A business is the best means of accumulating wealth, not only because of its growth potential, but also because profits can be reinvested before they are taxed. Taxable income of the business is the net income, equal to revenues minus expenses. A business offers the opportunity to save on taxes, allowing wealth to grow at a compounded, tax-free rate, growing wealth in a way that no other option offers. For instance, if you profit on the sale of an asset, you realize a gain, even if you reinvest the money in the same type of asset, such as real estate, which must be reported as income on your tax return. With a business, profits earned before the end of the year can be reinvested into the business, thus saving it from being taxed at the end of the year. However, some investments in the business cannot be excluded from annual income, such as buying another business. After all, if buying another business could be deducted from current income, then business people would be able to quickly expand their empires, at the expense of Uncle Sam. Nonetheless, a business offers great opportunities to shield income from taxes by investing it to expand the business so that greater income can be earned in successive years. The key to growing a business, especially in the early years, is to defer as many personal expenses as possible, and plow that earned income back into the business. Certain types of businesses have certain tax advantages, but what they all have in common, is that almost unlimited amounts of money can be reinvested in the business before it is taxed.
Choosing a Business Entity
When starting a business, there are several types of business entities that can be chosen: sole proprietorship, partnership, S corporation, C corporation, or limited liability company (LLC). Only a C corporation is a separate taxable entity from its owners and files its own tax return. Taxes on the profits of the other entities are paid by the owners, using their own tax return. The type of entity chosen will largely be determined by business, tax and legal objectives. There are many factors to consider, and this article only gives an overview of the federal rules for taxation. However, state laws applicable to business entities vary widely, and some options may not even be available. For instance, professionals, such as architects or doctors, cannot form a limited liability company in California. So for business entities other than a sole proprietorship, the taxpayer should consult a lawyer or tax professional to decide what type of business entity to form.
Tax Law Changes Effective for 2018 and Later
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, corporations have received the best benefits, which includes the following changes:
- The top corporate tax rate is reduced from 35% to 21%.
- Business interest is no longer fully deductible. Instead, excluding depreciation, amortization, and depletion, the deduction cannot exceed 30% of income.
- Business interest will still be fully deductible for all businesses with an average annual gross receipts not exceeding $25 million for the 3-year tax period before the current tax year.
- After 2021, depreciation, amortization, and depletion will not be excluded in calculating adjusted taxable income for the purposes of this provision.
- Eliminates the corporate alternative minimum tax.
- New investment purchases can be fully expensed in the 1st 5 years, but then it is phased out over 5 more years.
- The §179 deduction is increased to $1 million.
- The deduction of net operating losses is limited to 80% of taxable income.
- Previously, research and development expenses could be immediately deducted, but now they would need to be written off gradually.
Unlike the changes for regular taxpayers, most of which expire in 2025, most of the tax changes for businesses have been made permanent.
Also, pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorships and independent contractors will be able to deduct 20% of their qualified business income. However, this deduction starts to phase out for couples filing married filing jointly earning at least $315,000 or $157,500 for everyone else.
This new business deduction, referred to as the §199A deduction or the deduction for qualified business income, equals the lesser of:
- 20% of qualified business income + 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income, or
- 20% of taxable income – net capital gains
Family Medical Leave Act (FMLA) Credit
The new law also introduces a family leave business credit that will only apply for tax years 2018 and 2019. The credit is based on wages paid to employees on family or medical leave, which includes the birth of a child or to care for the newborn, time off for foster care or adoption proceedings, to care for a spouse, child, or parent with a serious health condition, or if the employee has a serious health condition. Employers must provide at least 2 weeks of paid leave, equal to at least 50% of wages, annually to all qualifying employees who work full-time, but it can be prorated for employees who work part-time. Qualifying employees are those who worked at least one year and who do not earn more than $72,000 in 2017.
The credit equals a percentage of wages paid to the employee while on leave. However, the employer cannot deduct the amount of wages covered by the credit nor can those wages be used to determine any other general business credit.
The minimum credit is 12.5% of wages paid for leave and is increased by .25% for each percentage point the wages exceed 50% of regular wages, up to a maximum of 25%.
Excess Employee Remuneration Not Deductible
For publicly traded corporations, this new law also eliminates the deduction for any compensation exceeding $1 million for a covered employee, which includes the principal executive officer, financial officer, and 3 of the other highest-paid officers. Although this is like previous law, the new law now extends the deductible limit for performance-based compensation.
A sole proprietorship is the simplest business entity and is usually chosen when there is 1 owner and no employees. A single member LLC is also treated as a sole proprietorship for federal tax purposes. The business owner simply pays taxes at the individual tax rate. Furthermore, there are very few tax rules that apply specifically to sole proprietorships. Sole proprietors file Schedule C, Profit or Loss from Business or the simplified Schedule C-EZ, Net Profit from Business to report their business income, which is included in their tax return. There is a similar form for farmers: Schedule F, Profit or Loss from Farming. A sole proprietorship is also easy to end, since the only thing that the owner must do is to stop doing it. The sale of a sole proprietorship is treated as a sale of its individual assets, which is reported on Form 8594, Asset Acquisition Statement under Section 1060.
Major disadvantages include the inability to raise money by selling an ownership stake in the business. Proprietorships are also subject to the highest IRS audit rates of any type of entity, since tax returns by sole proprietors usually have many more errors, overstated deductions, and are more likely to have omissions of income, especially for businesses that conduct many of their transactions in cash.
Most businesses with more than 1 owner are either partnerships or corporations, but spouses who file jointly can co-own a business as a joint venture, without forming a partnership. Each spouse simply reports their share of the income on a Schedule C, just as a sole proprietor would. However, the business cannot have any other co-owners and both spouses must actively participate in the business. Electing the joint venture status simplifies tax compliance while ensuring that each spouse is credited for the payment of Social Security and Medicare taxes.
There are some types of employment subject to special tax rules for certain workers whose employment closely resembles that of a sole proprietor, so special tax rules apply to independent contractors, statutory employees, and statutory nonemployees. However, misclassifying workers as independent contractors rather than employees can have serious consequences for the business owner, because the owner may have full liability for uncollected taxes. Even the owners of a corporation are not protected, because the IRS will assess tax penalties and back taxes on the people who were responsible for collecting the trust fund taxes.
Partnerships and Limited Liability Companies
A partnership is also easy to form, consisting of 2 or more business owners who conduct the business according to the partnership agreement, which can even be oral, although it is definitely wise to have it written. A partnership is a flow-through entity, in that the partnership does not pay taxes itself; instead, profits, deductions, credits, and other tax items pass through to the individual partners, who report those items on their own tax returns. However, a partnership must file an informational return both to the IRS and to the individual partners.
A major drawback to a sole proprietorship or a partnership is that the business owners assume full liability for the business. For a partnership, not only are the assets of the partnership itself subject to the claims of creditors, but also the assets of each individual partner. To limit liability, the business owners would either have to form a corporation or a limited liability company. A limited liability company (LLC) is generally conducted as a partnership, where the partners are often called members, but only the assets of the LLC or the assets of any members personally responsible for the liability are subject to the claims of creditors. So if 2 doctors form a partnership and one is sued for malpractice, then any claims extend only to the assets of the LLC and to the assets of the doctor responsible for the malpractice. The creditors cannot claim any assets of the other doctor. An LLC that is treated as a partnership is also a flow-through entity, since, except for the limited liability, an LLC is generally a partnership. States that do not allow professionals, such as doctors or architects, to form an LLC are usually permitted to form a limited liability partnership, which is basically an LLC that satisfies the rules for that state. An LLC can also have a single member, in which case it is considered a disregarded entity, since the entity and the individual are indistinguishable. However, the limited liability protection is significantly restricted, at least in the case of lawsuits, since the member can be sued as well as the LLC. For tax purposes, an LLC can be treated either as a partnership or as a corporation, so the tax treatment of the LLC will depend on the entity chosen.
If an LLC operates in more than 1 state, then it may not be recognized as an LLC by that state, which would expose its members to liabilities of the business incurred in that state. However, most states, but not all, recognize foreign LLCs, in which case it will be treated and recognized as an LLC in that state.
C Corporations and S Corporations
Corporations are the most difficult to form, since they are subject to many legal requirements. Applicable state rules also vary widely among the different states. Except under special circumstances, such as the liability for trust fund taxes mentioned above, the owners are not subject to the liabilities of the corporation. More is required of corporations than other business entities, such as the requirement to have annual meetings of the shareholders, to have a Board of Directors, who must be elected, and who must meet from time to time, at least annually, and to maintain records of those meetings. All corporations begin as C corporations, but some elect to be treated as an S corporation, which is a flow-through entity, like a partnership. So the S corporation pays no taxes itself, but income, expenses, and other tax items pass through to the shareholders, who report them on their own returns. The main advantage of an S corporation is that for those owners who actually work for the corporation, the payments to the owners can be divided between wages, which are subject to payroll taxes, and dividends, which are not. Moreover, the dividends paid by an S corporation are not subject to double taxation, as they are for a C corporation. Because an S corporation cannot accumulate earnings as a separate entity, it is not subject to the accumulation earnings tax nor the corporate alternative minimum tax. And although there can only be 1 class of stock for S corporations for distributions and liquidation proceeds, they may offer different classes of voting rights.
However, an S corporation cannot have more than 100 shareholders and the shareholders must be United States citizens or resident aliens. However, a tax-exempt organization, such as a qualified retirement plan trust, or a charitable organization, may be an S corporation shareholder. Moreover, a married couple can be treated as a single shareholder; other family members can also be treated as a single shareholder, if they so elect. Most corporations are S corporations and most have fewer than 4 shareholders. In community property states, both spouses may have to consent to the S corporation election if the shares are bought with community property.
An S corporation will terminate automatically if any of the requirements for the S corporation is violated, such as adding more shareholders causing the total to exceed 100 shareholders, or S corporation stock is transferred to a partnership, corporation, nonresident alien, or nonqualifying trust, or if another class of stock is issued. Once terminated, the S corporation election cannot be renewed for 5 years unless the commissioner of the Internal Revenue Service consents, though the IRS may waive an inadvertent termination if the corporation corrects the event that created the termination and agrees, together with all its shareholders, to make adjustments required by the IRS.
State law should also be considered: some states do not recognize the S corporation status for income tax purposes, so the corporation itself may have to pay tax on its income since it may not be passed through directly to shareholders; as with C corporations, if the S corporation does business in other states, then it may have to pay taxes to those states; if the shareholders of S corporation live in a different state from which the S corporation does business, then they will also have to file a tax return for that state; some states may also require a separate S corporation election for the state; otherwise, the IRS may not recognize the S corporation for federal purposes if it is not recognized under state law.
Unlike a partnership, LLC, or S corporation, a C corporation is an independent entity that files and pays its own taxes. The most important benefit of a C corporation is its ability to raise money by selling shares to investors. But even for a small, closely-held C corporation, which is one where the owners typically work for the corporation, there are several advantages. Money can be transferred to business owners either as wages, if they work for the corporation, or as dividends. Any dividends paid by the corporation are not deductible. Furthermore, recipients of the dividends must still pay taxes on them, so dividends paid by C corporations are subject to double taxation.
A minor disadvantage of both S and C corporations is that for owner-employees of the corporation, the full employment tax must be paid, half by the employee and the other half by the corporation. By contrast, members of limited liability companies, partners, and the self-employed can deduct the employer's portion of the employment taxes, yielding a net self-employment tax rate of 14.13% instead of the combined total of 15.3% of the employer and employee portion of the tax for each owner-employee.
However, C corporations offer several advantages over the other entities. A major advantage is that a C corporation can offer benefits that are not available to the other entities, such as a self-insured medical reimbursement plan. Additionally, some of those fringe benefits, such as health insurance, can be provided to employees free of all taxes, including payroll taxes. Another major benefit is that for incomes of $75,000 or less, the marginal tax rate paid by a corporation is less than for an individual. The 1st$50,000 earned by the corporation is subject only to a 15% marginal tax and the next $25,000 is subject to the 25% marginal tax, and obviously, earnings retained by the corporation are not subject to payroll taxes. However, the marginal tax rate rises steeply above $75,000, where the minimal marginal rate is 34%. Other benefits include:
- If the stock qualifies as small business stock under §1202, then 50% of the gain from the selling of shares can be excluded from income and the other 50% will only be subject to a 28% tax rate, yielding an effective tax rate of 14%.
- If the corporation fails, under §1244, an ordinary loss of up to $50,000, or $100,000 if married filing jointly, can be claimed that can be used offset other income.
Tax Consequences of Changing Business Entities
Sometimes, business owners will want to convert their business to a different type of entity. A sole proprietorship is the easiest to convert to any other type, since the business owner is the only owner, so starting another business entity is almost like starting it from scratch. Also simple, a partnership can easily convert to a limited liability company or a corporation, with few tax consequences.
Converting a corporation to another type of business entity is more problematic, since the corporation, as a separate taxable entity, will have to be dissolved, with tax consequences to both the corporation and to its owners. There are several tax consequences if a corporation operated as a C corporation, but then elected to become an S corporation. Any net operating losses carried by the C corporation cannot be carried forward by the S corporation. A C corporation that accounted for its inventory by using LIFO may have to pay a tax for that benefit. A capital gains tax may have to be paid on any assets that have appreciated above the book value of the C corporation if the asset is disposed of within 10 years of forming the S corporation. A tax may also have to be paid if more than 25% of the gross receipts of the C corporation comes from passive investment income, such as dividends, interest, rents, and capital gains, and the corporation had accumulated earnings and profits before conversion.
An LLC has the greatest flexibility in regard to business entities, because it can elect to be taxed like a partnership or a C corporation by filing Form 8832, Entity Classification Election or as an S corporation by filing Form 2553, Election by a Small Business Corporation.
Federal Employer Identification Number
To uniquely identify businesses, the IRS uses an employer identification number (EIN) that is issued to the business when it begins. Most states also use the EIN, but some use their own tax identification number. Most sole proprietors can use their own Social Security number. However, proprietorships with employees or a qualified retirement plan must use an EIN. A business can apply for a EIN either online at the IRS.gov website or by filing Form SS-4, Application for Employer Identification Number. A change in business entity requires a new EIN.
Although most sole proprietors do not need an EIN, it can be advantageous to have one to prevent identity theft, because it eliminates the need to use the owner's Social Security number, and it allows the establishment of credit in the name of the business rather than using the owner's credit.
When changing the type of business entity, the owner should consult an attorney and a tax professional, since there are many additional rules and consequences than what can be considered in this short article.