J.K. Lasser's Small Business Taxes 2018. Barbara Weltman
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the 2 % rule, only the portion of total miscellaneous deductions in excess of 2 % of adjusted gross income is deductible on Schedule A. Adjusted gross income is the tax term for your total income subject to tax (gross income) minus business expenses (other than employee business expenses), capital losses, and certain other expenses that are deductible even if you do not claim itemized deductions, such as qualifying IRA contributions or alimony. You arrive at your adjusted gross income by completing the Income and Adjusted Gross Income sections on page 1 of Form 1040.
Example
You have business travel expenses that your employer does not pay for and other miscellaneous expenses (such as tax preparation fees) totaling $2,000. Your adjusted gross income is $80,000. The amount up to the 2 % floor, or $1,600 (2 % of $80,000), is disallowed. Only $400 of the $2,000 expenses is deductible on Schedule A.
If you fall into a special category of employees called statutory employees, you can deduct your business expenses on Schedule C instead of Schedule A. Statutory employees were discussed earlier in this chapter.
Factors in Choosing Your Form of Business Organization
Throughout this chapter, the differences of how income and deductions are reported have been explained for different entities, but these differences are not the only reasons for choosing a form of business organization. When you are deciding on which form of business organization to choose, tax, financial, and many other factors come into play, including:
● Personal liability
● Access to capital
● Lack of profitability
● Fringe benefits
● Nature and number of owners
● Tax rates
● Social Security and Medicare taxes
● Restrictions on accounting periods and account methods
● Owner's payment of company expenses
● Multistate operations
● Audit chances
● Filing deadlines and extensions
● Exit strategy
Each of these factors is discussed below.
If your business owes money to another party, are your personal assets – home, car, investments – at risk? The answer depends on your form of business organization. You have personal liability – your personal assets are at risk – if you are a sole proprietor or a general partner in a partnership. In all other cases, you do not have personal liability. Thus, for example, if you are a shareholder in an S corporation, you do not have personal liability for the debts of your corporation.
Of course, you can protect yourself against personal liability for some types of occurrences by having adequate insurance coverage. For example, if you are a sole proprietor who runs a store, be sure that you have adequate liability coverage in the event someone is injured on your premises and sues you.
Even if your form of business organization provides personal liability protection, you can become personally liable if you agree to it in a contract. For example, some banks may not be willing to lend money to a small corporation unless you, as a principal shareholder, agree to guarantee the corporation's debt. For example, SBA loans usually require the personal guarantee of any owner with a 20 % or more ownership interest in the business. In this case, you are personally liable to the extent of the loan to the corporation. If the corporation does not or cannot repay the loan, then the bank can look to you, and your personal assets, for repayment.
There is another instance in which corporate or LLC status will not provide you with personal protection. Even if you have a corporation or LLC, you can be personally liable for failing to withhold and deposit payroll taxes, which are called trust fund taxes (employees’ income tax withholding and their share of FICA taxes, which are held in trust for them) to the IRS. This liability is explained in Chapter 29.
Most small businesses start up using an owner's personal resources or by turning to family and friends. However, some businesses need outside capital – equity and/or debt – to get started properly. A C corporation may make it easier to raise money, especially now. For example, access to equity crowdfunding, which allows businesses to raise small amounts from numerous investors, is effectively limited to C corporations (S corporations cannot have more than 100 investors; partnerships and LLCs would have difficulty in divvying up ownership among an ever-changing number of owners). Equity crowdfunding for accredited investors (net worth more than $1 million, excluding a principal residence or income exceeding $300,000) obviously works best for C corporations (unless the shareholder limit on S corporations is waived by a legislative change that was pending when this book was published; see the Supplement for any update).
For non-accredited investors (those who do not qualify as accredited investors because they don't have annual income of $200,000, or $300,000 with a spouse), equity crowdfunding investments are capped at up to 10 % of annual income for those with income over $100,000, or up to $2,000 or 5 % of annual income, whichever is greater, for investors with annual income under $100,000.
All businesses hope to make money. But many sustain losses, especially in the start-up years and during tough economic times. The way in which a business is organized affects how losses are treated.
Pass-through entities allow owners to deduct their share of the company's losses on their personal returns (subject to limits discussed in Chapter 4). If a business is set up as a C corporation, only the corporation can deduct losses. Thus, when losses are anticipated, for example, in the start-up phase, a pass-through entity generally is a preferable form of business organization. However, once the business becomes profitable, the tables turn. In that situation, C corporations can offer more tax opportunities, such as fringe benefits. Companies that suffer severe losses may be forced into bankruptcy. The bankruptcy rules for corporations (C or S) are very different from the rules for other entities (see Chapter 25).
The tax law gives employees of corporations the opportunity to enjoy special fringe benefits on a tax-free basis. They can receive employer-provided group term life insurance up to $50,000, health insurance coverage, dependent care assistance up to $5,000, education assistance up to $5,250, adoption assistance, and more. They can also be covered by medical reimbursement plans. This same opportunity is not extended to sole proprietors. Remember that sole proprietors are not employees, so they cannot get the benefits given only to employees. Similarly, partners, LLC members, and even S corporation shareholders who own more than 2 % of the stock in their corporations are not considered employees and thus not eligible for fringe benefits.
If the business can afford to provide these benefits, the form of business becomes important. All forms of business can offer tax-favored retirement plans. Corporations make it possible to give ownership opportunities to employees. Corporations – both C and S – can offer employee stock ownership plans (ESOPs) in which employees receive ownership interests through a plan that is much like a qualified retirement plan (see Chapter 16). Certain C corporations can offer employees an income tax exclusion opportunity for stock they buy or receive as compensation. For 2017, 50 %, 75 %, or 100 % of the gain on the sale of qualified small business stock (explained in Chapter 7) is excludable from gross income, depending on when the stock was acquired, as long as the stock has been held for more than five years. C corporations can also offer incentive stock option (ISO) plans and nonqualified stock option (NSO) plans (see Chapter 7). The tax law does not bar S corporations from offering stock option plans, but because of the 100-shareholder limit (discussed earlier in this chapter), it becomes difficult to do so.
With whom you go into business affects your choice of business organization. For example, if you have any foreign investors, you cannot use an S corporation, because foreign individuals are not permitted to own S corporation stock directly (resident aliens are permitted to own S corporation stock). An S corporation also cannot be used if investors are partnerships or corporations. In other words, in