The impact of our tax laws affects the life of a small businesses through three distinct phases — the formation, operation and disposition of your company. Throughout the life of your business, your overall objectives should be:
- Minimizing your income tax obligations while building a profitable business;
- Maintaining accurate financial and tax records as a defense against potential tax audits
- Selling or transferring your business in a tax-advantaged manner; and
- Reducing the value of your business for estate tax purposes.
BUSINESS FORMATION: — the foundation for your business. Consult with a Certified Public Accountant (“CPA”) who is familiar with your industry to set-up your accounting and budgeting procedures and to alert you to potential “red-flags” in your industry that could attract a tax audit. Until you are comfortable with the tax issues, have your CPA prepare your tax return.
If one or more owners will be passive investors, then a partnership or limited liability company (“LLC”) should be considered. These entities provide the opportunity to make “special allocations” of income and expenses among the owners. For instance, if A and B go into business with A providing the “sweat equity” and B providing $100,000 in cash, the agreement might read that until B receives his entire investment of $100,000, profits will be split A: 20% and B 80%. Thereafter, profits will be split 50/50.
Note: A “S” corporation cannot have special allocations — all income and expenses are reported in proportion to the stock ownership.
In most cases, you should operate your business either as an “S” corporation or as an LLC. LLC’s offer the flexibility of special allocations, however, in some states, an “S” corporation may receive more favorable state income tax treatment. For federal tax purposes, an LLC and “S” corporation are not taxed; the owners are taxed directly on the income. Also, some states might require that an LLC have at least two owners, so if you are a single owner, an S corporation might be the only entity available under your state law.
A small business should not normally operate as a regular “C” corporation (a separate taxpaying entity) because of the ever-present threat of a double-tax on business profits distributed to the owners (one tax paid at the corporate level and another paid by the owners as dividends). Operating as a “C” corporation is dangerous because IRS likes to audit them.
BUSINESS OPERATIONS: — Know the “red flag” issues in your industry. For example, for restaurants the red flags include employee tip reporting, cash payments for meals and take-out meals, and juke box revenues. For bars, tax authorities may reconstruct gross sales by the number of bottles poured.
Businesses that rely heavily on independent contractors can expect efforts by state and federal tax agencies to reclassify these workers as employees, which, if successful, could impose personal liability on the owners for back taxes, interest and penalties. Spouses and children on the payroll are other red flags.
To minimize your taxes, you need to maintain good records of your expenses, especially those that could have a mixed business and personal use — computers and telephones, automobiles, meals, travel and entertainment, and offices in the home. On audit, these issues are usually won or lost on audit by the quality of the records maintained. For instance, if you use your car for businesses and keep a diary regarding your business trips, your diary will serve as sufficient evidence as to the business purpose. On the other hand, if you don’t have records, potentially none of your business expense will be allowed.
TIP: Use one credit card for business expenses only and another for personal expenses. Also, you should have a separate business checking account. When your credit card statement comes, note which expenses constitute meals and entertainment and list the person entertained, his or her company and position, and the matter discussed. I suggest placing a number next to the item on the credit card statement, and then writing either on the statement on a separate paper which is stapled to the statement, an entry as follows, “Dinner, Jane Jones, VP with Acme Supplies re: Johnson bid.” Another approach would be to place this information on the your credit card receipt at the time of the meeting. TIP: Purchase an expandable file divided by monthly sections and place all your receipts and statements in the proper month.
The Costliest Small Business Mistake — The failure to pay the government its share of employment taxes. This not only can destroy your business, it could ruin your life!
Businesses hard-pressed to make payroll or facing a financial crises invariably fail to pay to the IRS the employees’ portion of taxes withheld. Beware: You hold those funds in trust for the federal government and the IRS will shut you down if you fail repeatedly to pay these taxes (this is called pyramiding taxes). Worse, the IRS will hold your personally responsible for this failure, even if you are operating as an LLC or corporation. And because these taxes are held in trust, you cannot discharge your tax liability in bankruptcy!
The same issues arises in the “C” corporation context when distributions to shareholder/employees treated as loans, rather than as wages. Often, start-up companies which strapped for cash will provide advances to shareholder/employees, rather than pay wages – a strategy that can be suicide if the IRS catches you. The company could be shut down and the officers of the corporation will become personally responsible for all the taxes on those “wages” that have not been paid.
EXIT STRATEGY: — The time to consider your exit strategy is when you are forming the business. Do you plan to sell within 5-10 years and if so, who is the likely buyer, a privately-held company, your employees, a public company? Will your business build value in its assets such that a buyer will pay a premium for your company, or are there no assets outside of your personal services (doctors, lawyers, accountants, entertainers, programmers)? Do you want to transfer your business to your children or family members (and just as important, do they want it)?
Usually you want to minimize taxes and run so-called personal expenses (to the extent possible) through your business. The one except to this general rule is if you are considering a sale to a public company or an initial public offering (“IPO”) of stock. In this case, you want to show as much income (and unfortunately pay tax on it) and you want a large accounting firm to provide you with audited financial statements. Large corporations and venture capitalists are interested in earnings and solid financial statements. By doing these at the inception of your business, it will become much more valuable in the long-run.
If you are selling to a non-public company, then make sure you understand the tax consequences of the sale. You want long-term capital gains on the transaction, but the purchaser will want to deduct as much of the purchase as possible. Watch out for payments designated as covenants not to compete or for consulting agreements – both are taxed to you as ordinary income, not capital gains.
TIP: A consulting agreement could be advantageous to you under certain circumstances: A short-term consulting agreement permits the buyer to deduct consulting fees upon payment, with the seller declaring the payments as ordinary income. A consulting agreement could have advantages to the seller, because he is now in the consulting business. He can maintain a Keogh retirement plan, and is permitted ordinary and necessary business expenses, including a home-office deduction.
TIP: Splitting Ownership Among Family Members: In almost every instance, if your company will grow in value, you should transfer part of the ownership to your children right at the beginning, before the business becomes valuable. Use the annual gift tax exclusion of $10,000 per beneficiary per year in cash or property (married couples may transfer $20,000 per year per beneficiary) to transfer interests to your family members.
For instance, if you have two children, consider transferring to them 10-20% each at the time of formation. If your children are underage you can hold their interests as a guardian under the Uniform Gifts to Minors Act.
TIP: Have your CPA or attorney explain how the “minority discount” technique will allow you to gift a much larger percentage of business than the equivalent amount of cash For example, assume your business is worth $200,000 and you and your spouse gift a 10% interest to your daughter. If the gift is subject to a 30% minority discount, the interest is not valued at $20,000 ($200,000 x 10% — the pro-rata amount of the total value), but is worth only $14,000. Thus, a 14.25% interest initially worth $28,500 but then discounted by 30%, receives a value of $19,950, which is under the $20,000 annual gift tax limit.
In addition, there could be valuable tax savings when your children reach age 14 and for estate planning purposes, the portion owned by your children is not considered part of your estate. Also, children on the payroll are taxed at their tax rates (usually 15%) regardless of age. Also, if the child earns at least $2,000, he or she is now eligible for a Roth IRA. Starting a Roth IRA at such an early age can be tremendous advantage for a child since the investment will grow tax-free and the earnings may be withdrawn tax-free at age 59 1/2.
Note: $10,000 may be withdrawn for a first-time home purchase regardless of age.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**