YOUR TAX IDENTITY
Given the wide range of individual and corporate tax rates, CPAs recommend that you
carefully consider how your business is organized. The type of business organization you
choose will determine your legal and tax treatment. The basic categories, available in
most states, are sole proprietorship, partnership, corporation, and limited liability
company (LLC).
Sole Proprietorship and Partnerships. In a sole proprietorship or partnership,
business income and losses are "passed through" to the individual owners and are
taxed at their individual rates.
C Corporations. A "C Corporation" is the most standard form of
corporation, with business income taxed at corporate rates. Under federal and state tax
laws, regular C Corporations and their owners are treated as separate taxable entities.
When earnings are distributed as dividends, they are taxable to the shareholders at
individual rates. For this reason, income from a C Corporation is said to be subject to
"double" taxation; once at the corporate rate and once at the individual rate.
S Corporations. An "S Corporation" is a special type of elected tax
status in which your business' income and expenses are passed through to shareholders and
taxed at their individual rates, whether or not the income is actually distributed. S
Corporations are generally not subject to corporate income tax, and distributions usually
are not taxable to shareholders. So, income is taxed only once. Keep in mind though, that
S Corporation status carries special eligibility requirements.
Personal Service Corporations (PSCs). PSCs are corporations that provide
services in such areas as health, law, engineering, architecture, accounting, and
consulting. PSCs operating as C Corporations pay a flat tax rate of 35 percent, regardless
of the level of income. You can also elect to have the PSC taxed as an S Corporation, or
convert it to an LLC, to change its tax treatment, but check first with your CPA.
Limited Liability Companies (LLCs). Generally, LLCs combine the "limited
liability" feature of a corporation with the tax treatment of a partnership. This
means that the LLC's income is taxable to the LLC members at their individual rates, and a
separate corporate tax is assessed on the LLC. In most cases, members are not liable for
debts and obligations of the business.
TAX-TRIMMING TIPS FOR THE SMALL BUSINESS
Tax Deductions for Compensation for Services. If your business takes a corporate
form and your corporate tax rates exceed the individual tax rates, you can reduce overall
taxes by compensating yourself and family members for services provided to the
corporation. However, the amount of the compensation must be reasonable in relation to the
services provided. If the IRS determines that the compensation is excessive, it may
disallow the compensation deduction, and treat unreasonable payments as nondeductible
dividends to the owner. In addition, you should also consider the effect of employment
taxes assessed on such wages.
Employment Tax Reductions. Since income distributions to an S Corporation
shareholder are not subject to employment taxes, you can pay yourself a reasonable salary
and withdraw the excess from the company free of such taxes.
Employee vs. Independent Contractor Status. You may be able to save on
employment taxes (as well as fringe benefits) by classifying certain workers as
independent contractors, rather than as employees. However, you must know the special
rules for qualifying as an independent contractor as opposed to an employee. You will face
stiff penalties and back taxes for misclassifying an employee as an independent
contractor.
Retirement Plan Contributions. CPAs recommend that you take advantage of tax
benefits associated with qualified retirement plans for your employees. As the employer,
you can take current tax deductions for contributions to qualified retirement plans for
your employees, and your employees will not recognize taxable income until they withdraw
the funds from the plans. Savings Incentive Match Plans for Employees (SIMPLE) were
created in 1996 to ease some reporting and testing rules, so more small businesses can
provide tax-favored retirement programs to their employees.
Deferred Compensation Plans. The use of qualified and non-qualified deferred
compensation plans also can provide valuable tax benefits both to you and your employees.
Deferred compensation plans allow employees to postpone receipt of part of their current
salary in later years. Therefore, if you or your key employees currently are in a high tax
bracket, you may want to consider establishing a deferred compensation plan to defer
income from high-income years to low-income (such as retirement) years.
Flexible Spending Accounts. Flexible spending accounts provide you and your
employees tax savings because the contributions are not subject to federal income or
employment taxes. Contributions also may be free from state and local income tax, but
generally have to be used by the end of the year or are forfeited by the employee.
Medical Savings Accounts. MSAs are available to small businesses and
self-employed individuals who have insurance plans with high deductibles. Both employers
and employees can contribute to the accounts, and employee contributions and withdrawals
are generally tax-free. Unlike flexible spending accounts, if the money is not spent
during the year, you don't lose it at year end.
Business Property Depreciation. Generally, businesses can elect to deduct
immediately up to $18,000 in 1997 ($18,500 in 1998), of the cost of qualifying property in
the year it is placed into service. However, keep in mind that this "immediate
expensing" deduction is limited to certain depreciable property used in the business
(such as office equipment or machinery) and begins to be reduced dollar for dollar once
the cost of business property exceeds $200,000.
Travel, Meal and Entertainment Expenses. If your business routinely reimburses
employees for travel, meal, and entertainment costs, make sure you meet the accountable
reimbursement plan rules to ensure that such reimbursements will be deductible by your
business and that they will not be treated as taxable income to the employee. Business
travel expenses are fully deductible and business-related meals and entertainment are
50-percent deductible. The rules mandate that the employee submit adequate supporting
documentation. In addition, you may elect to pay your employees a "per diem"
allowance, in lieu of reimbursing actual travel and meal expenses, as long as the amount
does not exceed the applicable federal rate, which varies depending on geographic
location.
Family Employment. You may be able to reduce your business' overall taxes by
paying members of your family for services provided to the corporation. If you hire your
parents, spouse, or child under age 21, the business can deduct the salaries, and if the
business is unincorporated, it does not have to pay Federal Unemployment (FUTA) tax for
the family member. If your child is under age 18 and works for you, Social Security (FICA)
does not have to be paid.
Obsolete Inventory Deductions. Review the rules for deducting obsolete
inventory. Goods that cannot be sold at normal prices or in the usual way because of
damage or changes of style may be valued for deduction purposes at bona fide selling
prices, less direct costs of disposition. Take necessary steps, such as disposing of
obsolete inventory, to realize expected losses.
Donating Overstocks to Charity. Excess overstock, if donated to a qualified
charity, can earn your company a federal tax deduction.
Bad Debt Write-Offs. If your business uses the accrual method of accounting,
review all outstanding business debts to determine which are uncollectible. If you have
outstanding receivables with no chance of collection, write them off in the year they
become partially or totally worthless.
The Most Advantageous Accounting Method. One aspect of tax planning you should
not overlook is choosing the right accounting method. Generally, taxpayers may choose
between the cash and accrual methods of accounting for reporting income and deductions.
All taxpayers generally are required to use the accrual method if inventory is a material
income producing factor. Therefore, you should seek the advice of your CPA to determine
which method is best (or required) for your business, and if you currently are using an
impermissible one, how to minimize the tax cost of changing methods.
Acceleration of Deductions and Deferral of Income. If you use the cash method of
accounting, you may be able to defer recognizing income and prepay some expenses to reduce
your current year's tax bill. If you are an accrual-basis taxpayer however, you generally
must report income in the year when the right to the income is secured, whether or not it
has actually been received. Likewise, as an accrual-basis taxpayer, you generally will not
be able to prepay your expenses. Regardless of what method you use, your CPA can help you
make the most of the opportunities that are available.
Estimated Tax Payments. If you anticipate that your business will owe $500
($1,000 for tax years beginning after 12/31/97) or more in income taxes for the year, you
must pay your estimated tax bill in quarterly installments. Corporate taxpayers with
annual taxable income of $1 million or less may avoid stiff underpayment penalties by
making quarterly estimated tax payments of at least 100 percent of the prior year's tax
(provided there was tax owed, and it was a full tax year). However, if your company's
taxable income was at least $1 million in any of the last three years and you made
estimated tax payments that totaled less than your actual current year's taxes, you cannot
avoid the underpayment penalty.
Penalty Avoidance. Making a mistake in calculating your taxes can be quite
costly. The IRS may assess a 20-percent penalty on negligent underpayment, in addition to
any taxes that are owed, if you fail to follow the tax rules.
PLANNING AHEAD:
CHANGES MADE BY THE 1997 TAXPAYER RELIEF ACT
Home Office Deduction. The new law makes it easier for taxpayers to take the
home office deduction, by expanding the definition of "principal place of
business" to include a home office that is used by a taxpayer to conduct
administrative or management activities of a business, as long as there is no other fixed
location where the taxpayer conducts substantial administrative or management activities
for that business. The new definition helps those self-employed persons who manage a
business from their homes, but also provide a service or meet clients at another location.
Remember, however, that the office is deductible only if it is used exclusively,
on a regular basis, as a place of business. Taxpayers won't benefit from this new
definition until 1999, since it is effective for tax years beginning after December 31,
1998.
Health Deduction for Self-Employed. For those who are self-employed and must pay
their own health insurance, the new tax law brought welcome news by allowing the cost of
health insurance to be 100% deductible. The deduction will be phased in over the next ten
years. In 1997, the deduction is 40%, and in 1998 and 1999, it will increase to 45%. The
deduction will increase every few years until 2007 when it will be 100%.
EFTPS. Businesses with more than $50,000 in employment tax deposits are required
to enroll in the Electronic Federal Tax Payment System (EFTPS). Originally, taxpayers had
to begin making electronic deposits by July 1, 1997, or face a 10% penalty. The IRS then
delayed the imposition of penalties for failing to make payments electronically through
December 31, 1997. The new tax law further delays the penalty date through June 30, 1998.
The IRS sent notices to all businesses required to use EFTPS, but if you did not receive a
notice, don't assume it doesn't apply to your business. Check to see if it does. If you
think the EFTPS program may apply to you, don't wait until the last minute to enroll.
AMT. Under prior law, all corporations except S corporations, could be subject
to the alternative minimum tax (AMT). The new law repeals, for tax years beginning after
1997, the AMT for small business corporations, i.e., those with average gross receipts of
less than $5 million for the three-year period beginning January 1, 1995.
New Estate Tax Exemption For Family Businesses. Previously, there was no
exemption for family-run businesses; only the $600,000 individual unified credit exemption
was available. Under the new tax law, when more than 50% of the estate is comprised of a
family-owned business and/or farm, the amount exempt from estate taxes will be $1.3
million (inclusive of the unified credit exemption), effective next year; there is no
phasing in of this exemption.
General Business Credit Modified. The general business credit combines a variety
of business credits, such as the employer Social Security credit and investment tax credit
to determine each credit's allowance limits and determine the carrybacks and carryforwards
into past and future years. The new law reduces the carryback period for the general
business credit from 3 years to 1 year and extends the carryforward period from 15 years
to 20 years. The provision is effective for credits arising in tax years beginning after
December 31, 1997.
Net Operating Loss Rules Modified. The new law places greater restrictions on
deducting business losses. Under the new law, the net operating loss (NOL) carryback
period has been reduced from 3 years to 2 years, and the NOL carryforward period has been
extended from 15 to 20 years.
Financial Advice. Even for the smallest of businesses, tax rules can be complex
and compliance difficult. CPAs—as highly qualified business and financial
advisers—can provide the expertise you need to minimize your taxes and maximize your
profits.
