J.K. Lasser's Small Business Taxes 2018. Barbara Weltman
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shareholders must be individuals who are not nonresident aliens (there are exceptions for estates, certain trusts, and certain exempt organizations).
The number of owners also presents limits on your choice of business organization. If you are the only owner, then your choices are limited to a sole proprietorship or a corporation (either C or S). All states allow single-member LLCs. If you have more than one owner, you can set up the business in just about any way you choose. S corporations cannot have more than 100 shareholders, but this number provides great leeway for small businesses.
If you have a business already formed as a C corporation and want to start another corporation, you must take into consideration the impact of special tax rules for multiple corporations. These rules apply regardless of the size of the business, the number of employees you have, and the profit the businesses make. Multiple corporations are corporations under common control, meaning they are essentially owned by the same parties. The tax law limits the number of tax breaks in the case of multiple corporations. Instead of each corporation enjoying a full tax benefit, the benefit must be shared among all of the corporations in the group. For example, the tax brackets for corporations are graduated. In the case of certain multiple corporations, however, the benefit of the graduated rates must be shared. In effect, each corporation pays a slightly higher tax because it is part of a group of multiple corporations. If you want to avoid restrictions on multiple corporations, you may want to look to LLCs or some other form of business organization.
Both individuals and C corporations (other than PSCs) can enjoy graduated income tax rates. The top tax rate paid by sole proprietors and owners of other pass-through businesses is 39.6 %. The top corporate tax rate imposed on C corporations is 35 %. (There is some political support for reducing the top corporate tax rate.) Personal service corporations are subject to a flat tax rate of 35 %. (The domestic production activities deduction in Chapter 21 effectively lowers the top rate to less than 32 % for corporations that are eligible to claim it.) But remember, even though the C corporation has a lower top tax rate, there is a 2-tier tax structure with which to contend if earnings are paid out to you as dividends – tax at the corporate level and again at the shareholder level.
While the so-called double taxation for C corporations has been eased by lowering the tax rate on dividends, there is still some double tax because dividends remain nondeductible at the corporate level. The rate on qualified dividends for most taxpayers is 15 % (zero for taxpayers who are in the 10 % or 15 % tax bracket; 20 % for those in the 39.6 % tax bracket).
The tax rates on capital gains also differ between C corporations and other taxpayers. This is because capital gains of C corporations are not subject to special tax rates (they are taxed the same as ordinary business income), while owners of other types of businesses may pay tax on the business's capital gains at no more than 15 % (zero if they are in the 10 % or 15 % tax bracket; 20 % if they are in the 39.6 % tax bracket). Of course, tax rates alone should not be the determining factor in selecting your form of business organization.
Owners of businesses organized any way other than as a corporation (C or S) are not employees of their businesses. As such, they are personally responsible for paying Social Security and Medicare taxes (called self-employment taxes for owners of unincorporated businesses). This tax is made up of the employer and employee shares of Social Security and Medicare taxes. The deduction for one-half of self-employment taxes is explained in Chapter 13.
However, owners of corporations have these taxes applied only against their salary and taxable benefits. Owners of unincorporated businesses pay self-employment tax on net earnings from self-employment. This essentially means profits, whether they are distributed to the owners or reinvested in the business. The result: Owners of unincorporated businesses can wind up paying higher Social Security and Medicare taxes than comparable owners who work for their corporations. On the other hand, in unprofitable businesses, owners of unincorporated businesses may not be able to earn any Social Security credits, while corporate owners can have salary paid to them on which Social Security credits can be generated.
There have been proposals to treat certain S corporation owner-employees like partners for purposes of self-employment tax. To date, these proposals have failed, but could be revived in the future.
The additional Medicare surtaxes on earned income and net investment income (NII) are yet another factor to consider. The 0.9 % surtax on earned income applies to taxable compensation (e.g., wages, bonuses, commissions, and taxable fringe benefits) of shareholders in S or C corporations; it applies to all net earnings from self-employment for sole proprietors, partners, and limited liability company members. The 3.8 % NII tax applies to business income passed through from an entity in which the owner does not materially participate (i.e., one in which the owner is effectively a silent investor).
As you will see in Chapter 2, the tax law limits the use of fiscal years and the cash method of accounting for certain types of business organizations. For example, partnerships and S corporations in general are required to use a calendar year to report income.
Also, C corporations generally are required to use the accrual method of accounting to report income. There are exceptions to both of these rules. However, as you can see, accounting periods and accounting methods are important considerations in choosing your form of business organization.
In small businesses it is common practice for owners to pay certain business expenses out of their own pockets – either as a matter of convenience or because the company is short of cash. The type of entity dictates where owners can deduct these payments.
A partner who is not reimbursed for paying partnership expenses can deduct his or her payments of these expenses as an above-the-line deduction (on a separate line on Schedule E of the partner's Form 1040, which should be marked as “UPE”), as long as the partnership agreement requires the partner to pay specified expenses personally and includes language that no reimbursement will be made.
A shareholder in a corporation (S or C) is an employee, so that unreimbursed expenses paid on behalf of the corporation are treated as unreimbursed employee business expenses reported on Form 2106 and deducted as a miscellaneous itemized deduction on Schedule A of the shareholder's Form 1040. Only total miscellaneous itemized deductions in excess of 2 % of the shareholder's adjusted gross income are allowable; if the shareholder is subject to the alternative minimum tax, the benefit from this deduction is lost.
However, shareholders can avoid this deduction problem by having the corporation adopt an accountable plan to reimburse their out-of-pocket expenses. An accountable plan allows the corporation to deduct the expenses, while the shareholders do not report income from the reimbursement (see Chapter 8).
Each state has its own way of taxing businesses subject to its jurisdiction. The way in which a business is organized for federal income tax purposes may not necessarily control for state income tax purposes. For example, some states do not recognize S corporation elections and tax such entities as regular corporations.
A company must file a return in each state in which it does business and pay income tax on the portion of its profits earned in that state. Income tax liability is based on having a nexus, or connection, to a state. This is not always an easy matter to settle. Where there is a physical presence – for example, a company maintains an office – then there is a clear nexus. But when a company merely makes sales to customers within a state or offers goods for sale from a website, there is generally no nexus. (However, a growing number of states are liberalizing the definition of nexus in order to get more businesses to pay state taxes so they can increase revenue; some states are moving toward “a significant economic presence,” meaning taking advantage of a state's economy to produce income, as a basis for taxation.)
Assuming that a company does conduct multistate business, then its form of organization becomes important. Most multistate businesses are C corporations because only one corporate income tax return needs to be filed in each state where they do business. Doing business as a pass-through entity means that each owner would have to file a tax return in each state the company does business.