Online Plus Edition Monday, August 16, 2004
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Beat the business survival odds with smart tax planningBy Tax Time James Angelin Many people, at some time in their lives, contemplate starting their own business. Indeed, the backbone of our economy is made up of entrepreneurs who have taken this risk. Creating an idea, executing the idea and enjoying the fruits of your success can be one of the most satisfying events in a persons life. However, starting a business is a high risk high reward venture, and only for those willing to make the personal commitment. According to the U.S. Small Business Administration, more than 50 percent of small businesses fail in the first year and 95 percent fail within the first five years. Apart from the personal challenges and commitment a business requires there are numerous tax considerations. Dont even think about starting a business without legal, accounting and tax help. If you cant afford these professionals then you are undercapitalized and should not start the business. The tax decisions you make up front can be crucial to the success of the business. Mistakes here can be very costly and very difficult to correct. There are many decisions to make but the important ones are: What type of entity do you want to be? Which assets do you want to transfer to the entity? How will you finance the company (i.e. how much stock and how much debt)? It is easy to create an entity and often very difficult to change. Your choices are: Self employed or sole proprietor C corporation S corporation Partnership Limited liability company Entities are either tax-paying entities or conduit entities. A conduit entity is one that passes all its income (or losses) through to owners. The entity itself does not pay tax, usually. There are only three types of entities subject to tax under the Federal income tax: Individuals sole proprietors (self-employed) file schedule C which is part of form 1040 C corporations; (file form 1120) and Estates and trusts (fiduciaries) (file form 1041). Businesses are not normally operated in this form. There are also three conduit entities: Partnerships (file form 1065) Income or loss is passed through to the partners and is taxable to them. The partnership never pays any tax. S corporations (file form 1120S) Income or loss is passed through to shareholders. The corporation usually does not pay tax, unless it was once a C corporation and converted to S status after the first year of its life. Trusts (file form 1041) Note that trusts are both tax-paying and conduit entities. Income is taxed to the beneficiaries if it is distributed to them. If it is retained by the trust then the trust pays the tax. Limited liability companies (LLCs), if formed correctly, are usually taxed as partnerships for federal purposes, if you so choose, and if there are two members. Single member LLCs are allowed in MA. An LLC can also choose to be taxed as a corporation, via the "check the box" form 8832. The big advantage of a corporation (C or S) or LLC is the limited liability they afford. This means that creditors can take the assets of the entity but usually cannot take the owners assets. This protection is not available in a sole proprietorship. All corporations start out as C corporations. They have to elect to be taxed as S corporations within the first 75 days of the year (March 15 for most). If you miss this 75-day deadline (only 2<1/2> months) then you will be a C corporation for the first year at least. This is a shame because often new businesses have losses and those losses are stuck in the C corporation and are not deductible, rather than flowing through to an owner of an S corporation, partnership or LLC, where they may be deductible. Missing this deadline is a common, but costly, mistake for new businesses. One note regarding the evil and ever growing Social Security (or self-employment) tax. There is a big difference between an S corporation and a partnership in how this tax is imposed. In an S corporation, the flow through of income, or payment of dividends, is not subject to self-employment tax. In a partnership the flow through of income is subject to this tax. This is a 15.3 percent difference on the first $87,900 and 2.9 percent after that. So, the S corporation is preferable in this regard. A C corporation pays tax on its taxable income. If a portion of that profit is distributed as a dividend, the distribution generally is taxed to the shareholder, but it is not deductible by the corporation. This represents double taxation of the corporate profits, once to the corporation and once to the shareholder when it is distributed as a dividend. C corporations also pay twice on liquidation. When they liquidate, they pay tax at the corporate level on the gain on any appreciated assets, and then the shareholders pay tax again when they receive the liquidating dividend. So, try not to put assets that will appreciate, such as real estate, into a C corporation. There are ways to avoid the double taxation of dividends by taking money out of the corporation as something else, such as rent or interest, which are deductible by the corporation. Electing to be an S corporation will usually avoid this double tax also. The deductibility of company fringe benefits, such as health insurance, education, etc. is more restrictive for S corporations and partnerships, than it is for C corporations. This can be a major factor in the choice of entity decision. The second big decision you have to make early on in the life of a business is which assets to transfer to the entity and which to retain and lease to the entity. As mentioned, if you form a C corporation you will avoid double taxation by taking rents out of the company, which are deductible, rather than non-deductible dividends. The other big advantage of extracting rents out of the business is that rents (of real estate) are not subject to payroll taxes. So you could reduce your salary and take out the difference as rent and save 15.3 percent Social Security and Medicare health insurance taxes right away. In addition, the real estate will generate depreciation deductions that are non-cash. The final big decision to make when forming the entity is how you will capitalize it. If it is a corporation, you can put the assets into the corporation in exchange for stock (equity) or stock and some debt (a note owed to you). The advantages of receiving interest on the debt, which is deductible by the corporation, are similar to the rent situation (no payroll taxes). Also, repayment of the principal is tax-free. However, debt is inflexible and many new businesses do not want to saddle themselves with too much debt, even if it is owed to the owners. Starting a business is exciting, yet risky. Dont increase the risk unnecessarily by ignoring important tax issues. * * * North Shore resident James P. Angelini, Ph.D., MBA, CPA is s professor of accounting and taxation and director of the master of science in taxation program in the Sawyer School of Business at Suffolk University, Boston. Contact him at jangelini@adelphia.net.
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