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For many people who own their own businesses, they have found that
working for themselves is far more rewarding than working for others.
But, they’ll also probably tell you that it’s a lot more work. There are a
number of ways that individuals can own their own business: sole proprietorship,
partnership, corporation, LLC, etc. The way your businesses
is established could mean a lot on tax day. Some forms of
ownership, like partnerships and S-corporations, have their business
year end at the same time as individuals do: December 31, or the end
of the calendar year. However, C-corporations can choose when their
year ends. This could amount to a large difference as far as taxes are
concerned. “Incorporation” doesn’t mean a huge building with hundreds
of employees, with you at the helm of a multinational enterprise.
A corporation is an entity without a soul, a few legal documents that
reside in a file folder at your attorney’s office. But should you incorporate
your business? Can you even consider this as an option?
The answer to the second question is almost always yes.
Although there are associated costs with incorporating, incorporating
your business may be the best option from a tax standpoint.
(Though you may find that your business is better suited to another
form of ownership.) You just have to follow the rules that go along
with it. But what if you work for someone else? Can you still incorporate?
The answer is still yes, as long as you have income other than
your employment income. For example, if you own some rental property
and derive an income from that property that is separate from
your work income, then it may be in your best interests to incorporate
your side business of owning and running the rental property.
Business owners are allowed to pay their expenses before they
pay their taxes. This is something that employees aren’t allowed to
do. Look at your most current paycheck stub. What is the first thing
that comes out of your pay? If you invest in your company’s retirement
plan, that does. Otherwise, taxes come out first. And by taxes,
I’m including federal, state, local, and Social Security taxes (FICA).
Then the rest of the money goes to you, and you try to use it in the
wisest way possible. With business entities, it earns as much as it can,
spends as much as it can, and then is taxed on the rest. In this manner,
business entities, such as corporations, are probably the biggest
tax loophole left! By owning your own corporation, or being selfemployed,
even everyday things, such as car payments and gas for
your vehicles can become business expenses. You just have to use
your pretax dollars from your business for these things.
An important advantage to incorporating is to protect your personal
assets. What if one of your tenants from your rental properties
sued you? If you incorporated your rental property business, then the
tenant would be suing the corporation, not you as the individual. But
if you hadn’t incorporated, you, the individual, would be sued. How
accepting are you of losing your personal property in a lawsuit?
Sole Proprietorships
All the business’s assets, liabilities, and operations are a part of the
owner’s personal financial situation. As the name indicates, there can
only be one owner of the business, and no separate business entity
exists. Because of that, for tax purposes, everything from the business
(profits, losses, etc.) is passed through to the owner. The business
doesn’t file its own taxes, and there are no papers to file to set
up the business. The owner is also personally liable for his or her
business and any legal action that may be taken against it. The best
bet for a sole proprietor to help protect against any type of legal
claim is to purchase commercial liability insurance.
Although there is the advantage of being the only person in control
of your business (i.e., no shareholders or partners to answer to),
it also becomes a potentially huge liability when you consider that
you are solely responsible both on the business front and personally.
General Partnership
Partnerships are associations between two or more persons to carry on
a business. The definition of “person” here is very broad and can be an
individual or an entity, such as a U.S. citizen, nonresident alien, resident
alien, corporation, limited liability company, trust, or other type of partnership.
However, there are no registrations to file, and a written partnership
agreement is not required, although it is usually a good idea.
The partners of a general partnership are jointly liable for the debts,
claims, or other obligations arising from the partnership. There is an
unlimited personal liability for claims against the business, even those
resulting from another partner who is acting for the business.
From a tax perspective, general partnerships are like sole proprietorships.
That is, they are pass-through entities and pay no tax on their
own. All partnership gains, losses, credits, and deductions are taxable to
the partners individually. While the partnership pays no taxes, it does
report the taxes because it is required to determine each partner’s share.
Thus, as with a sole proprietorship, the partners derive no preferable tax
treatment (aside from being able to divide the tax liability between two
or more entities) by holding the business as a partnership.
C Corporations
These are corporations that are established under the state law in
which they are formed. C corporations may have as many shareholders
as they want, whether that be one or more. They are also not
limited to the type of stock they issue. Therefore, they could have
several different classes each of common stock and preferred stock,
one class each of common and preferred, or a variation. The shareholders
of the C corporation are limited in their liability to the
amount of their investment, but they can still participate in the management
of the business without jeopardizing this limited liability.
Generally, many shareholders of C corporations are also employees.
As far as income tax goes, C corporations are responsible for their
own taxes under the IRS’s code Subchapter C. They may also be responsible
for the corporate alternative minimum tax,1 as well. C corporations
are not pass-through entities, but they may be subject to the corporate
double-tax. That occurs when the corporation is taxed, as well as the
shareholders. However, the shareholders are only taxed on the dividends
that are declared and distributed by the corporation. Usually in closely
held C corporations, the business elects not to declare dividends (to the
extent that it is possible), so as to avoid any double taxation. The tax
strategy is to take out the profits in other, legal, ways so that there are
deductions that may be taken against the business’s profits.
A C corporation’s taxable income is its gross income subject to
tax, minus any allowable deductions. Corporations normally deduct
their ordinary and necessary business expenses, although there are
some exceptions. They may also have what is known as a net operating
loss. This is when the corporation’s deductions exceed its gross
income. Corporations generally may carry this NOL, first back 2
years, then forward over the next 20 years.
As mentioned earlier, C corporations can determine when their
business year ends. This allows you to split up when you pay your
personal taxes and when the corporation pays its taxes. Also, if you
discover that your company will be making more than anticipated,
the business can give bonuses or move income to you before the end
of its year, but after you need to pay your taxes.
S Corporations
S corporations are those that are incorporated under the state laws in
which they were formed. It also elects to not be taxed as a corporation.
Otherwise, S corporations are similar to C corporations. Shareholders
continue to have a limited liability in the corporation, but can
participate in the management without risking their liability. Again,
many shareholders may also be employees of the firm.
Similar to general partnerships, S corporations don’t pay any
taxes. However, they do compute taxes and report them to the IRS.
All gains, losses, credits, and deductions are passed down to the
shareholders. They are taxed even if the corporation doesn’t declare
any dividends. However, if the corporation did declare and distribute
dividends to its shareholders, these dividends would generally not be
taxable since the shareholders are the ones who pay taxes on the corporation’s
gains and income.
Only small business corporations may qualify to become S corporations,
and then they are subject to certain requirements:
- The corporation must be domestic.
- There may be no more than 75 shareholders. (A husband and wife
count as one shareholder.)
- The corporation may only have certain classes of eligible shareholders.
- S corporations may only have one class of stock.
Limited Liability Corporations
An LLC may be a sole proprietorship, corporation, or partnership.
Keep in mind, though, that a minimum of two members is
required for federal tax purposes to operate an LLC as a partnership.
Consequently, all tax benefits depend upon how the LLC operates.
An LLC is an entity formed under state law by filing articles of
organization as an LLC. An LLC with two or more members is classified
as a partnership for federal income tax purposes unless it
elects to be taxed as a corporation or was formed before 1997 and
was taxed as a corporation. An LLC with one member is not treated
as a separate entity for income tax purposes unless it elects to be
taxed as a corporation.
So, what’s the best way to hold your company? There is no easy
answer for that. It’s something that you should discuss with your
CPA. These previous sections are not designed to be all-inclusive
about each of the types of businesses you can own. We’ve left out
limited liability companies, limited partnerships, and a few others
that may be more suited to your situation. But, this is just a way of
showing the positive tax implications of incorporating your business
and comparing the tax consequences of corporations to those
involved with owning a sole proprietorship or general partnership. |
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