Posts tagged " Small Business "

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.

Avoiding Phantom Income

July 25th, 2016 Posted by Tax Planning No Comment yet

I am going to go off on a limb and guess that you do not want to pay any more tax than you are required to.  You don’t enjoy paying taxes on the income you earn, so you certainly do not want to pay taxes on “phantom income”.  Phantom income is income that is reported to the IRS for tax purposes but that you did not actually receive.

Phantom income

Image from www.moneyobserver.com

One of the most common instances of phantom income that occurs is when an individual purchases an ownership interest in a partnership (or an LLC that is taxed as a partnership) that owns appreciated assets.  Lets look at an example to understand what I mean:

Years ago, Tom and Ed formed an LLC.  They each contributed $75,000 to the business, and used those funds as a down payment to purchase a rental property for $600,000.  They borrowed the remaining $450,000.  Over the years, the property appreciated in value and is now worth $750,000.  Sam is interested in joining the LLC and agrees to purchase a one-third ownership interest for $250,000.  As part of that purchase, he acquired one-third of the “original basis” in the rental property ($200,000).

If the LLC sold the property the next day, it would recognize a gain of $150,000.  Each owner’s K-1 would show capital gains of $50,000 which they would be required to report on their individual tax return.  However, this is not fair to Sam.  He already paid for the appreciation on the property when he purchased his ownership interest, so he should not be taxed on it now.  This is phantom income.

To avoid this issue, partnerships  and LLCs can make an election under Internal Revenue Code Section 754.  If this election is made, for tax purposes the business would step up the basis of the rental property to reflect the additional contribution made by Sam.  Therefore, after this election is made the business would show a basis in the rental property of $650,000.

Upon the sale of the rental property, this basis would be specially allocated among the owners.  Tom and Ed would each still have a basis of $200,000, and Sam would have a basis of $250,000.  Therefore, if the rental property was sold for $750,000, Tom and Ed would show capital gains of $50,000 each and Sam would not show any capital gains.

Another element of this election is that if the Section 754 basis is allocated to depreciable property, the Section 754 basis can be depreciated.  In Sam’s case, residential rental property can be depreciated over 27.5 years so Sam is able to depreciate his $50,000 over 27.5 years for an annual tax deduction of $1,818.

Child Care Tax Credit

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

If you own a business, you know how important it is to retain your top talent.  You can offer great pay, benefits, and interesting work, but your employees may decide that it is cheaper to stay home than to pay for child care.  How can you compete with that?

One option may be to provide child care for your employees, and the federal government will help pay for it through the Employer-Provided Child Care Tax Credit.  This tax credit is equal to 25% of qualified child care expenditures and 10% of qualified child care resource and referral expenditures, up to a maximum tax credit of $150,000.

Child Care

Qualifying expenditures include:

  • Costs to acquire, construct, rehabilitate, or expand the property that is being used as a qualified child care facility, as long as it is not part of the principal residence of the employer or any of the employer’s employees;
  • The operating costs of the qualified child care facility; and
  • Contracts with a qualified child care facility to provide services to employees.

The operating costs of the facility includes, in addition to all normal expenditures for this type of facility, the cost to train employees and to offer scholarship programs.

To get a better understanding of how this tax credit operates, lets look at an example:

XYZ Corporation has been experiencing a high turnover rate because of the number of young parents that it employs.  In an effort to retain a greater number of its most valued employees, it decided to convert some unused office space into a daycare facility at a cost of $300,000.  XYZ Corporation hired several individuals with extensive training in the field to operate the facility at a cost of $200,000 per year.

XYZ Corporation can claim a federal income tax credit of $125,000 (25% of the qualified expenses) in the first year, and a $50,000 tax credit (25% of the operational costs) in the following years.

Small Business Tax Credit

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

Small business owners need every tax credit that they can get.  One tax credit that you are likely entitled to but may not know about is the Small Business Health Insurance Premiums tax credit.

Tax Credit

For tax years 2010 through 2013, the federal income tax credit was worth a maximum 35% of premiums paid by small business employers.

Starting in 2014, the federal income tax credit is worth a maximum 50% of premiums paid by small business employers.

There are a few qualifications that you must meet in order to claim this credit:

  1. Starting in 2014, the premiums must be paid on a qualified health plan offered through a Small Business Health Options Program (SHOP) Marketplace.

    In California, there are, currently, 6 health insurance companies that are available for year-round enrollment in the SHOP program.  To view the list of qualifying health insurance companies and the available plans, click here.

  2. There must be fewer than 25 full-time equivalent employees.
    It is important to understand that this does not mean less than 25 employees.  The number of full-time equivalent employees is a calculated figure that is determined by taking the total number of hours worked by all non-owner employees and dividing that number by 2,080.  The resulting figure is then rounded down to the nearest whole number.

    For example, if you had 13 employees and they all worked for a total of 1,500 hours during the year, you would have 9 full-time equivalent employees (13 x 1,500 = 19,500; 19,500 / 2,080 = 9.38; 9.38 rounded down is 9).

  3. The average wages must be less than $50,000.

    To determine this number, you divide the total wages of the non-owner employees by the number of full-time equivalent employees.

    For example, if you paid your employees a total of $390,000 during the year, you would have average wages per full-time equivalent employee of $43,333 ($390,000 / 9).

  4. The health insurance premiums must be paid through a qualifying arrangement.
    To be considered a “qualifying arrangement”, the employer must pay at least 50% of the single-coverage insurance for its employees.  The IRS has ruled that the employer does not have to pay for the premiums covering the employee’s spouse or children.  Generally, an employer must pay a uniform percentage of the premium cost for each enrolled employee’s health insurance coverage.  However, exceptions exist for businesses who utilize either composite billing (uniform premiums paid rather than a uniform percentage) or list billing (differences in premiums exist for each employee based upon age or other factors).

The maximum credit is for 50% of the premiums paid starting in 2014 (35% in prior years).  However, it may be less than 50% if: 1) there are more than 10 full-time equivalent employees; 2) the average wages exceeds $25,000; or 3) actual health insurance premiums exceed average premiums paid for health coverage in the employer’s area.

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%).

Single-Member LLC

March 4th, 2016 Posted by Tax No Comment yet

Sometimes the number of owners a business has affects what types of entities it is allowed to operate as.  While a corporation can have one or more owners (shareholders), a partnership by definition must have two or more owners.  A limited liability company (LLC) can be thought of as a hybrid between corporations and partnerships, so can it have only a single owner (member)?  Yes, but it might not be recognized as an LLC.

Single Member LLC

Image from www.corporatedirect.com

How the federal government views an LLC depends upon how the LLC elects to be taxed.  LLCs have the option of being taxed as either a corporation or a partnership, but the default rule is that they will be taxed as partnerships.  If a single-member LLC elects to be taxed as a corporation, then the federal government will recognize the LLC as a corporation.  However, if a single-member LLC elects to be taxed as a partnership, then the federal government will treat the LLC as a “disregarded entity”.

The federal government essentially creates a legal fiction that the disregarded entity does not exist. It looks through the disregarded entity and attributes all of the entity’s actions to its owner.  The owner is required to report the entity’s income on its own tax return.

Married couples can avoid this treatment by the federal government by electing to be treated as two separate individuals, and thus be considered a traditional LLC rather than a single-member LLC.

Unlike the federal government, California recognizes single-member LLCs as LLCs (not as corporations or disregarded entities).  California requires single-member LLCs to file their own tax returns.  In addition, because LLCs are created under state law, a single-member LLC has all of the same legal protections that any other LLC would have, such as limited liability protection.

 

An LLC – What is it?

March 2nd, 2016 Posted by Tax 3 comments

Your business has reached the point where you are no longer comfortable operating it as a sole proprietor and you know that you need to form a business entity, but which structure is right for you? You thought about a C-corporation, but you do not want the double taxation or all of the corporate formalities that would have to be observed. A general partnership does not work for you because you want to have limited liability protection.  A limited partnership sounds great, but you and your partners all want to be actively involved in the management of the business and each partner who is involved in management decisions is then a general partner who does not have limited liability protection.  An S-corporation sounds great because you still have all the protections that C-corporations have, including limited liability, and there is only a single level of taxation.  However, you would still have to follow all of the corporate formalities and that is not appealing to you. What option is left to you?

LLC

Image from www.bluemavenlaw.com

You could form a Limited Liability Company (LLC).  An LLC can be thought of as a hybrid between a corporation and a partnership.  Like a corporation, an LLC has limited liability protection, can enter into contracts, purchase assets, loan and borrow money, and sue and be sued. However, like a partnership, the taxable income and losses of the LLC flows through to the owners so that the LLC does not have to pay income taxes itself.   (Note: California assesses a “minimum tax” and an LLC fee, as we will discuss in detail in a future post). LLCs also do not have to follow the same corporate formalities that C-corporations and S-corporations do.

To form an LLC in California, you will have to file Form LLC-1 “Articles of Organization of a Limited Liability Company (LLC)”.  I would also recommend talking to a business attorney and having that attorney help draft an Operating Agreement between the members (owners) of the LLC.

Unlike an S-corporation, there are no restrictions on the number of owners that an LLC can have. Also, unlike S-corporations, corporations, partnerships, and foreign residents are allowed to be owners in an LLC.

As I previously mentioned, an LLC does not have to follow the same corporate formalities that a corporation does.  However, this does not mean that an LLC does not have any formalities that it has to follow- it is just very relaxed in comparison to a corporation.  A California LLC still has to file Articles of Organization with the Secretary of State, pay taxes and fees assessed by California, maintain adequate business records, and maintain separate bank accounts for the business. However, because the corporate formalities required of an LLC are so relaxed, one of the main factors that will be considered if a litigant is attempting to “pierce the corporate veil” and remove your LLC’s limited liability protection is whether the LLC is adequately capitalized.  You will want to speak to a business attorney to determine what is adequate capitalization for your business.

One drawback of LLCs is that not everyone is allowed to form them.  Doctors, lawyers, and accountants are just a few examples of professions that cannot operate their business through an LLC.

There are a number of differences that exist between S-corporations and LLCs that are not addressed here that may affect your tax situation.  We will be discussing those in detail in future posts.

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.