflected on their personal returns.
• Income is taxed at the individual partner’s rate.
• There is no double taxation, since the partnership pays no taxes.
• Partners can deduct losses to the extent they are personally liable for partnership obligations (basis).
• The allocation percentages to partners of profit and loss can be changed easily from one year to the next as circumstances dictate (dependent on the partnership agreement).

MAJOR DRAWBACKS

• Each general partner is fully liable for all the debts and obligations of the partnership.
• Profits are taxed even though they’re not distributed to the partners.

LIMITED LIABILITY COMPANY (LLC)
Operates like a partnership for tax purposes and
enjoys the advantages of a corporation for liability purposes

ADDITIONAL ADVANTAGES OVER A PARTNERSHIP

• Has the same legal protection as a corporation against personal liability for debts, obligations and lawsuits of the business.
• Permits a single-member partnership in some states (not Illinois).

DISADVANTAGE

• Annual fees and initial legal fees are more costly than a partnership or corporation.

REGULAR “C” CORPORATIONS

TAX DISADVANTAGE

• These businesses have their own tax structure. The profits are separately taxed. That is, they’re taxed twice, once at the corporate level, and again when dividends are distributed to stockholders.

WAYS TO AVOID THE DOUBLE TAX

• Retain earnings in the corporation and pay little or nothing in dividends.

TRAP
The IRS imposes a penalty on unreasonable accumulation of earnings, those in excess of $250,000. To avoid the penalty, the company must show valid business reasons to retain and accumulate earnings.
SOLUTION 1
The money is needed for expansion, for working capital, or to repay borrowings.
SOLUTION 2
Officer-stockholders can pay high salaries and bonuses to themselves, thus reducing taxable profits.
TRAP ON SOLUTION 2
The IRS will challenge, as a non-deductible dividend, salaries that are not reasonable in relation to the work performed and in line with what other companies pay officers in similar positions.

LEGAL ADVANTAGE

• Offers legal protection against personal liability for debts, obligations, and lawsuits of the business.

TAX REASONS FOR VERY SMALL BUSINESSES TO INCORPORATE

• C-Corporation shareholder/employees are allowed deductible health and accident insurance plans and medical reimbursement plans.

• To take advantage of lower federal corporate tax rates on the first $50,000 of income.

How corporate income is taxed federally:

SUBCHAPTER S-CORPORATION
A BUSINESS THAT ELECTS TO OPERATE UNDER SUBCHAPTER S
OF THE INTERNAL REVENUE SERVICE TAX CODE

TAX ADVANTAGES

• No double taxation. Income is taxed only once, directly to the corporation’s shareholders on their personal income tax returns.
• Income is taxed at lower individual income tax rates.
• The penalty tax that regular corporations pay on accumulated earnings in excess of $250,000 ($150,000 for professional corporations) is avoided. S-corporation income is taxed to the stockholders even if it is not distributed.
• The double tax that regular corporations pay when assets are liquidated is avoided. When a regular corporation liquidates, the corporation pays tax on the gain, and the shareholders pay tax on the part of the gain that is passed through to them. This double taxation is eliminated with S-corporation status since there is no tax at the corporate level.

LEGAL ADVANTAGE

• Offers legal protection against personal liability for debts, obligations, and lawsuits of the business.

MAJOR DRAWBACKS

• The deduction for losses is limited to the amount of money a shareholder invested in or loaned to the company (basis).
• Money accumulated in an S-corporation is taxed to shareholders, whether they receive it or not.
• There are eligibility requirements to become an S-corporation. For example, an S-corporation cannot have more than 75 shareholders and cannot have a foreign shareholder. In addition, corporations and partnerships cannot be shareholders.
• The cost of key fringe benefits for shareholders who are also employees are not deductible by the corporation. This includes accident, health, and group-term life insurance.

WHEN TO ELECT SUBCHAPTER S-CORPORATION STATUS

• All of the following requirements are satisfied.
• An election can be made by filing Form 2553 either:
• At any time through the 15th day of the third month of the tax year if filed during the tax year that the election is to take effect.
• At any time during the tax year preceding the tax year that the election is to take effect.
• During the first 75 days of the new corporation
  

REQUIREMENTS FOR ELECTING
SUBCHAPTER S-CORPORATION STATUS

A corporation must meet the requirements of Code Section 136 to be eligible to make an S corporation election:

• The corporation must be a domestic corporation.
• The corporation may have no more than 75 shareholders.
• Corporations and partnerships may not be shareholders.
• The shareholders must be U. S. citizens or resident individuals, estates, or electing small business trusts.
• All beneficiaries of the small business trust must be individuals or estates eligible to be Subchapter S shareholders.
• A grantor trust is allowed to hold Subchapter S stock for two years from date of death.
• A trust that becomes a Subchapter S shareholder due to a will can hold the stock for two years from date of the stock transfer into the trust.
• Beginning in 1998, tax-exempt organizations may become Subchapter S shareholders.
• The corporation may not have more than one class of stock. Differences in voting rights in one class of common stock do not violate the one-class-of-stock rule, but care must be taken in issuing debt, since debt can be potentially treated as a second class of stock. However, commercial lender loans can no longer be treated as a second class of stock.
• Banks, insurance companies, possessions corporations, and past and present domestic international sales corporations are ineligible. However, domestic building and loan associations, mutual savings banks and cooperative mutual banks are eligible.
• A corporation generally must meet the eligibility requirements listed above both on the date of its election and on each day of each taxable year for which the election is effective.
• All shareholders must consent to the election.

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