Small Business Taxes For Dummies. Eric Tyson

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should you rush out and incorporate in one of these corporate-friendly states if you live in one of the other 47 states? The answer is probably not. The reason is that the state in which you operate your company probably also requires you to register your corporation and pay the appropriate fees and taxes.

      You should also consider the fact that some folks with whom you do business may be puzzled or concerned by your out-of-state incorporation. If you’re considering incorporating out of state, you should definitely consult with an experienced small-business legal advisor and tax advisor.

Corporations also offer continuity of life, which simply means that corporations can continue to exist despite the death of an owner or the owner’s transfer of their share (stock) in the company.

      

Don’t incorporate for ego purposes. If you want to incorporate to impress friends, family, or business contacts, you need to know that few people would be impressed or even know that you’re incorporated. Besides, if you operate as a sole proprietor, you can choose to operate under a different business name (“doing business as” or d.b.a.) without the cost — or the headache — of incorporating.

      Knowing where to get advice

      If you’re totally confused about whether to incorporate because your business is undergoing major financial changes, getting competent professional help is worth the money. The hard part is knowing where to turn because finding one advisor who can put all the pieces of the puzzle together can be challenging. And be aware that you may get wrong or biased advice.

Attorneys who specialize in advising small businesses can help explain the legal issues. Tax advisors who do a lot of work with business owners can help explain the tax considerations. Also, a tax advisor should be able to prepare tax illustrations comparing the same business operated as a sole proprietorship, LLC, S corporation, and C corporation and the tax that the business would owe under different scenarios. If you find that you need two or more advisors to help make the decision, getting them together in one room with you for a meeting may help and ultimately save you time and money. Chapter 13 has details on getting help for your small business.

      One step further: S corporations

      Subchapter S corporations, so named for that part of the tax code that establishes them, offer some business owners the best of both worlds. You get the liability protection that comes with being incorporated as with a C corporation, and the business profit or loss passes through to the owner’s personal tax returns (like in a sole proprietorship). In this section, I discuss the tax specifics of using S corporation status and the requirements for S corporations.

      S corporation tax specifics

      An S corporation is known as a pass-through entity for tax purposes. This simply means that the income that the company earns passes through to the company’s owner/shareholders and is taxed at each person’s individual level.

      So if the business shows a loss in some years, the owners/shareholders may claim those losses in the current year of the loss on their tax returns against other income earned. This is potentially useful in the early years of a new business, a time when most companies lose money. To be able to claim losses, you must “materially participate” in the business, which generally means that you actively work in the company at least 500 hours per year, although 100 hours will suffice if that’s the most among all other shareholders.

      If, like most businesses, the company becomes profitable, it may actually make sense then to convert back to a regular C corporation to partake of the potential advantages of that status. That includes being able to retain earnings in the company, which you can’t do with an S corporation, and being able to use tax-advantaged fringe benefits. (If you plan to take all the profits out of the company, an S corporation may make sense for you.)

Even though the corporation doesn’t pay federal income tax, the company must annually complete and file IRS Form 1120S — “U.S. Income Tax Return for an S Corporation” (see the first page of the form in Figure 2-2; the complete form is located at www.irs.gov/pub/irs-pdf/f1120s.pdf). Also, some states levy a state income tax on S corporations, and many states require paying an annual fee.

      

One way an S corporation can save its owner/shareholders tax money is by paying them some of their compensation in the form of dividends. The reason this saves tax money is because dividends aren’t subject to payroll or employment taxes. You must be careful, though, to ensure employee salaries are reasonable and not set artificially low and made up for by high dividend payments. Speak with a tax advisor who has experience advising other small business owners in situations similar to yours.

      Courtesy of the Internal Revenue Service

      FIGURE 2-2: Page one of IRS Form 1120S, “U.S. Income Tax Return for an S Corporation.”

      S corporation requirements

      All corporations actually begin as so-called C corporations, which are the corporations discussed in the section “Deciding whether to incorporate” earlier in this chapter. To become an S corporation, your business must go through an additional “tax election” step. See IRS Form 2553, “Election by a Small Business Corporation.”

U.S. tax laws allow most, but not all, small businesses to be taxed as an S corporation. To be an S corporation in the eyes of the almighty IRS, a company must meet all the following requirements:

       Be a U.S. company

       Have just one class of stock

       Have no more than 100 shareholders who are all U.S. residents or citizens and aren’t partnerships, other corporations, or, with certain exceptions, trusts

      

Be sure to investigate limited liability companies (LLCs), the subject of a later section, before committing to forming an S corporation. LLCs offer the passing through of income that S corporations do and are generally simpler to initiate and operate. As the operator of an LLC, you can still have the future option of converting to an S corporation.

      Partnerships

      A partnership occurs in the eyes of the tax authorities when two or more people — the general partners (GPs) — operate a business together and divide the profits (or losses). The division need not be done equally.

      The GPs are responsible for the company’s debts and liabilities. A partnership may also have limited partners (LPs) who generally provide financing to the business and who aren’t active in the company itself.

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