applies to taxable compensation (e.g., wages, bonuses, commissions, and taxable fringe benefits) of shareholders in S or C corporations; it applies to all net earnings from self-employment for sole proprietors, partners, and limited liability company members. The 3.8 % NII tax applies to business income passed through from an entity in which the owner does not materially participate (i.e., one in which the owner is effectively a silent investor).
As you will see in Chapter 2, the tax law limits the use of fiscal years and the cash method of accounting for certain types of business organizations. For example, partnerships and S corporations in general are required to use a calendar year to report income.
Also, C corporations generally are required to use the accrual method of accounting to report income. There are exceptions to both of these rules. However, as you can see, accounting periods and accounting methods are important considerations in choosing your form of business organization.
In small businesses it is common practice for owners to pay certain business expenses out of their own pockets – either as a matter of convenience or because the company is short of cash. The type of entity dictates where owners can deduct these payments.
A partner who is not reimbursed for paying partnership expenses can deduct his or her payments of these expenses as an above-the-line deduction (on a separate line on Schedule E of the partner's Form 1040, which should be marked as “UPE”), as long as the partnership agreement requires the partner to pay specified expenses personally and includes language that no reimbursement will be made.
A shareholder in a corporation (S or C) is an employee, so that unreimbursed expenses paid on behalf of the corporation are treated as unreimbursed employee business expenses reported on Form 2106 and deducted as a miscellaneous itemized deduction on Schedule A of the shareholder's Form 1040. Only total miscellaneous itemized deductions in excess of 2 % of the shareholder's adjusted gross income are allowable; if the shareholder is subject to the alternative minimum tax, the benefit from this deduction is lost.
However, shareholders can avoid this deduction problem by having the corporation adopt an accountable plan to reimburse their out-of-pocket expenses. An accountable plan allows the corporation to deduct the expenses, while the shareholders do not report income from the reimbursement (see Chapter 8).
Each state has its own way of taxing businesses subject to its jurisdiction. The way in which a business is organized for federal income tax purposes may not necessarily control for state income tax purposes. For example, some states do not recognize S corporation elections and tax such entities as regular corporations.
A company must file a return in each state in which it does business and pay income tax on the portion of its profits earned in that state. Income tax liability is based on having a nexus, or connection, to a state. This is not always an easy matter to settle. Where there is a physical presence – for example, a company maintains an office – then there is a clear nexus. But when a company merely makes sales to customers within a state or offers goods for sale from a website, there is generally no nexus. (However, a growing number of states are liberalizing the definition of nexus in order to get more businesses to pay state taxes so they can increase revenue; some states are moving toward “a significant economic presence,” meaning taking advantage of a state's economy to produce income, as a basis for taxation.)
Assuming that a company does conduct multistate business, then its form of organization becomes important. Most multistate businesses are C corporations because only one corporate income tax return needs to be filed in each state where they do business. Doing business as a pass-through entity means that each owner would have to file a tax return in each state the company does business.
Each year, the IRS publishes statistics on the number and type of audits it conducts. The rates for the government's fiscal year 2016, the most recent year for which statistics are available, show a very low overall audit activity of business returns.
The chances of being audited vary with the type of business organization, the amount of income generated by the business, and the geographic location of the business. While the chance of an audit is not a significant reason for choosing one form of business organization over another, it is helpful to keep these statistics in mind.
Table 1.2 sheds some light on your chances of being audited, based on the most recently available statistics.
Table 1.1 Federal Corporate Tax Rate Schedule
Table 1.2 Percentage of Returns Audited
*Fiscal year from October 1 to September 30.
Source: IRS Data Book.
Many tax experts agree that your location can impact your audit chances. Some IRS offices are better staffed than others. There have been no recent statistics identifying these high-audit locations.
Past audit rates are no guarantee of the likelihood of future IRS examinations. The $458 billion tax gap for 2008–2010 (the most recent statistics), which represents the spread between what the government is owed and what it collects, has been blamed in large part on those sole proprietors/independent contractors who underreport income or overstate deductions. While the IRS has indicated that it would increase audits of certain sole proprietors and other small businesses, due to budgetary constraints, the number of audits is still on the decline.
How your business is organized dictates when its tax return must be filed, the form to use, and the additional time that can be obtained for filing the return. Pass-throughs (partnerships and S corporations) reporting on a calendar year must file by March 15; they can obtain a 6-month filing extension. Calendar year C corporations don't have to file until April 15 (the same deadline for individuals, including Schedule C filers); they too have an extended due date of October 15. The September 15 extended due date gives S corporations, limited liability companies, and partnerships time to provide Schedule K-1 to owners so they can file their personal returns by their extended due date of October 15.
Table 1.3 lists the filing deadlines for calendar-year businesses, the available automatic extensions, and the forms to use in filing the return or requesting a filing extension. Note that these dates are extended to the next business day when a deadline falls on a Saturday, Sunday, or legal holiday.
Table 1.3 Filing Deadlines, Extensions, and Forms for 2017 Returns
*The scheduled due date is April 17, 2018.
**The scheduled extended due date is September 17, 2018.
The tax treatment on the termination of a business is another factor to consider. While the choice of entity is made when the business starts out, you cannot ignore the tax consequences that this choice will have when the business terminates, is sold, or goes public. The liquidation of a C corporation usually produces a double tax – at the entity and owner levels. The liquidation of an S corporation produces a double tax only if there is a built-in gains tax issue – created by having appreciated assets in the business when an S election is made. However, the built-in gains tax problem disappears a certain number of years after the S election, so termination after that time does not result in a double tax.
If you plan to sell the business some time in the future, again your choice of entity
