If the corporation distributes a dividend to the shareholder, again, the shareholder reports the dividend as income on his or her individual income tax return. In the case of dividends, however, the corporation cannot claim a deduction. This, then, creates a 2-tier tax system, commonly referred to as double taxation. First, earnings are taxed at the corporate level. Then, when they are distributed to shareholders as dividends, they are taxed again, this time at the shareholder level. There has been sentiment in Congress over the years to eliminate the double taxation, but as of yet there has been no legislation to accomplish this end other than the relief provided by capping the rate on dividends (zero for individuals in the 10 % or 15 % tax bracket; 15 % for those in the 25 %, 28 %, 33 %, or 35 % brackets; 20 % for those in the 39.6 % bracket).
In view of the favorable corporate rate tax structure (compared with the individual tax rates), certain tax penalties prevent businesses from using this form of business organization to optimum advantage.
● Personal holding company penalty. Corporations that function as a shareholder investment portfolio rather than as an operating company may fall subject to the personal holding corporation (PHC) penalty tax of 20 % on certain undistributed corporate income. The tax rules strictly define a PHC according to stock ownership and adjusted gross income. The penalty may be avoided by not triggering the definition of PHC or by paying out certain dividends.
● Accumulated earnings tax. Corporations may seek to keep money in corporate accounts rather than distribute it as dividends to shareholders with the view that an eventual sale of the business will enable shareholders to extract those funds at capital gain rates. Unfortunately, the tax law imposes a penalty on excess accumulations at 20 %. Excess accumulations are those above an exemption amount ($250,000 for most businesses, but only $150,000 for PSCs) plus amounts for the reasonable needs of the business. Thus, for example, amounts retained to finance planned construction costs, to pay for a possible legal liability, or to buy out a retiring owner are reasonable needs not subject to penalty regardless of amount.
Employees
If you do not own any interest in a business but are employed by one, you may still have to account for business expenses. Your salary or other compensation is reported as wages in the income section as seen on page 1 of your Form 1040. Your deductions (with a few exceptions), however, can be claimed only as miscellaneous itemized deductions on Schedule A. These deductions are subject to 2 limitations. The total is deductible only if it exceeds 2 % of adjusted gross income and, if your income exceeds a threshold amount that depends on your filing status, the otherwise deductible portion of miscellaneous itemized deductions is reduced by a phaseout. For 2017, the threshold amount at which itemized deductions (including miscellaneous itemized deductions) begins to phase out is $261,500 for singles; $287,650 for heads of households; $313,800 for joint filers; and $156,900 for married persons filing separately.
Under the 2 % rule, only the portion of total miscellaneous deductions in excess of 2 % of adjusted gross income is deductible on Schedule A. Adjusted gross income is the tax term for your total income subject to tax (gross income) minus business expenses (other than employee business expenses), capital losses, and certain other expenses that are deductible even if you do not claim itemized deductions, such as qualifying IRA contributions or alimony. You arrive at your adjusted gross income by completing the Income and Adjusted Gross Income sections on page 1 of Form 1040.
Example
You have business travel expenses that your employer does not pay for and other miscellaneous expenses (such as tax preparation fees) totaling $2,000. Your adjusted gross income is $80,000. The amount up to the 2 % floor, or $1,600 (2 % of $80,000), is disallowed. Only $400 of the $2,000 expenses is deductible on Schedule A.
If you fall into a special category of employees called statutory employees, you can deduct your business expenses on Schedule C instead of Schedule A. Statutory employees were discussed earlier in this chapter.
Factors in Choosing Your Form of Business Organization
Throughout this chapter, the differences of how income and deductions are reported have been explained for different entities, but these differences are not the only reasons for choosing a form of business organization. When you are deciding on which form of business organization to choose, tax, financial, and many other factors come into play, including:
● Personal liability
● Access to capital
● Lack of profitability
● Fringe benefits
● Nature and number of owners
● Tax rates
● Social Security and Medicare taxes
● Restrictions on accounting periods and account methods
● Owner's payment of company expenses
● Multistate operations
● Audit chances
● Filing deadlines and extensions
● Exit strategy
Each of these factors is discussed below.
If your business owes money to another party, are your personal assets – home, car, investments – at risk? The answer depends on your form of business organization. You have personal liability – your personal assets are at risk – if you are a sole proprietor or a general partner in a partnership. In all other cases, you do not have personal liability. Thus, for example, if you are a shareholder in an S corporation, you do not have personal liability for the debts of your corporation.
Of course, you can protect yourself against personal liability for some types of occurrences by having adequate insurance coverage. For example, if you are a sole proprietor who runs a store, be sure that you have adequate liability coverage in the event someone is injured on your premises and sues you.
Even if your form of business organization provides personal liability protection, you can become personally liable if you agree to it in a contract. For example, some banks may not be willing to lend money to a small corporation unless you, as a principal shareholder, agree to guarantee the corporation's debt. For example, SBA loans usually require the personal guarantee of any owner with a 20 % or more ownership interest in the business. In this case, you are personally liable to the extent of the loan to the corporation. If the corporation does not or cannot repay the loan, then the bank can look to you, and your personal assets, for repayment.
There is another instance in which corporate or LLC status will not provide you with personal protection. Even if you have a corporation or LLC, you can be personally liable for failing to withhold and deposit payroll taxes, which are called trust fund taxes (employees’ income tax withholding and their share of FICA taxes, which are held in trust for them) to the IRS. This liability is explained in Chapter 29.
Most small businesses start up using an owner's personal resources or by turning to family and friends. However, some businesses need outside capital – equity and/or debt – to get started properly. A C corporation may make it easier to raise money, especially now. For example, access to equity crowdfunding, which allows businesses to raise small amounts from numerous investors, is effectively limited to C corporations (S corporations cannot have more than 100 investors; partnerships and LLCs would have difficulty in divvying up ownership among an ever-changing number of owners). Equity crowdfunding for accredited investors
