Posts tagged " S Corporation "

Shareholder Compensation

August 1st, 2016 Posted by Tax No Comment yet

As a small business owner, you spend countless hours working on your business.  Now that  the business is finally generating a profit, the last thing you want to is pay more in taxes than you need to.

If your business is set up as a partnership or an LLC, your income is subject to self employment taxes.  However, if your business is established as an S-corporation, you are not subject to self-employment taxes.  This is because you are treated as an employee of the S-corporation.  As an employee, your wages are subject to the same payroll taxes that any employee’s wages are subject to.

CompensationSelf-employment taxes are designed to achieve a similar result as payroll taxes.  Therefore, theoretically there should not be any significant difference in taxes paid between an LLC and an S-corporation. However, many S-corporation shareholder-employees discovered a loophole.  If an S-corporation shareholder-employee takes very little to no compensation and primarily takes shareholder distributions from the business, less taxes would be paid.

Be warned though that S-corporation shareholder-employees are required to take a reasonable salary.  There are a number of factors that are used to determine what is a reasonable salary:

  • Timing and experience;
  • Duties and responsibilities;
  • Time and effort devoted to the business;
  • Dividend history;
  • Payments to non-shareholder employees;
  • Timing and manner of paying bonuses to key people;
  • What comparable businesses pay for similar services;
  • Compensation agreements; and
  • The use of a formula to determine compensation.

If the IRS determines that your compensation is inadequate or unreasonable, it has the authority to reclassify amounts you received as a distribution as compensation.

There have been a number of tax court cases in recent years in which the IRS has successfully reclassified distributions as compensation.  In one case, the shareholder was the only employee of the business and he did not take any salary.  Instead, all the money he withdrew from the business was classified as distributions.  Because all of the income was derived from his own efforts and the distributions paid to him would be a reasonable amount for a full-time worker in his position, the courts upheld the IRS’ reclassification of the distributions as compensation.

In another case, a business owner with over 20 years of experience within his field paid himself a salary of $24,000 and took more than $200,000 in distributions.  It was eventually determined that others in a similar position within his industry were paid a salary of $67,000, so a portion of his distributions were reclassified.

College Access Tax Credit

July 20th, 2016 Posted by Tax Planning No Comment yet

Most likely if you are donating your money to a charitable cause, you are doing so for reasons other than the tax benefits (although the tax benefits are likely a welcome bonus).  However, California is offering tax savings through the College Access Tax Credit that may be reason enough to contribute.

California’s goal in offering this tax credit is to bolster the Cal Grants program, which benefits to low-income college students.

Tax CreditThis tax credit is available to individuals and business entities that file tax returns in California.  To qualify, a taxpayer must apply for a credit allocation reservation. This is a fairly simply process of providing identifying information and the amount that you wish to contribute.  California will then send the taxpayer approval along with instructions on how to send the contribution.  The taxpayer must be prepared to make the contribution within 20 days of the date of the Notice of Allocation Reservation (the approval form).

This tax credit is worth 50% of the contributed amount for tax years 2016 and 2017 (the year in which this credit is due to expire).  However, if you make the contribution through an S-corporation (which I strongly recommend), the S-corporation is also entitled to a tax credit equal to 16.67 percent of your contribution.

In addition to the California tax savings, the contribution is deductible on your federal income tax return as a charitable contribution.  This means that, if you take itemized deductions, you will have federal tax savings as well.  However, the amount of your federal benefits depends upon your marginal tax rate.

Lets look at an example:

Richard, a California taxpayer, is the 100% shareholder of an S-corporation.  The S-corporation makes a $10,000 contribution to the College Access Tax Credit Fund.  As a result, the S-corporation is entitled to a tax credit of $1,667.  The corporation’s shareholder (Richard) is entitled to California tax credit of $5,000 and a $10,000 federal charitable contribution deduction. If Richard is in the top federal tax bracket (39.6%), his charitable deduction would be worth $3,960 to him.  All together, Richard and his S-corporation saved $10,627 by making a $10,000 contribution (a net gain of $627).

 

S-corp vs. LLC: Unequal Allocations

March 11th, 2016 Posted by Tax Planning No Comment yet

As we have discussed, there are a number of important differences between S-corporations and LLCs.

S-corporations have to follow the traditional corporate formalities, while the formalities that LLCs have to comply with are far more relaxed.

California S-corporations pay the state a tax equal to the greater of 1.5% of their net income or $800.  California LLCs, on the other hand, pay the state $800 in taxes and then may have to pay an additional LLC fee based upon their revenue.

The shareholders (owners) of an S-corporation can choose to take their compensation from the business as salary or as distributions.  The members (owners) of an S-corporation, however, can only take their compensation from the business as a distribution.

An additional difference between the two is the amount of flexibility the owners have in allocating income, losses, and distributions between the owners.

The shareholders (owners) of an S-corporation must divide all income, gains, losses, and deductions in proportion to their ownership percentage. Therefore, if you own 30% of an S-corporation then you will pick up 30% of the corporation’s taxable net income on your tax return, and you are entitled to 30% of all the distributions made.

The members (owners) of an LLC, on the other hand, are allowed to have unequal allocation of income, gains, losses, and deductions as long as certain criteria are met. For example, you and your co-owner each own 50% of the LLC. You may have decided among yourselves that all of the depreciation deductions will be allocated to you, while all of the other items of income, gain, losses, and deductions will be split 50:50. You are allowed to do that as long as several requirements are met.  Those requirements are too complex to discuss in this blog, so I strongly recommend talking to a CPA if you are considering establishing an LLC whose operating agreement authorizes non-proportional allocation of income, gains, losses, and deductions.

S-corp vs. LLC: Income

March 9th, 2016 Posted by Tax Planning No Comment yet

In the last post, we discussed that one primary difference between California LLCs and S-corporations is how California taxes them.  Another significant difference that you should consider is how your income as the owner will be classified for tax purposes.

Income

Image from www.nanohealthtechnology.com

The owner of an LLC will likely spend countless hours working for the business. However, the owner is not treated as an employee, so the owner does not receive wages or a salary. Instead, for tax purposes, the owner is treated as receiving the entire profits of the LLC as compensation regardless of whether or not any money is taken out of the business. These profits are treated as self-employment income, and therefore are subject to self-employment taxes. It is important to understand that self-employment taxes are an additional tax assessed on your normal income tax return that is designed to imitate payroll taxes.

On the other hand, the owner of an S-corporation can be compensated by the corporation in two different ways.  The first, like LLC members (owners), is through ownership distributions.  These are withdrawals of the business’ profits.  The second method, which is not available to LLC members, is through a salary.  In fact, an owner-employee of an S-corporation is required to take a “reasonable salary” before taking distributions from the business. What is a reasonable salary varies from business to business, so I would recommend talking to a corporate attorney to determine what is a reasonable salary for your business.  The factors that helps to determine what is a reasonable salary include: your position (title) in the business, the compensation of those with a similar position within your field, and the number of employees a business has. However, you are not required to take any money out of the business, whether through salary or distributions.  This means that even if you should have a reasonable salary of $50,000, you do not have to take $50,000 out of the business.  You could, for example, take out $20,000.  However, up to that hypothetical $50,000 everything should be taken through payroll as a salary.

An S-corporation’s net profits is reduced by the amount of salary paid to the owners- the same as it would be by the salary of any other employee.

Regardless of whether your business is structured as an LLC or as an S-corporation, the business’s profits are passed through to the owners and subject  to income taxes.  They are subject to income taxes regardless of whether the profits are retained by the business or distributed to the owners. However, only LLC owners pay self-employment taxes on the net profits of the business.

S-corp vs. LLC: California Taxes

March 7th, 2016 Posted by Tax Planning 1 comment

Besides the formalities that S-corporations have to observe, there are a few other differences between S-corporations and LLCs.  One difference that will affect your bank account is how California assesses taxes.

California Taxes

Image from www.alliancetrustcompany.com

The amount of California taxes that an S-corporation will pay is based upon its net income.  An S-corporation pays the greater of $800 or 1.5% of its net income.

An LLC, on the other hand, pays $800 of California taxes and may be assessed an LLC fee based upon its revenue.  The table below shows the LLC fee for the various revenue ranges.

RevenueLLC Fee
$0 – $249,999$0
$250,000 – $499,999$900
$500,000 – $999,999$2,500
$1,000,000 – $4,999,999$6,000
$5,000,000 +$11,790

Therefore, whether an S-corporation or an LLC makes more sense for your business (based purely on the amount of taxes you will pay to California) depends on what you expect you revenues to look like compared to your net income.  Lets look at a few examples.

Example 1

You expect your business to have $600,000 of revenue but only $60,000 of net profit.  In this case, it makes more sense to operate as an S-corporation.  As an S-corporation you would be paying $900 in taxes to California ($60,000 x 1.5%).  However, as an LLC you would pay $3,300 ($800 of taxes plus a $2,500 LLC fee).

Example 2

You expect your business to have $900,000 of revenue and $300,000 of net profit.  In this example, it makes more sense to operate your business as an LLC.  As an LLC, you will be paying $3,300 to California ($800 of taxes play a $2,500 LLC fee).  However, as an S-corporation you would be paying $4,500 in California taxes ($300,000 x 1.5%).

Built-in Gains Tax

February 29th, 2016 Posted by Tax No Comment yet

If you have been operating your business as a corporation but are now contemplating making the S Election, make sure you speak to a tax advisor about how the Built-in Gains Tax could potentially impact you.

 As I discussed in the blog post “Is an S-Corporation Right for You?“, an S corporation has all the traditional benefits of a C-Corporation (or what you typically think of as a corporation) including limited liability protection, but like a partnership the owners only have to pay income taxes on the distributed profits once.

The S Election could be made right after the business is incorporated, in which case you do not have to worry about the Built-in Gains Tax. However, the election can also be made years after the corporation has been formed.  In that event, it is important that you understand when the Built-in Gains Tax is triggered and how it operates because it could impact the business decisions you would otherwise make.

The Built-in Gains Tax may also apply if an S-corporation ever acquires assets from a C-corporation in a tax-free transaction.

The purpose of the Built-in Gains Tax is to prevent the shareholders of a C-corporation from converting to an S-corporation with the intend of avoid the tax consequences that would otherwise apply in a liquidation.  In other words, the Built-In Gains Tax is intended to prevent owners of a C-corporation from avoiding the taxes they would otherwise have to pay when shutting down or selling off all or part of their business by converting to an S-corporation.

Essentially, when converting to an S-corporation, the corporation must look at the assets it owned prior to the S Election taking effect and determine if those assets have appreciated in value (a formal appraisal is highly recommended).  If they have, the amount of appreciation on each asset will be known as the net unrealized built-in gain.  If the S-corporation then, within the applicable time period, sells that asset, the corporation (not the shareholders) must pay the Built-in Gains Tax, which is equal to the top marginal corporate tax rate (currently 35%), on the net unrealized built-in gain.

Currently, the applicable time period is 5 years.  However, we strongly advise talking to a trusted advisor to ensure that the law has not changed, and that your circumstances is not affected by special rules.

Is an S-Corporation Right for You?

February 26th, 2016 Posted by Tax No Comment yet

A corporation provides you with limited liability protection, but the high cost of double taxation makes it unappealing to many business owners.  A partnership has flow-through tax attributes so you are only taxed once on your business income, but the risk of being sued because of your partners’ actions is too great of a risk.  A limited partnership isn’t an option for you because all the owners want to be actively involved in managing the business.  A different option that is available to you is an S-corporation.

Image from Pacific Associates Corporation

Image from Pacific Associates Corporation

Every S-corporation starts off as a C corporation, or what you may think of as a “regular corporation.”  Then, the corporation will make an election, commonly referred to as an S Election, to be taxed under Subchapter S of the Internal Revenue Code. Basically, what this means to you is that taxes are paid at the owner-level rather than at the business-entity level, just like with partnerships.  But unlike partnerships, because an S-corporation is still a corporation it has the benefit of limited liability protection.

 The S Election is made by filing Form 2553 with the Internal Revenue Service.  Once the election is made with the IRS, S-corporation status is automatically recognized by California.  The election may be filed anytime during the year prior to when the election is to take effect, or within the first 2 months and 15 days of the year in which the election is to take effect.

However, there are restrictions on what corporations can be S-corporations.  First, the corporation must be incorporated within the United States.  Next, all the shareholders (owners) must be either individuals, estates, and certain types of trusts.  An S-corporation may not have partnerships, corporations, or non-resident aliens as shareholders.  Additionally, an S-corporation may not have more than 100 shareholders, and there can only be one type of stock issued.  The reason there can only be one class of stock issued is that all the shareholders must have the same rights in the corporation.  Finally, an S-corporation is not allowed to engage in certain types of business, such as finance or insurance.  If any of these restrictions are violated, the S-corporation status will be revoked.

S-corporations have to comply with the same formalities that their C corporation counterparts do. Some of these formalities are:

  • Filing Articles of Incorporation with the California Secretary of State;
  • Electing a Board of Directors;
  • Enacting Corporate Bylaws;
  • Holding Board meetings at least once a year;
  • Holding shareholder meetings at least once a year;
  • Maintaining separate bank accounts for the corporation; and
  • Maintaining corporate records.

However, this is not an exhaustive list and you should talk to a corporate law attorney to see what other formalities have to be observed.

In future blog posts, we will discuss in more detail the distinctive characteristics of S-corporations and specifically how they differ from other types of entities.

Protecting Your Liability Shield

February 15th, 2016 Posted by Tax 1 comment

You have established your business as a separate entity with limited liability protection, but that is not enough to protect yourself from legal liability.

Image from www.michaelsmithlaw.com

Image from www.michaelsmithlaw.com

Even for the types of legal liability that limited liability entities are designed to protect you from (see Limited Liability Protection), it will not do you any good if plaintiffs are able to “pierce the corporate veil.” We recommend talking to a business attorney to get a thorough understanding what it means to pierce the corporate veil and what you need to do to prevent that from happening, but this post will provide a general overview based upon California law.

Essentially what it means when a plaintiff is attempting to pierce the corporate veil is that the plaintiff is claiming that your business is really your “alter ego” and not its own separate entity. If a plaintiff is successful, you can be held personally liable for the actions of your business and potentially have your assets seized if there is a judgement against you.

Courts will look at a number of factors to determine whether to pierce the corporate veil.  These factors vary among the states and continues to evolve, so I strongly recommend discussing these factors with a business attorney to ensure that your business is being operated in a while that will protect you.

One factor that courts will consider is whether the entity engaged in fraudulent behavior.  This should be common sense; you cannot reasonably expect to use your business to defraud others and then escape personal liability just because the fraud was committed through a limited liability entity.

Another major factor is whether the business followed the required formalities (see Corporations for a list of some of the required corporate formalities). This factor is more relaxed for limited liability companies (LLC), but even with LLCs there are formalities that must be followed.

The general concept behind piercing the corporate veil is that if you want your business to be treated as a separate legal entity by others, then you must also treat it as a separate legal entity.  This means that even if you are the sole shareholder of a corporation you must hold a Board meeting at least once a year, maintain the meeting minutes, as well as meet all of the other formalities. Likewise, you cannot commingle business and personal funds. You must have a separate bank account for your business and only pay business expenses out of that bank account. If you put all of your personal and business funds into the same bank account, it strongly indicates to a court that you do not consider the business to be its own separate entity. Similarly, if you pay personal expenses out of the business bank account, then it gives the court the impression that it is just another personal account.

Another major factor that courts will evaluate is whether the business is undercapitalized.  This means that when you are first contributing money to the new business it must be a reasonable amount.  For example, if you expect your business to have $5,000 of operational expenses a month, an initial capitalization of $1,000 does not appear to be reasonable.

Finally, a factor that will be considered is the amount of control you are able to exert over the business.  For example, if you are the sole owner of the business then you are fully in control of the business, and it would be easier for a plaintiff to argue that the business is really just an extension of yourself, your “alter ego”.  On the other hand, if you are one of 100 co-owners each owning 1% of the business, it would be very difficult for a plaintiff to argue that the business is your alter ego.
Forming a business entity that has limited liability protection is great, but only if you take the proper steps to protect your liability shield.

Limited Liability Protection

February 12th, 2016 Posted by Tax 6 comments

Many businesses start off as sole proprietorships before the owners choose to create a separate entity for their business, like a corporation or limited liability company (LLC).  A major motivation for these business owners in transforming their business into a separate entity is to gain limited liability protection.

 

liability shieldCorporation, S-corporation, limited liability companies (LLCs), and limited partnerships (for the limited partners only) provide limited liability protection to their owners.

What protection limited liability provides exactly does vary from state to state, so for purposes of this discussion we will focus on California law.  We recommend talking to a business attorney about limited liability as case law is constantly evolving.  As the name implies, the legal protection offered is limited to certain types of liability.

The first type of legal protection that limited liability provides is from personal liability for the entity’s debts.  For example, Jason owns a corporation, ABC Inc.  ABC Inc. borrowed $100,000 from XYZ Lending, but business has not been doing well and ABC Inc. is no longer able to make the required payments on its loan.  XYZ Lending is able to sue ABC Inc. and potentially seize its assets to attempt to be repaid, but it is unable to recover anything from Jason personally.

The other type of legal protection that limited liability provides is personal liability for the actions of co-owners or employees of the business.  For example, Steven owns Delivery Inc., a successful package delivery corporation.  Delivery Inc. employs several drivers.  One day, one of Delivery Inc.’s drivers ran a red light while delivering packages and hit a pedestrian.  The pedestrian sued Delivery Inc. for damages, but is unable to sue Steven personally.  However, if Steven had run the business as a sole proprietor he could have been held personally liable for the actions of his employee and had his assets seized.

However, even with limited liability protection you remain personally liability for your own actions.  If you personally injure another person, for instance, then you are potentially liable regardless of whether your business has limited liability protection.  As an aside, this is a reason to consider purchasing insurance regardless of whether your business has limited liability.

Because limited liability protection can frustrate plaintiff’s attempts to collect damages, plaintiffs will often try to get around this liability shield by “piercing the corporate veil” (a legal concept that will be explained in the post).

Why Form a Business Entity?

February 8th, 2016 Posted by Tax 2 comments

Congratulations!  You have turned your passion into a business, and you are doing everything you can to make sure that it is a success.

You’ve heard people talk about incorporating their business or forming a partnership or an LLC, and now you are wondering if that is the right thing to do for your business.

Table borrowed from www.strategicofficesupport.com

Table borrowed from www.strategicofficesupport.com

It may be, but there are a few factors that you need to consider before you decide.

One factor is whether you would like your company to have limited liability protection. Corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) all provide limited liability protection.  Sole proprietorships and general partnerships do not.

Limited liability protection will be discussed in great detail in a future blog post, but in very general terms it means that only the entity’s assets (i.e., not your personal assets) are at risk of loss.  For example, let’s say that your business has $10,000 worth of assets and you have $250,000 of personal assets outside of the business.  If your business is sued, the plaintiffs can only attempt to collect on the $10,000 of business assets and cannot seize your personal assets.

You may feel that it is very unlikely that you will be sued or that if you are that is the reason why you have insurance.  You may be right, but you also want to keep in mind that your business is not only potentially liable for your actions but for the actions of your employees.  For many business owners, the desire to hire employees makes having limited liability protection a more significant factor to consider.

Another factor that you must consider is whether the business will have multiple owners.  The general rule is that if a business has multiple owners and no action has been taken to form a different type of entity (such as a corporation or LLC), it is a general partnership.  In a general partnership, each partner is personally liable for the actions of every other partner, their employees, and the business.  While for various reasons it may make sense to you to be in a general partnership, you want to make sure that it is a conscious decision and not simply the default because your business has multiple owners.  Therefore, if your business has multiple owners generally it will be an entity, so the decision then is what type of entity.

A third factor to consider are the tax implications to either operating your business as a sole proprietorship or as a business entity.  There are different tax implications to however you choose to structure your business.  For example, certain business structures would treat your income as “self-employed income” which affects how it is taxed.

Finally, you should consider the likelihood of an IRS audit.  There is a widespread belief among tax professionals, for various reasons, that a sole proprietorship is more likely to be subjected to an IRS audit than a business entity.  This is not to say that business entities are not audited by the IRS (they are all the time), but many tax professionals believe that sole proprietors are audited more frequently.  This is an important consideration because even though you will be filing your taxes properly an IRS audit is still expensive.