the remaining costs must be amortized.
In order to utilize your startup expense deductions, you’ll need to choose the write-off election. To do this, attach IRS Form 4562 to your first annual return. (You can file Form 4562 for both organizational and startup costs). As well, for more information on these and other important tax issues please see Tom Wheelwright’s Tax-Free Wealth (RDA Press, 2012).
As soon as you decide you want to go into business, start keeping records. The more you document, the better your ability to take the tax deductions and credits your business deserves. The better you document your financial transactions and decisions, the better you protect your corporate veil – and allow it to keep protecting you.
Key Tax Issues of Corporate Entities
The biggest advantage of a legal entity over a sole proprietorship or a general partnership is the corporate veil. This is what protects corporate shareholders and LLC members from personal liability for business debts. In order for a creditor to get as far as an owner’s personal assets, the entity veil has to be pierced, which means the creditor has to prove the corporation or LLC didn’t act like a separate legal entity by filing the correct IRS paperwork, adhering to the tax laws and following other legal formalities. You want to maintain this veil of protection and thus you will follow the rules. So for all you extreme and unchained rebels out there: Please channel your boundless energy into your business and not against the rules which, if followed, will actually help you.
S Corporation
The advantage of an S corporation over a C corporation is the flow-through nature of the entity. (Know that an LLC can also be a flow-through entity and that an LP must be taxed in such a manner.) Profits are taxed not at the entity level but rather at the shareholder level.
For startup businesses that expect to incur losses early, an S corporation may be a better entity choice than the C corporation. S corporation shareholders are able to deduct a share of those losses on their personal income tax returns to the extent of the number of shares they own and to the extent of the amount of any loans they have made to the business. C corporation shareholders aren’t allowed to take these deductions. Then again, the C corporation (but not the shareholders) can use their losses to offset future gains.
In an S corporation, once the business begins making a profit, those profits are taxed as income to shareholders at their individual tax rate, even if the profits are not distributed. So if your one person company has a profit of $50,000 at the end of the year and you need that money in the company for next year’s expansion you’ll pay tax on a $50,000 gain. (One solution may be to flow through enough money to pay the taxes. So if your tax rate is 28% you’d distribute $14,000 from the Company to you to pay the 28% tax on a $50,000 profit.) Know that S corporation income is reported on your individual return.
A key advantage of the S corporation has to do with Social Security withholding taxes. (In some situations they are called FICA taxes, in others self-employment taxes. We will generally refer to these monies headed to our bankrupt Social Security system as ‘payroll taxes’.) Shareholders in an S corporation who take a salary can also take distribution of excess profits without paying payroll taxes. However, the salary the shareholder receives must be reasonable. Too low a salary coupled with higher distributions of profits can signal to the IRS that a shareholder is avoiding paying the Social Security system its ‘fair’ share and trigger an audit. If the discrepancy between the low salary and the high amount of distributions is too great, the IRS may disallow the distribution and consider all monies received to be salary, with taxes to be owed on that amount (along with penalties and interest).
The chart below helps to explain the concept. In example A, the owner pays herself a very low salary of $10,000 and thus only pays payroll taxes of $1,530. The company makes a profit of $1,000,000 and while the owner will pay regular income taxes on the flow through distribution she won’t pay any payroll taxes on that amount.
The IRS will make a very reasonable argument when reviewing this case: Could you hire someone else to run your business for $10,000 a year to make you a million dollar profit? Of course, the answer is no.
Which is why Example B is closer to the economic and market reality of the transaction. In today’s market you would more likely have to pay someone at least $100,000 a year to manage a business that now produced $900,000 in annual profits. Notice the difference for the Social Security system. Instead of just $1,530 a year Social Security gets $15,300 a year. They want that money. They need that money.
So be careful on what you take for a salary. Don’t make it too low, or too high. You just need to be on the cheaper side of reasonable. There is a website called salary.com which offers comparisons for salary levels in various industries. And work with your CPA to arrive at a reasonable salary amount.
C Corporation
Unlike the S corporation, a C corporation is taxed as its own taxpayer, separate from the shareholder owners. Just as an individual’s tax return is determined by figuring income, credits, losses and deductions, a C corporation’s taxes are figured the same way. The C corporation pays a tax on income. If any money is later distributed to the shareholders they will pay an income tax on those distributions individually. Double taxation is a disadvantage of the C corporation.
Another disadvantage for some is that losses for the business are held at the corporate level in a C corporation. While the business can use the losses to offset later profits, unlike an S corporation the losses do not flow through to the individual shareholder. For businesses that may incur losses during their startup and for the first few years, the S corporation will flow through the losses to the shareholders. The C corporation will not. The losses are trapped, if you will, in the entity. A C corporation can be a disadvantage this way, but maybe not. It depends on your strategy and situation.
Two factors minimize the C corporation’s double taxation and the losses held at corporate level. First, a C corporation’s first $50,000 income is subject to only a 15 percent tax. This may allow the corporation to keep more money inside the company for expansion. Second, if most income the C corporation receives will be payable as salary to the shareholder-employees, the corporation can deduct the salaries and pay a lower tax on its income. But if the shareholders take excess profit as dividends, those funds are taxed to the shareholders as income which, again, involves paying a double tax on the same dollar of income. So, it is important to work with your tax advisors on which way is best for you.
LLC
The LLC, if you so choose, can be a flow-through entity (with either partnership or S corporation taxation) where taxes are not taken at entity level. Or it can be taxed as a C corporation if you’d like. So you have a great deal of taxation flexibility with an LLC.
One disadvantage of operating a business (versus real estate) through an LLC is that current regulations require that payroll taxes be paid on all earnings. As well, a single member LLC may be considered a disregarded entity with all taxes paid at the individual level. Again, payroll (self-employment) taxes would be due on all such income.
But there are many other advantages to the LLC, as well as the other entities, which we explore through our three teams as we go through this book.
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