To be successful and hold the line financially, tax experts agree that even the smallest of businesses may benefit by incorporating.
- Owners of a Limited Liability Company (LLC) can have limited personal liability for the debts and actions of the company.
- If the LLC is taxed as a partnership, the income from Schedule K-1 is shown on Schedule E and may or may not be subject to self-employment taxes.
- An LLC taxed as a partnership is not required to pay taxes on property it distributes to its partners.
- Incorporating as a C corporation allows a company to carry losses forward, enabling it to lower the taxes for each year over which the losses are spread.
Unincorporated businesses may be missing out on tax breaks
In the eyes of many small business owners, the corporate world is the realm of massive conglomerates such as Microsoft and General Motors. To be successful and hold the line financially, however, tax experts agree that even the smallest of businesses may benefit by incorporating.
An S corporation, as defined by the Internal Revenue Service, is a domestic corporation that elects to pass income, losses, deductions, and credits through to their shareholders for federal tax purposes. The corporation also is limited to no more than 100 "allowable shareholders"—including individuals, certain trusts and estates. It may not include partnerships, other corporations or non-resident alien shareholders. It may offer only one class of stock. S corporation rules require the shareholder employees are paid wages on a Form W-2 and the corporation is liable for payroll taxes.
C corporations, also known as general corporations, have no restrictions on the number of shareholders. The website Active Filings explains that corporations identified with large public stock offerings typically are C corporations. It notes that each shareholder's personal liability is normally defined by the amount of their investment in the corporation.
"A Limited Liability Company (LLC)," the IRS website explains, "is a business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are typically more like a partnership, providing management flexibility and the benefit of pass-through taxation." An LLC can be classified as an S corporation or as a partnership for income tax purposes. If the LLC is taxed as a partnership, the income from Schedule K-1 is shown on Schedule E of a member's personal tax return and may or may not be subject to self-employment taxes. A general partner's or managing member's income from a partnership or LLC is typically subject to self-employment tax as is the income from any guaranteed payments made to members.
“New businesses are not usually aware that the self-employment tax is coming at the end of the year, so it can be a real shock,” says Richard Chapo, a San Diego tax attorney.
Sole proprietors typically use single-entry accounting, logging all of their spending or payments in a personal checkbook. Corporations, however, typically use double-entry accounting, which requires two ledgers—one for debits and one for credits. That, says Fran Coet, a certified financial planner in Westminster, Colorado, creates a system of checks and balances that can reduce mistakes.
The proof of that benefit is visible in statistics published in the 2010 IRS Data Book. In 2010, the IRS audited only 0.4 percent of S corporations, but it audited 8.0 percent of individual business owners who made more than $100,000. That might suggest that the safeguards afforded by double-entry accounting ultimately yield tax filings with significantly fewer errors or red flags signaling the need for review.
The IRS does not require partnerships, S corporations and C corporations with gross receipts of less than $250,000 and assets less than $250,000 to show a balance sheet on their returns. However, even if corporations are not required to use double-entry accounting, Coet strongly advises they do so. Not using it poses risks: “There is no reconciliation of the disbursements and receipts," Coet said. "And that is a very dangerous approach if you want to comply with the requirement that a taxpayer file a complete, accurate and true tax return.”
Spreading the losses
Incorporating as a C corporation can allow a company to carry losses forward, enabling it to lower the taxes for each year over which the losses are spread.
For example, if a company lost $60,000 in 2023 it could likely choose to carry that loss forward, typically for up to seven years. If it then makes $100,000 in 2024, it can apply a portion of those losses to its income, lowering its taxable income, said Richard Chapo, a tax attorney in San Diego.
Unlike a sole proprietor, the owner of an incorporated business may take a reasonable portion of the earnings as a salary subject to employment taxes. The rest of the earnings are typically not subject to self-employment taxes
Disadvantages of incorporating
Moving from limited liability company to C corporation carries some disadvantages.
"For federal income tax purposes," the IRS explains on its website, "a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders."
Kell Riess, an adjunct business professor at Tulane University, noted that a corporation’s profits are taxed by state and federal governments, and shareholder distributions are typically taxed on the individual's tax return.
This leads to double taxation of the profits of C corporations when they distribute property out of the company, Riess said.
A multi-member LLC, by contrast, is most often taxed as a partnership, and only the partners pay federal taxes.
Assume, for example, that a C corporation owns a car for which it originally paid $25,000. Over a period of a few years the value of the car has depreciated by $22,000 to $3,000, but it carries a fair-market value of $7,000. If the C corporation distributes the car to a shareholder, the corporation will pay 39.5 percent to 40 percent in taxes on $4,000—the difference between the assessed value and the fair market value. The shareholder must also pay taxes on the fair market value of the vehicle.
An LLC, however, is not required to pay taxes on property it distributes to its partners, so you may more easily distribute property, Riess said. C corporations also have additional filing requirements if they are public corporations, which can be extensive and time consuming.
C corporations, S corporations and LLCs all have to hold regular shareholder meetings and keep good records of the meetings.
Being unincorporated can leave a business open to greater tax liability, especially when it comes to self-employment tax, according to Chapo. “New businesses are not usually aware that the self-employment tax is coming at the end of the year, so it can be a real shock,” Chapo said.
The sole proprietor of a business typically must pay self-employment taxes—Social Security and Medicare taxes—as well as federal and state income taxes on all earnings. If the owner incorporates the business, however, they may take a reasonable portion of the earnings as a salary subject to employment taxes, and the rest of the earning are typically not subject to self-employment taxes.
Small business owners who are not incorporated can face an uphill battle when it comes to taking loans out from banks, said Fran Coet, a certified financial planner in Westminster, Colorado.
“If you’re just a sole proprietor, Joe the plumber, and you have a truck and it’s just you, what do the banks have to look at?” Coet asked.
Businesses that have set up corporations, however, often present a far superior financial picture to lending institutions.
“You’ve got accounting and financial statements instead of a bucket of receipts in the back of a pick-up truck," Coet said. "And a lot of people operate that way because being a sole proprietor allows them to do that. There are few or no checks or balances.”
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