Run Your Own Corporation. Garrett Sutton
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play catch up in figuring out how you’re keeping your books, and to keep it simple, there are only a handful of systems allowed. The two main systems are the cash method and the accrual method. In addition, the IRS permits a hybrid method of cash and accrual, and may permit other forms of accounting allowable under IRS code. But let’s stick with the main ones.
The cash method accounts for income and outflow in real time. Income is recognized when received by the business. Expenses are considered deductible when paid. So work invoiced or billed in one financial year (i.e. December) and paid in the next (January) is not taxable the year it was invoiced but rather in the year that the money was actually received (January). Expenses coming due in one financial year and paid in the next are considered deductions in the year they were actually paid, not the year they were invoiced. So by real time we mean that income is recognized when it is really received and expenses are recognized when they are really paid.
Under the accrual method, income is recognized when it’s earned, whether or not the funds are actually received. Similarly, expenses are deductible when incurred, whether or not it takes some time to actually pay them off. So a business with a calendar (December 31st) year-end which sends out invoices in December and is paid in January is still responsible for taxes on the amount invoiced for the calendar tax year that ended in December. Again, under the cash method, taxes on the invoiced amount wouldn’t be due until the invoiced amount was actually received. So accrual is not real time receipts but rather real time billed. I prefer the certainty of receiving cash over the hope of billing for it.
Most businesses elect the cash system of accounting unless inventory is a large part of the business. No matter which method is chosen, the IRS requires business owners to make a choice and, once that choice is made, you need the IRS’s permission to change it.
In order to keep the corporate veil intact, decisions such as electing a system of accounting need to be an actual election, a vote taken or a decision made during a documented meeting of members of the LLC or shareholders of the corporation. Include such decisions in the minutes of the meeting and keep the minutes in the corporation book. Election of the professional team the business is working with, the system of accounting, opening and closing bank accounts, applying for loans and credit are all decisions that need to be recorded and maintained in the corporate minutes. Those decisions made by shareholders, members, managers or directors outside the annual meeting are made as resolutions, which need to be recorded in a written document as well and kept with the corporate meeting minutes. Decisions that need to be documented include:
• Initial election of type of business entity
• Determination of shareholder-employee or member-employee salaries
• Choice of accountant and bookkeeper
• Opening of bank accounts
• Sale of stock
• Issuing dividends
• Purchase or sale of equipment
• Purchase of real property
We will be dealing with the important topic of documentation throughout the book.
Choose Your Tax Year
Another choice you’ll be making during this time is your fiscal year. You can choose to have your company’s fiscal year end at the end of any month, but be aware that federal taxes are due 2.5 months after the end of your fiscal year, not 3.5 months as personal taxes are. So if you elect a calendar year (January through December and ending on December 31st) as your corporate fiscal year, your federal return will need to be filed March 15, not April 15. And as with personal taxes, a six-month extension is available by filing IRS Form 7004, which will probably extend the filing period for your state income tax as well. State income taxes are required for corporate entities in every state with some notable exceptions, including Nevada and Wyoming. Remember that an extension is for filing the tax return, not for paying the estimated taxes due. (You extend, you still pay.)
However, if you’re making quarterly estimated payments to the IRS, this shouldn’t be such a shock at the end of the year. While federal tax payments for Social Security and Medicare are required to be made quarterly with IRS Form 941 (unless you’re informed by the IRS they find your paperwork too much nuisance for too little income from you, and you file annually with a Form 944), you can also choose to make payments on a monthly, biweekly or weekly basis. Sometimes it’s less painful to pay more often and in smaller increments.
Be sure to work with your CPA on these matters to get them right. Failure to pay or even falling behind on your payroll tax obligations can lead to personal liability and serious penalties. We will consider such a case further ahead.
IRS Definitions and Requirements
The IRS defines a corporation as an entity formed under state law by the filing of articles of incorporation with the state. Articles of incorporation need to be date stamped (or file stamped) by the Secretary of State’s office in order to be official.
The IRS defines S corporations as corporations that elect to pass corporate income losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income.
The IRS code really doesn’t define LLCs. As such, the IRS allows them the flexibility to be taxed however you, the LLC owner, wants. You can choose C corporation, S corporation, partnership or, if one member, disregarded entity taxation. Your election will be filed on Form 8832.
The following is a quick comparison of federal tax requirements for traditional C corporations, S corporations and LLC entities.
C Corporation
• Files IRS Form 1120.
• Balance sheet required on tax return.
• Must use double-entry bookkeeping system.
• Corporation must file all necessary employment tax returns.
• Pays tax on all profits. When shareholders take profits as dividends, distributions are taxable on shareholder’s tax returns (double taxation).
• Some C corporations are defined as personal service corporations (such as professional corporations for physicians) and these are generally taxed at a higher rate.
• Tax elections are at corporation level.
• Allocation of income/deductions not permitted.
• Tax responsibility does not flow through to individual shareholder level.
• Shareholders who work for the corporation are considered employees (shareholder-employees) and need to draw a reasonable salary which is subject to payroll and withholding taxes. Dividend distributions, however, are not subject to social security tax.
S Corporation
• Must make the election (Form 2553) for IRS to consider an S corporation.
• Files IRS Form 1120S.
• Must use double-entry bookkeeping.
• All S corporations are required to file payroll tax and reporting forms for shareholders functioning as employees.
• Income and expense flow through to shareholders and are not taxed at corporation level.
• Tax elections are at S corporate level.
• Shareholders who function as employees must receive reasonable compensation (wages) and