Taxation of a buisiness

TO: Bob Jones

FROM: Robert Shulzinsky

DATE:

SUBJECT: Business entity, Accounting method, and Tax Laws

Business Entity

Entity selection is a vital decision that business owners must make. Business incorporation comes with different tax ramifications that need to be considered when making the decision. Business owners need to consider both the tax and the nontax implications where they decide the most appropriate business structure. However, they should not only take into account tax considerations since other crucial factors need to be considered when developing a business. In this case, Bob should not operate as a sole proprietorship since he is required to report the entire business income on his income tax return. Bob is aged and he feels that he should incorporate Mandy into the ownership of the business. The sole proprietorship, which gives him the entire control and ownership, is not the right form of business for him hence the need to change to another form. The liability of the current business lies all on Bob’s shoulders as it has unlimited liability.

Incorporating the business will be substantial in formalizing the business and separating its activities from Bob’s activities. Incorporation will allow Bob to increase latitude in succession planning. Bob will also be able to protect his assets and investments from creditors and the business entity. There are various forms of business entities that Bob could choose. These include a partnership, S corporation, C Corporation, and LLCs. In the S corporation, owner’s income, losses, and credit, deductions are passed to shareholders for tax purposes. In the C Corporation, the business is taxed separated from its owners. Both partnerships and LLCs pass through the loss of income to each member’s tax return. Due to the nature of the business and ownership structure of Bob’s business, the most appropriate business structure for taxation purposes is the S corporation. (Cordes et al., 2005). According to the IRS tax regulations, an S corporation is treated as a partnership for taxation purposes. An S corporation is a limited liability company meaning that it is not liable for income tax. It does not have the corporate level tax. The revenue and losses of an S corporation are distributed to shareholders from where they are taxed based on their allocated income. It is known as a pass-through entity.

Accounting method

Due to the taxation effects of an S corporation, Bob will be required to maintain accurate records of their incomes and investments. These are reported at the corporate level and are crucial in the allocation process to the company’s shareholders. There are two main accounting methods. These are the cash basis and the accrual basis. The cash basis involves recognizing incomes and expenses at the real time of cash flows. That is, recoding incomes as are received and expenses as they are paid. The cash basis cannot be used when the business maintains material income-producing inventory. The accrual basis involves recording incomes as they are earned and expenses as they are incurred. The appropriate accounting method for Bob to use is the accrual method. This accounting method recognizes both revenue and expenses when earned or incurred irrespective of the time of receiving or giving out the associated cash. Under the accrual basis, taxes are paid on revenue before actually receiving the income while expenses being written off before actually doing the payment. (Melville, A. 2017).

A clear advantage with the accrual basis is that it gives a relatively accurate record of business performance in the long run while its disadvantage is that income taxes may be subjected on revenue just before any payment is received risking losing the amount paid on tax in an event this revenue is not collected. The above business pays annual wages to Mandy and Bob while on the S corporation taxation regulations, both Mandy and Bob will not be liable for self-employment tax on their portions of business profits hence, will not have deductions from the annual wages received from the firm.

Tax laws

Registering the car business as an S corporation will be vital in minimizing double taxation effects. According to the firm structure, the business pays both Bob and his daughter annual wages. Based on the S corporation taxation requirements, both Bob and his daughter will not pay the self-employment tax on their allocation of business profits. (Kahn et al., 2013). It is a crucial employee benefit since there will be no deductions from their annual salaries received from the firm. S corporations are able to avoid double succession as they report income and losses through their personal tax returns. Items of an income, deductions, and credits are passed through to shareholders.

There are various tax benefits associated with S corporation. Bob and his business will only be liable for a single taxation. All the business earning and losses are passed onto the shareholders who are taxed directly. The resulting tax liability is assessed and paid at the individual level. The losses that might be incurred by the business are applied to other business incomes which, in turn, reduce the tax liability of individual shareholders. There is no payment or other forms of taxes by the business which results in tax savings. S corporation splits the income meaning that shareholders will not be eligible for deductions on their payroll.

Tax effects on cash withdrawals and dividends

For an S corporation, salary is tax deductible. Hence, withdrawing cash for the payment of taxes will likely increase the taxes for the business. Employees are taxed directly taxed from their basic salaries. However, dividends are not taxed under the S corporation. Provided that an employee, a shareholder or not, works for the S corporation, he is assumed to be equal to other employees who are not shareholders when it comes to taxation. All employees receive a common tax treatment, whereupon issuance of the paycheck the taxes are withheld and self-employment taxes deducted. Thus, withdrawing cash to pay for employees’ salaries would increase the corporate tax.

In many cases, S corporations make no dividend distributions. They often make non-dividend distributions. These distributions are tax-free and are not subject to FICA taxes. Thus, the choice of an entity type is an important key to any given investor. Among the justifications for this are the different tax structures and non-tax impacts that are important to consider when making such a decision. (Engdahl, S. 2011). For instance, in operating as a sole proprietor is relatively expensive to the firm as he is expected to report the whole business income when filing his tax return hence he should consider incorporating the business to separate the entity activities from himself. Incorporation will enable Bob to develop an easy succession strategy in the case of a bad event of death and also shield his personal assets and other forms of investment from various creditors and the entity itself. An S corporation is classified as under partnership for purpose of taxation as under the IRS tax laws. (Melville, A. 2017). This type of corporation has got a limited liability hence, is not for income tax and so all income or losses are distributed in the agreed portion to the shareholders from where then they are taxed proportionately.

Based on the kind of entity in the establishment, its key to understand the related tax laws, various forms to be filled, documents to be distributed based on the business entity and also the due dates for tax return. According to the 26 U.S code &1361, S corporations refer to corporations that pass loses, revenue, deductions, and credits through to their owners for the federal tax purposes. The owners in the S corporation report their income/losses through their personal tax returns that are assessed at their own individual tax rates hence enabling the avoidance of occurrence of double taxation on their income. (Melville, A. 2017). The S corporations do a filing of their returns of tax on the tax form the 1120s where it puts down all revenue and expenses. This form will, in turn, bring about the K-1 schedule which will be given to each owner of a share in the S corporation. In a case where the S corporation does not distribute its income, the owners are still needed to claim that income on their individual tax returns.

Percentage of ownership

Bob in embracing an S corporation type of entity can give Mandy a certain percentage of ownership for which, less her salary and all other expenses from the business will be able to prepare Bobs tax 1120S to return and come up with a K-1 schedule for both Bob and Mandy (Engdahl, S. 2011). In this case, Bob’s general tax liability for the business will be lowered while increasing Mandy’s tax liability regards to the general business performance and the salary. All these shall be determined once the business’ and the personal tax return are prepared.

An owner of the S corporation working for the enterprise are categorized as employees and thus, get the same tax treatment as any other worker for the business and is not a shareholder and so, owners working for the enterprise should be given a relevant compensation for the type of engagement performed. (Engdahl, 2011).Unlike C corporations, S corporations don't make any dividend distribution but instead, make non-dividend distributions which are tax-free so long as the distribution doesn’t exceed the owners stock basis. In the case where the distribution exceeds the owner’s shares, then the amount in excess is subjected to tax as a long-term capital gain. Thus a withdrawal of $180000 and $70000 from the business to pay for the client’s salary and that of his daughter would be taxable in their personal basis and reflected on their annual tax return filing while would not be passed as a tax liability to the business.

An S corporation should not have more than 75 % shareholders. Also, the only possible entities who could become shareholders of the business include individuals, certain trusts, and tax-exempt taxable organizations. This form of business has freely transferable stock. For the case of Bob’s business, under the S corporation, power may be transferred to Mandy through the transfer of stock. One way of changing the ownership percentage of a shareholder is through the allocation of shares. Mandy could buy back a percentage of shares from Bob to increase his percentage of ownership. Alternatively, the business could issue more of its shares while Bob retaining his initial percentage. (Melville, A. 2017).

In general, an inherited property from a descent gets an increase on the basis same to the market value of the related property at the time of demise. In this case, the inheritor avoids paying capital gain tax on any realized appreciation in the value of the property. (Melville, A. 2017). For example, Bob bought land at $450000 back in 1996 and so this forms his tax basis in this property. If he, in turn, was to sell it at its market value of $9000000 he would be required to pay a capital gain tax on the $8550000 of the value that has appreciated. (Engdahl, S. 2011). Instead, if Bob keeps this property to death and is inherited by his family, the basis automatically moves to $9000000 as of the time of his death and so if the family decides to sell this property at let’s say, $10000000, then they will pay only the capital gain tax on $1000000 of the value appreciation hence, tax savings. (Melville, A. 2017).However, when the family inherits property owned by the S corporation, the increase in basis is not applied to the property. For instance, if Bob transferred his real owing to the new S corporation, this corporation has its own basis of ownership on this property separated from Bob’s basis. (Engdahl, S. 2011). And so at his death, Bob owned the personal property and not the real property and so his share gets an increase in basis up to its value at the time of his death.

Tax planning proposal

Tax planning proposal is important, especially when used with the tax codes because it purposely decreases the taxable estate. Upon converting his business from a sole proprietorship to the S corporation, there are many things that Bob need to consider for tax planning. First, it is good to pay attention not only to the corporate formalities but also to the tax formalities. This type of business is a corporation that has elected to follow the state law requirements and the S Corp tax status. They are thus subjected to the Internal Revenue Code.

One of the readily available tax-reduction approaches available to the S corporation is valuation. The S corporations have efficient valuation approaches compared to the C corporations according to the Internal Revenue Service. All that is needed in order to reflect the estimated corporate income taxes is to adjust the earnings of the business. this is because the S corporation is a pass-through entity with no corporate taxes.

Strategic plan

The main goal of any business owner is to avoid or to minimize the effect of the federal estate tax. Firstly, the client has to draw a will before he or she dies. Writing of the will is important because it breaks down the properties of the client to the family which will enable the family shares the properties well. In the event the client dies without a will, the beneficiaries will have to go through tough processes including paying court fines to get the estate (Clarke, Robert, & Speechly, 2014)

Secondly, it is necessary to check out the beneficiaries. This is very important because in some cases the client does not name the beneficiary. Among the properties that are not captured in the will may be the retirement benefits. This forces the clients to just name the next in command of the benefits when they will come. In the event the client dies without naming the next of kin, the matter will be handled by the probate court where the judge names the beneficiary. For this reason, it is always advisable to evaluate the information of the heirs after important and drastic life changes like bearing children and death.

Estate planning strategies

An S corporation can be a useful estate/succession tool. It now includes a generic plan of inclusion of assets in the decedents’ estate. This helps in the creation of a separate entity for the successor of the business. An important developing issue is an issue of developing trust. This normally happens when the client has an estate which he or she thinks may bring problems when sharing. The client then comes up with a trust where he or she employs a trustee who will oversee the sharing of wealth in case the client dies. The trusts are formed through many ways but the most permanent trust has the best tax benefits. This is so because once wealth is put into the trust, the wealth sizes to be the client’s wealth but instead belongs to the trust. The main importance of the trusts is that the estate money in there cannot be taxed. The trustee now is in charge of the money and the client is in charge of decisions hence the money can be given to beneficiaries even when the client is still living. The trusts pay not the taxes when they earn income from dividends and interests but at times, the tax rates levied on them are higher as compared to client’s rates and hence cheaper to pay the expenses through the trusts than paying individually. (Weiss, 1998)

In addition, it is important to have Roth's account transformed from the traditional retirements account. This is important because when the IRAS accounts are passed to non-spouses, the money will be subjected to the income tax. Presently, the income taxes charged covers the entire life of the beneficiary. The client avoids the situation to the beneficiaries by changing the traditional accounts to Roth accounts. The Roth accounts preferred by many clients have no distribution tax. The biggest challenge is that the owner needs frequent changes of the traditional account to the Roth accounts. The purpose of the many conversions is to save the beneficiary from the many higher tax bracket on his or her income earnings.

Gift or transfer of assets

It is advisable for the client to give the wealth to the beneficiaries when he or she is still alive. This can be through gifts that goes up to $ 13 000 annually according to IRS. This is important in the event the client worries about the heavy taxation on his estate so he gives gifts to beneficiaries to reduce the value of the estate and also allows free money to the beneficiaries.

The client can also be able to reduce the tax on the estate by coming up with the donor-advise fund. The value of the estate can be reduced by giving out to the charity groups. The purpose of the donor-advised funds is to give an instant reduction of the tax rate to the money put in the donor-fund and allows the owner to make charitable grants time and again. This is important when the client names the child or grandchild as the beneficiary because the family will be engaged in philanthropy. (Tax Planning, 2010)

Sell the business

The sale of a C corporation may have a major tax implication to the owner. It may have a tax-reducing strategy- the tax death, which would reduce the corporate tax paid. Upon the sale of the business, if the gain from the sale is deemed to be passive, it might be subject to an additional tax of up to 3.8 percent. If the inventory of the business is treated as assets during the time of sale, there would be only one level of tax since the proceeds from the sale would have to be distributed to the seller as dividends.

Advantages and disadvantages

Bob can choose between continuing to operate his business as a sole proprietorship or convert it to a partnership, an S company or a C company. The advantages of operating the business as a sole proprietorship include the fact that the owner has full control over the business. The business is the easy to operate as it has few formalities. A sole proprietorship requires no payment of the corporate tax. The business is also easily transferable, at the discretion of the owner. It is the sole proprietor who pays taxes and the entity is not taxable. A sole proprietorship faces no double taxation. A sole proprietorship, however, may cease to exist if the owner dies. This has been the major concern for Bob who wants to include his daughter as an owner of the business. There is no transferability of interest under a sole proprietorship, unlike the other forms. Another disadvantage of a sole proprietorship is that it has unlimited liability. Bob could be held responsible for the obligations of the business which may lead to loss of personal property. It also has no transferability of interest as the case with S and C corporations. (Causey, 2012).

A partnership can enhance its performance through the diverse skills of different partners. It also involves a minimal tax filing compared to the S and C corporations. There is no double taxation in partnership as earnings flow directly to partners. However, compared to both S and C corporations, the liability of a partnership, just as is the case with a sole proprietorship, is unlimited. Also, partners also face self-employment tax deductions, similar to the other form of business. (Causey, 2012).

The S corporation is advantageous in the sense that shareholders have limited liability to the operations and obligations of the business. The business can also exist after the death of a shareholder, unlike the sole o proprietorship. The S corporation also allows for transferability of interest as per the IRS regulations. This type of business also offers a chance for pass-through taxation. That is, there is no tax at the entity level and incomes are passed through to shareholders. Even though salaries are subject to employment taxes, shareholders’ distributions are not subjected to employment taxes. The S corporation also offers flexibility in the use of an accounting method. The corporation does not have to use the accrual method unless it holds inventory. The disadvantages of this form of business include the rigidity of profit and loss allocation, that is, profits and losses are located based on a percentage of ownership. It also has strictly qualification requirements most of which are not applicable under sole proprietorship. For example, the S corporation must have a maximum of 100 shareholders and there cannot be different forms of stock. (Willson, Windfeld-Hansen, Tax Management Inc., & Bloomberg 2015)

The C Corporation is advantageous in that it has perpetuity even after death or withdrawal of a shareholder. Similar to the S corporation, the C Corporation has limited liability. It also has easily transferability of shares of stock. The main disadvantage of this form of business is that it faces possible double taxation. In addition to paying the corporate income taxes, dividends to shareholders are also taxed. Hence, the S corporation would be the right alternative that Bob should choose. He would be guaranteed of the business’s existence even if he were to die. The S corporation would prevent the business from double taxation as dividends to shareholders are not taxable. (Causey, 2012).

Liquidation of the business

For both the sole proprietorship and partnership, liquidation or transfer is subject to a similar tax scheme. The business would be taxed on the current profit/operating profit and on the capital gains. The operating profits should be taxed subject to the tax base whereas the capital gains are taxed half of the global rate. Upon liquidating the sole proprietorship, the owner would need to track the debts and payments in order to complete the Schedule C tax form which documents the transactions of the business as part of the owner’s tax returns. As a pursuant of liquidation, for both the S and C Corporations, if bob distributes the assets to Mandy, it would be assumed that he has sold them to Mandy at the market value price. The gain or loss is passed through to the shareholder. (Bleiwas, Hutson, Kellough, Canadian Tax Foundation, Fraser Milner Casgrain, & Deloitte, 2010).

Transferring the business activity

In the transfer of activity, when a sole proprietorship converts to an S company, there is no tax on the conversion. This is due to the pass-through treatment for the S corporation income. Upon the decision to transfer the business, the owners need to report the transfer to the bodies under which the business was registered for deregistration. When an S corporation or a C corporation converts to a sole proprietorship, there is usually a payment of a tax of liquidation. Bob would thus consider converting his business from sole proprietorship to an S corporation for tax reasons as well as the perpetuity. (Willson, Windfeld-Hansen, Tax Management Inc., & Bloomberg 2015)

References

Bleiwas, P., Hutson, J., Kellough, H. J., Canadian Tax Foundation., Fraser Milner Casgrain (Firm), & Deloitte (Firm). (2010). Taxation of private corporations and their shareholders. Toronto: Canadian Tax Foundation.

Causey, C. (2012). A Comprehensive approach to types of business entity. Delhi: University Publications.

Cordes, J., Ebel, R., & Gravelle, J. (2005). The encyclopedia of taxation & tax policy. Washington, D.C.: Urban Institute Press.

Deciding whether to elect to be an S corporation after the '86 Tax Reform Act. (2006). New York.

Engdahl, S. (2011). Taxation. Farmington Hills, MI: Greenhaven Press.

Kahn, D., Kahn, J., & Perris, T. (2013). Taxation of S corporations in a nutshell.

Melville, A. (2017). Taxation. Pearson Education Limited.

Willson, P., Windfeld-Hansen, M., Tax Management Inc.,, & Bloomberg BNA,. (2015). State taxation of pass-through entities: General principles.