taxes

Business Entity – S Corporation

As defined by the Small Business Administration (SBA), and S corporation (sometimes

referred to as an S Corp) is a special type of corporation created through an Internal Revenue

Service (IRS) tax election (Retrieved From: https://www.sba.gov/content/s-corporation)

As a corporation, an S Corporation is created through filing Articles of Incorporation with the Secretary of State or similar government body. In most cases, it issues stock and is governed as a corporation. The owners, who are called shareholders, have the same protection from liability as shareholders of a C corporation. As S corporation shareholder’s personal assets, such as personal bank accounts, cannot be seized to satisfy business liabilities.

Initially an S Corporation is set-up through the IRS as a Corporation and a business owner will determine if their business will qualify under the IRS stipulations for election as an S Corporation. Once it is determined that a business qualifies as an S Corporation, they must file an IRS Form 2553 and all shareholders must sign the form. The IRS has restrictions to the number of owners that an S corporation can have, 100. All owners must be US citizens/residents (cannot be non-resident aliens). Additional, an S corporation owners cannot be C corporations, other S corporations, limited liability companies (LLCs), partnerships or certain trust. Some additional IRS restrictions, apart from ownership restrictions also apply to S corporations. There can be only one class of stock and the corporation must be a domestic corporation.

Based on wanting to change his business structure and include Mandy and a possible owner and to limit his liability and Mandy’s liability and based on the tax savings and S Corporation can provide, I would recommend to change the overall business from a sole proprietorship to an S corporation. Which will allow Bob to give Mandy a percentage of ownership agreed by both and in the future they can add some additional owner if they so desire (limited to 100).

Account Methods

When a business is formed, the business must determine what accounting method with be used in order to keep the financial and accounting records. Accounting methods refer to the basic rules and guidelines under which keep their financial records as prepares their financial reports. The two most commons methods used today are the Accrual Method and the Cash method. Additional to the two most common methods of accounting, a third method a company may chose is the Hybrid Method, which will also be explained in detail. One a method is selected the business should use that method for the entire tax reporting year.

Cash basis accounting records prepared using the cash basis recognize income and

expense according to real-time cash flow (Retrieved From: http://www.bizfilings.com/learn/s-corporation-advantages-and-disadvantages.aspx. Income is recorded upon receipt of funds based on the amount that will billed for products or service upon receipt of funds, rather than based upon when it is actually earned. All expenses are recorded as they are paid, rather than when the expense actually was incurred. Under the cash basis accounting method, it is possible to defer taxable income by delaying billing so that payments not received in a given year are not billed and paid until the next year. Depending on the company, they may not bill their December services until the end of the year, so that the income is received until the New Year. On the other hand, it is possible to accelerate expenses by paying them as soon as the bills are received, in advance of their due dates to be able to lower their taxable income.

Accrual basis accounting a company recognizes both income and expenses at the time they are earned or incurred, regardless of when cash associated with those transaction changes hands. Under the accrual basis accounting method, revenues are recorded when it is earned rather that when payment is received. Additional, expenses are also recorded when they are incurred rather that when payments are made. Taxes are paid on income prior to the income coming end at the end of the year and expense are also written off prior to then being paid.

The cash method offers several advantages, it is simpler to manage that the accrual method. It provides a more accurate picture of cash flow and income is not subject to taxation until the money is actually received. A disadvantage of the cash method is that expenses and revenues are not matched in time.

The accrual method of accounting is designed to recognize income and expenses in the

period to which they apply, regardless of whether or not money has changed hands (Retrieved

From: http://www.inc.com/encyclopedia/accounting-methods.html. The main advantage of the accrual methods is that it provides a more accurate picture of how a business is performing over the long-term that the cash method. The main disadvantages are that it is more complete than the cash basis and that income taxes may be owe on revenue before payment is actually received. In the event a bill for services isn’t paid and never collected, then you have paid taxes on money not received and the following tax period you end of have bad debt expense (which will be a credit), but you have paid that money out and the IRS doesn’t pay you interest on monies paid to them for taxes you paid on income you didn’t receive.

Hybrid Method (Anderson, Pope, Rupert, 2016 p 3.5), a corporation uses the accrual method of accounting for sales, cost of goods sold, inventories, accounts receivable, and accounts payable. They will use the cash method of accounting for all other income and expense items. The hybrid method of accounting is sometimes used by businesses with inventory (Retrieved From: http://thismatter.com/money/tax/accounting-methods.htm). Unless the business qualifies for small inventory business exception, tax law requires businesses to use the accrual method of accounting to account for inventory and it sales. Many businesses with inventory also use a cash basis for all other income and expenses because of its simplicity.

Since Bob owns a used car dealership, and the fact has inventory, he could either use the Hybrid Method of accounting, or the accrual method of accounting. Dealerships typically maintain a distinct inventories and tend to account for them differently (Retrieved From: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Inventory-Automotive-Tax-Tips). When a business must account for an inventory in their business, it is recommended they use an accrual method of accounting for their purchases and for their sales. It can be recommended based on the fact that Bob is a small business owner and owns a car dealership, that he use the accrual method of accounting when he changes his business entity to an S Corporation.

Tax Law

Depending on the type of business entity established, one most understand the related tax laws, the required forms to be filed, the due date for the tax return and what documents should be distribute based on the business entity that was established.

26 U.S. Code § 1361 - S corporation are corporations that elect to pass corporation income, losses, deductions and credits through to their shareholders for federal tax purposes (Retrieved From: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations and https://www.law.cornell.edu/uscode/text/26/1361). 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 S corporation’s income. S corporation are responsible for tax on certain built-in gains and passive income at the entry level.

An S corporation will file their tax return on tax form 1120S, in which it will record all income and expenses. The 1120 S will also generate a schedule K-1 which will be provided to each shareholder that owns a shares of stock in the S corporation. The shareholder will share in the profit and losses of the S corporation. In the even the S corporation decides not to distribute the income, the shareholders are still required to claim that income on their personal tax returns.

With Bob selecting an S Corporation as his new business entity, he can provide Mandy with a percentage of ownership, which, less her salary and other business expenses we will prepare his tax 1120S tax return and generate a schedule K-1 for both Bob and Mandy. This in fact could lower Bob overall tax liability for the business. It could increase Mandy’s tax liability based on the overall performance of the car dealership and the salary she will be given. This will all be determine once the business and individual tax return are prepared.

References

Anderson, Kenneth E., Pope Thomas R., Rupert, Thomas J., (2016). Federal Taxation 2015, Corporation, Partnerships, Estates & Trust

SBA, U.S. Small Business Administration, (2016) Retrieved From: https://www.sba.gov/content/s-corporation

BizFiling, (2016) Retrieved From: http://www.bizfilings.com/learn/s-corporation-advantages-and-disadvantages.aspx

Inc. (2016) Retrieved From: http://www.inc.com/encyclopedia/accounting-methods.html

thisMatter.com (2016) Retrieved From: http://thismatter.com/money/tax/accounting-methods.htm

IRS.Gov (2016) Retrieved From: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Inventory-Automotive-Tax-Tips

IRS.Gov (2016) Retrieved From: https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations

Cornell University Law School: Retrieved From: https://www.law.cornell.edu/uscode/text/26/1361

ANOTHER EXAMPLE

Dear Mr. Jones,

It is my recommendation that you adopt the C Corporation form for your used car business. A corporation will enable you to bring your daughter, Mandy, into the business with 40% ownership, and will also make it possible for you to retire when you are ready to do so, with business continuity assured, all the while enjoying protection from liability that your current sole proprietorship does not offer. You will not be taxed on earnings on a personal level unless a dividend or salary is paid. And, as to the matter of your compensation, I further recommend that you choose to take it in the form of salary rather than dividend. I have factored into my analysis an annual salary high enough to accommodate your income needs but low enough to avoid constructive dividend issues. You will be able to adopt a fiscal year, which will fit in well with the seasonality of your car sales. Finally, as I will illustrate, the corporate tax rates (26 USC §11(b)) are favorable to the highest marginal individual tax rate that applies in your current situation as sole proprietor.

I recommend the Hybrid method of accounting. Your current and projected gross receipts are less than $5 million so you don’t need to use the pure Accrual method. But since you have inventory, you are unable to use the Cash method.

The cost to prepare your tax returns will be slightly higher as a corporate tax payer, and now you will need corporate forms as well as personal forms. According to the IRS, the average cost for preparing a Form 1120 is $806 versus the cost of a Schedule C for your Form 1040, which is $218 (Internal Revenue Service, 2014).

The tax benefits associated with the corporate form (with your taking compensation as salary) versus alternative business forms is shown below. This analysis has used a salary of $200,000 along with your business income of last year. As you can see, the C Corporation choice results in the lowest total tax of $397,106.

As mentioned above, the C Corporation form offers liability protection for the shareholder. Shareholder-employees are liable for only half their Social Security taxes and receive nontaxable fringe benefits. The corporation is liable for half of the Social Security taxes of the employees and provides fringe benefits with pre-tax dollars.

Tax law supports the selection of the C Corporation in other ways:

(1) The corporation will be allowed a deduction for organizational expenses in the year in which you start business up to $5,000, but this deduction would be reduced if you spent $50,000. I think you’ll be spending less than $50,000 for your auto business, but any amount you spend over $5,000 can be deducted ratably over the 180-month period beginning the month the corporation begins business (26 USC §248).

(2) No gain or loss will be recognized when you form this corporation because you’ll be transferring money and property for stock, you’ll be in control of at least 80% of the corporation, and you won’t be receiving anything but stock in the transaction (26 USC §351).

(3) Your adjusted basis in the stock received will be the same as the adjusted basis in the property transferred, since you’re not recognizing any gain or receiving any boot or assuming any liabilities (26 USC §358).

(4) I rejected setting up an S Corporation instead, as I found that your total tax would be higher (see above table) and there were insufficient compensating attractive factors to warrant S corporation selection (26 USC §1361).

(5) I rejected setting up a partnership for you and your daughter because while the Florida Revised Uniform Partnership Act (Larson, 1995) eases the need for partnership dissolution upon death of a partner, and while a solid partnership agreement can foil many problems, Mandy would nevertheless only have a 40% interest, and this could present a problem in continuing the partnership in the event of your death, since there are no other partners (26 USC §708).

References

Internal Revenue Service (2014). Tax preparation costs and fees. Retrieved from www.irs.com/articles/tax-preparation-costs-and-fees

Larson, John W. (1995). Florida’s new partnership law: The revised Uniform Partnership Act and limited liability partnerships. Retrieved from http://archive.law.fsu.edu/journals/

lawreview/issues/232/larson.html

26 USC §11(b). Tax imposed. Retrieved from https://www.law.cornell.edu/uscode/text/26/11

26 USC §248. Organizational expenditures. Retrieved from https://www.law.cornell.edu/ uscode/text/26/248

26 USC §351. Transfer to corporation controlled by transferor. Retrieved from https://www.law .

cornell.edu/ uscode/text/26/351

26 USC §358. Basis to distributees. Retrieved from https://www.law.cornell.edu/ uscode/text/26/358

26 USC §708. Continuation of partnership. Retrieved from https://www.law.cornell.edu/ uscode/text/26/708

26 USC §1361. S corporation defined. Retrieved from https://www.law.cornell.edu/ uscode/text/26/1361

Bob Jones - Business Entity Comparison

(Based on last year's income level)

Sole

Proprietor

C Corporation

with Salary

C Corporation

with Dividend

S Corporation

with Salary

S Corporation

with Distribution

Entity Level Analysis:

Income before salary1,200,000$ 1,200,000$ 1,200,000$ 1,200,000$ 1,200,000$

Salary deduction- (200,000) - (200,000) -

Taxable income1,200,000 1,000,000 1,200,000 1,000,000 1,200,000

Entity Level Tax (a)-$ 340,000$ 408,000$ -$ -$

Individual Level Analysis:

Pass-through income1,200,000$ -$ -$ 1,000,000$ 1,200,000$

Salary income- 200,000 - 200,000 -

Interest income20,000 20,000 20,000 20,000 20,000

Dividend income from business- - 200,000 - -

Dividend income non-business6,000 6,000 6,000 6,000 6,000

Total Income - Personal1,226,000 226,000 226,000 1,226,000 1,226,000

Individual Level Tax (b)440,689$ 57,106$ 2,539$ 440,689$ 440,689$

Total Tax440,689$ 397,106$ 410,539$ 440,689$ 440,689$

(a) Entity Level Tax calculations:

Entity Level Tax for C Corporation with Salary

113,900+(34%(1,000,000-335,000)) = $340,000

Entity Level Tax for C Corporation with Dividend

113,900+(34%(1,200,000-335,000)) = $408,000

(b) Individual Level Tax calculations:

Ordinary Income1,220,000$ 220,000$ 20,000$ 1,220,000$ 1,220,000$

Marginal Tax Rate39.6%33.0%15.0%39.6%39.6%

Tax on Ordinary Income439,489$ 56,206$ 2,539$ 439,489$ 439,489$

Dividend Income6,000$ 6,000$ 206,000$ 6,000$ 6,000$

Dividend Tax Rate20.0%15.0%0.0%20.0%20.0%

Tax on Dividends1,200$ 900$ -$ 1,200$ 1,200$

Total Tax Individual Level440,689$ 57,106$ 2,539$ 440,689$ 440,689$