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Business Structure Dictates Tax Rules
So what tax factors have to be considered in choosing a business setup or changing the structure of an existing company?
CPA Scott Ritsema of Crowe Chizek and Co. LLP provided some insight at a recent seminar at Grand Valley State University’s DeVos Center downtown.
Ritsema, senior engagement manager of the firm’s local office, discussed the form and tax implications of different business structures from sole proprietorships to limited liability companies.
As Ritsema pointed out, a prospective business owner has to consider a number of things when choosing a business structure and correlating tax structure:
- The business’s projected income or loss generation.
- The nature and amount of business investment.
- The composition of business assets.
- The owner(s) desired level of interaction of business with personal taxes.
- The desired future goals of the business.
Tax structure is different for companies than for individuals, Ritsema said.
Many businesses are originally established as either sole proprietorships or partnerships.
A sole proprietor is taxed as an individual, so net income is reported with personal taxes. He also has unlimited personal liability for company debt or lawsuits against the company.
“The tax implications with a Schedule SE 1040 are that it’s all taxed on your personal return; you are the business,” Ritsema said. “And all business income is subject to self-employment tax.”
The owner’s medical expenses do not qualify as a business expense because the owner is self-employed, and that catch often surprises people, he noted.
“However, starting next year you are going to be able to deduct, toward adjusted gross income, 100 percent of your medical insurance premium,” Ritsema said. This year it’s 70 percent.
Ritsema warned that in a sole proprietorship owners have to watch out for the “passive activity loss” trap.
If the owner actively participates in the business, losses are deductible against other income if he is at risk for debt. If the owner has a passive role in the business, he can’t deduct the loss.
Another tax implication of this type of business structure is that it’s a higher IRS audit risk, especially for a business with high gross receipts and low margins because that “raises a couple of eyebrows” at the IRS, he said.
“One of the targets of IRS audits is Schedule C owners because they have a high propensity of gross receipts.”
So if the sole proprietor doesn’t have some accounting savvy, he may want to do something about it or consider an alternative business structure.
Partnerships operate similarly, with income reported on each partner’s personal tax return.
General partners are subject to self-employment tax on partnership income, but limited partners usually are not.
Furthermore, general partners are subject to unlimited liability, whereas limited partners have liability only to the extent of their investment.
“When it comes to deductible losses, this is where a lot of business owners get confused,” Ritsema said. “If the place went belly up, would the partner have to ante up on some of the debt? If you’re a general partner, you’re generally at risk for all your debt. If you’re a limited partner you’re not liable for any of it; you’re limited only up to your investment and that’s it.”
However, if a general partner is active in the business, has used up all his initial investment and is at risk for his share of the debt, he can deduct the loss, Ritsema explained.
If the partner is not active in the business, he can’t deduct the loss unless there are other passive activities to offset it or until the partnership generates income that offsets it.
Like sole proprietorships, medical expenses are not a tax-deductible business expense in a partnership setup.
A common tax implication for both sole proprietorships and partnerships is that the owners cannot be employees of their own company. Sole proprietors take a personal draw and partners get guaranteed payments.
“The definition of ‘employee’ affects who is eligible for pension, profit sharing contributions and other plans,” he explained. “The IRS since 2002 has really started cracking down on this.”
There are other tax implications for C-corporations, S-corporations and Limited Liability Companies.
A C-corporation is a separate tax-paying entity. Corporations can deduct losses or carry them back or forward to offset income in profitable years. All the owners have limited liability for the business’s debt.
C-corporation partners are taxed on their earnings and shareholders are taxed on the dividends they receive. Shareholders’ personal liability is limited to the amount of their investment, and the self-employment tax does not apply.
And there are numerous tax implications for companies with multi-classes of stock, Ritsema added.
Since President George W. Bush has proposed elimination of the double tax on earnings, whether or not shareholders continue to pay tax on dividends remains to be seen.
As it is now, the only way an owner can get earnings out of a corporation taxed once is if he hasn’t had his compensation, which sometimes led to arguments about unreasonable compensation, Ritsema said.
Under Bush’s proposal, only a corporate tax would be paid on the earnings, and that could lead to some interesting things, he added.
“What’s going to happen is that instead of litigating ‘unreasonable compensation’ we may start seeing corporations litigating what is ‘reasonable compensation.’”
The character of an S-corporation is the same as the C-corporation, but the tax scheme is different. The corporation is treated as a conduit for tax purposes, and all its income and loss flow to the owners.
An S-corporation can have no more than 75 shareholders, which can include individuals, estates, tax-exempt organizations and certain types of trusts. However, nonresident aliens and C-corporation shareholders are not permitted to be shareholders in S-corporations.
Each shareholder’s portion of income passes through to his personal tax return and is based on “share days” of ownership.
S-corporations are restricted to one class of stock, and all dividend distributions are pro rata based on stock ownership, Ritsema said. All fringe benefits have to be added to a shareholder’s W-2 tax form as wages.
Limited Liability Companies (LLCs) are the “chameleon” of the tax code, he noted. Generally, they combine the flexibility of partnerships with the limited liability of corporations.
“An LLC can be anything it wants to be, but the tax rules of each entity apply,” Ritsema observed.
All company profits pass through to its members and the money is taxed as income on each member’s personal tax return, unless the LLC elects to be treated as either a C- or an S-corporation.
An LLC protects its owners from being personally liable for debts or liabilities of the company. Shareholders, or members, have only the money they put into the company to lose.In addition, an LLC usually provides tax-deductible benefits for the business owners and their employees.