Every business has a different cycle based on industry, size, and other factors, but when it comes to paying taxes, there are a lot of common requirements and issues that small to medium-size businesses face each year. We recently finished a very busy tax season, and afterwards, many business owners suffered from something I call the “post-tax blues”. This refers to the uncomfortable feeling that you paid too much in taxes. Even though some business owners have a fiscal year that is different from the calendar year (and thus a different business tax return due date), all small and medium business owners still have to be concerned with filing (or extending) their individual tax returns by April 15th. Thus, the effect of the business results on their personal tax picture is very much felt around April 15th and the following months. Tax planning is one of the services I offer my clients, so today and in future articles, let me share some ideas to consider that may help reduce your taxes in the coming years.
Do you have the best organizational structure for your business from a tax perspective?
The type of business structure has a large effect on the tax picture for businesses. The choices for small and medium businesses include: sole proprietorship, partnership, “C” Corporation, Limited Liability Company (LLC), and “S” Corporation. There are many factors that should be considered in determining the best structure for your business, including tax, legal, business and personal issues and preferences. For this article, I will focus on the tax issues for the structures that seem to be chosen most often these days. Partnerships are selected less often these days, for a variety of reasons, so I will not cover them today.
From the IRS standpoint, a sole proprietor business is really just an extension of the individual. The business results are reported in the 1040 Individual tax return on a Schedule C. All profits and losses from the business flow directly into the personal adjusted gross income (AGI) on the individual or “married filing jointly” tax return. The business income is subject to income tax and self-employment taxes (Social Security and Medicare taxes) This is the simplest structure for tax preparation, but it also limits flexibility and can result in higher self-employment taxes.
A “C” Corporation is appropriate for a business where there are multiple shareholders who are willing to invest, but may not all be involved in the day-to-day management of the company, and do not want their personal taxes directly affected by the ups and downs of the business. A corporate tax return must be filed each year, and the profits or losses of the corporation do not flow through to the shareholders except as distributions, such as dividends, or in the gain/loss on sale of stock. For a small or medium business that has only a few shareholders who are running the business, there is a tax disadvantage in that any profits will be taxed twice, both in the corporation and then again when dividends are distributed to the shareholders. However, there are times when the full separation for tax purposes of the business from the individual in a “C” corp can be advantageous from a tax perspective.
LLC or “S” Corp
LLC’s and “S” corporations are becoming very popular for liability protection reasons, since, when created and maintained properly, they can protect the personal assets of the owners from the liabilities of the business. For both LLC’s and “S” Corps, there is no double taxation, because the profits and losses flow through to the owners personal tax returns. LLC’s are used for a variety of purposes, such as real estate ownership across multiple owners or members. When there is a single owner for an LLC, the taxes are filed on a Schedule C in the 1040, similar to a sole proprietorship, but taxes are filed on a separate business tax return when there are multiple owners or members.
“S” corps are also becoming popular for tax reasons because they enable small business owners to have more flexibility in characterizing income received from the corporation, without having double taxation on the profits. “S” corps are a good choice for the company with a small number of owners (shareholders), where the shareholders are actively involved in the business management and operations. Taxes are always filed on a separate corporate tax return, but the profits and losses flow through to the individual’s adjusted gross income (AGI) by means of a K-1 form that is used as input to the individual 1040 tax return. Profits and losses affect the shareholder’s AGI in the year of the business results, usually whether or not money is taken out of the corporation or additional money is invested in the corporation by the shareholder. (An exception to this can occur for a loss where the shareholder’s investment in the company is less than the amount of the loss.) There is also some control for the shareholders over how much of the income is subject to employment taxes, although a reasonable amount of income for active participants in the business must be taken as wages, subject to Social Security and Medicare taxes.
I hope this information has shared some understanding about the alternatives available to you as a small or medium-size business owner. I highly recommend you seek the advice of a CPA who is knowledgeable in the area of business taxation, before you make a decision about the structure that is best for your business.
In future articles on this blog, I will share ideas for other ways to reduce taxes and avoid the “post-tax blues” in the coming years .