• Corporate Payment of Shareholder Expenses
• Hire your kids, cut your taxes
• Don't be fooled
• Implication of tax law
• Setting up your business?
• Smorgasbord of Benefits
• Tax planning
• Tax traps
• Travel expenses
• True impact of tax cut

SETTING UP YOUR BUSINESS...THE TAX ANGLES

It is a good idea to consider your FORM of business operations. Whether it should be incorporated or not ... from the tax angles. Especially in view of the ever-changing tax and benefits laws.

This section outlines the key points that you should weigh. The advantages that incorporation of a company often will bring. Plus some pitfalls that exist and can be avoided with care.

Small firms often shy from corporate form because of double tax on earnings ... once to corporation and again as dividends to stockholders. This may be a bigger bugaboo than warranted depends on your situation: How much income you earn from your business, how much from other sources. Type of income involved. Your tax bracket, and those of your co-owners.

The tax rates on corporations and individuals are different. For corporations, the top rate is 35% on income over ten million. Below that ... 15% on the first $50,000 of income and 25% between $50,000 and $75,000. And a 34% rate on income between $75,000 and ten million.

As corporate income exceeds $100,000, an additional tax soaks up what the lower rates save. Tax on the first $200,000 of income ... $61,250. Lower rates aren't available for personal service corporations in: Accounting, Actuarial Science, Architecture, Consulting, Engineering, Health, Law and Performing Arts. They pay a flat 35% on all their income.

For individuals with $200,000 of regular income after deductions, singles will pay about $60,000 in tax and married couple approximately $56,000. Nowadays, personal tax brackets are automatically adjusted for inflation.

These tax levels may make it less attractive to form a business as a regular corporation, rather than as a partnership, S corporation or a new kind of hybrid known as a "limited liability company" or LLC.

Accumulated earnings tax scares some away from the corporate form. IRS imposes a penalty of 39.6% on earnings left in a corporation if more than needed. First $250,000 of retention’s is usually exempt from penalty. (Lid is only $150,000 for personal service corporations mentioned before.) Penalty is in addition to the regular corporate income tax of up to 35%.

The penalty will not be applied to corporations that can prove they need the retained income for expansion, replacing aging assets, etc. Best way to do this is with bona fide plans. A vague intent won't do.

Partnerships and sole proprietorships are the main alternatives to incorporating. In these, owners are taxed on income of the business, even when they leave funds there for expansion or other needs of the firm.

Partners can deduct business losses on their personal tax returns. Normally, shareholders cannot do that. Gives an advantage to new ventures that have not fully established themselves and are operating in the red... allows active owners to use firms' losses to offset their other income.

Amount of loss that they can deduct is limited by amount invested in the firm, their share of the firm's debts ... and, for inactive owners, their net income from other limited business interests that they have.

Partnership income is taxed to owners in each partner's tax year in which the firm's year ends. Partnerships can operate on a fiscal year. But most that do must keep a revolving fund on deposit with the Service ... amount fluctuates with profitability and when the firm's fiscal year ends.

Corporate profits aren't taxed to shareowners until paid to them. However, unlike partnerships, corporations are taxed on their own income. Corporations can have fiscal years too. But personal service corporations must make minimum pay outs to owners in order to deduct accrued salaries.

Special types of income get "passed through" to the partners. For example, a partnership's capital gain or loss is taxed to the partners as gain or loss. Tax-exempt interest stays exempt.

The rule is different for corporations. The type of income earned doesn't matter ... capital gains and tax-exempt interest are mixed together and taxed as dividends (ordinary income) when company pays out earnings.

Tax credits also are taken by partners, not by the shareholders.

Dividends received by corporations get favored tax treatment ... 70% of pay outs from U.S. firms is tax free to payees owning less than 20% of payer. This makes the top tax on dividends paid to corporations 11.7%. However, there are limits on how much income firms can have from interest, dividends, etc., before IRS slaps on a 39.6% personal holding company tax.

Proprietors and partners cannot exclude any taxable dividends.

Capital gains treatment of corporations and unincorporated firms also differ... and for some that might mean a non-corporate form is better.

Tax rates on Unincorporated firms are the same as for individuals. Thus, the tax burden on a net long-term capital gain generally is 20%.

Corporations usually pay a flat rate of 35% on their net gains. However, corporations earning less than $75,000 pay 15% or 25% on gains. But capital gains paid to stockholders normally are taxed as dividends.

If your business has lots of income or gobs of fast write-offs ' you may have to consider the minimum tax in your decision to incorporate.

Individuals, corporations pay minimum tax if MORE than normal tax. To figure the minimum tax, you add some exclusions, deductions to income.

Tax rates differ. Individuals, 26% and 28%. Corporations, 20%.

Also deductions, exclusions, credits figure in the minimum tax.

Adjusted earnings is the key item of the corporate minimum tax... you increase corporate alternative minimum taxable income (AMTI) by 75% of the excess of earnings and profits (with some adjustments) over AMT.

Small normally won't face an AMT for 1999 ... if their average gross for all three-year periods from 1994 through 1998 is less than $7.5 million.

Individuals lose some itemized deductions when figuring the AMT ...state & local taxes, non-mortgage interest, miscellaneous write-offs, etc.

Some corporations also must shave a few deductions ... trim by 20%: Mining exploration and development costs. Pollution control facilities. Bad debt reserves, interest deductions tied to tax exempts ...banks, etc.

Corporations can reduce their taxable profits via salaries. Could eat up all the profits as long as salary payments are not so high that IRS concludes they are unreasonable and slashes company's deduction.

But look at the owners' tax brackets too, before paying them more, especially if owners do not need the income and the firm can use the cash. At upper levels, IRS may be getting about the same whatever you decide.

Partnerships have more leeway on some expenses than corporations. A partner who puts up assets can take the depreciation if partners agree. Traveling partner can claim travel costs. Ditto for an overseas partner.

On other expenses, corporations have advantages. They can deduct reasonable pay to owners who are employees, even if it gives firm a loss.

A big tax advantage for corporations has been on fringe benefits. But Congress has trimmed that advantage in recent years. And we believe that the trend probably will be accelerating over the next decade or two.

There still are differences that may justify your incorporating.

Group-term life insurance is not available for a sole proprietor or a partner. But corporate plans are OK, with limits for key employees.

Medical Coverage: Corporations can fully deduct medical expenses, including insurance, for owner-employees. But self-employed can deduct only 60% of their health insurance in 1999 ... increases to 100% by ‘03. Now 100% if spouse is an employee and firm covers spouses of employees. Self-employed also can deduct balance if they itemize medical expenses.

Social security taxes are about even. Self-employed now pay the same total rate levied on employers and employees. But self-employed get a deduction for half their SECA tax in calculating their INCOME tax. They also can deduct 7.65% of their net earnings when figuring SECA tax. If there's a loss, corporations pay FICA... self-employed do not pay SECA.

And proprietors don't pay FICA or FUTA on their children under 18. But corporations employing owners' children do pay FICA and FUTA on them.

There's a compromise among corporations and unincorporated firms.

The S Corporation ...named for part of tax law where its rules are. Ss are especially appealing if corporation has losses that owners can use on their own returns ... very common in early years of a firm's existence.

It's a corporation in reality, but pays no corporate income tax. Income or loss is taxed to owners as though they were partners. However, losses are deductible only up to amount invested in the company, which includes stock and loans made to the firm. And, like partnerships, S firm losses exceeding owner's investment can be used in later years ... equal to the amount of additional capital, including loans, from owners. Also, only active owners can use losses to offset salary, dividends, etc.

These aspects of S corporations should be borne in mind too:

Can have no more than 75 shareowners ... a husband & wife owning stock count as one owner, even when owned separately. S status lasts until revoked by majority of owners. Limited to one class of stock ... but voting rights can vary. Pension & profit sharing rules are same as other corporations. No accumulated earnings tax. Salaries should be paid to owner-employees as a precaution should S status be lost ... deduction reduces corporate tax. Firm may have to maintain a deposit with IRS if a fiscal tax year is used.

IRS can slap social security tax on salary disguised as dividends.

Corporations with retained earnings that become an S pay a 35% tax to the extent more than 25% of income is from dividends, interest, etc. And pay a tax on appreciated assets sold during first decade as an S firm.

S status offers many advantages, but IRS is quick to spot errors that let it void S status and slap a corporate income tax on the business.

Limited liability companies are another hybrid. They are taxed like partnerships, but without the complex rules that face S corporations. All owners have limited liability. Now permitted in all fifty states.

Family partnerships and family S corporations have a special rule.

IRS won't bar their use to shift income to kids, etc., in lower brackets, unless salaries of shareowners who do the work in the company are too low.

Related companies have a couple of pitfalls to keep in mind: Corporations under common control don't get to use the lower rates on the first $75,000 of income EACH earns. Split them on combined income.

Rules are complicated and should be checked whenever 80% of a corporation is owned by fewer than six people, some of whom own stock in other small. And ANY companies with common control are subject to reallocations of income and expense if IRS doesn't like their way of apportioning them.

Owners of corporations that go bust have a special tax break...

"Section 1244 stock." Lets owner deduct up to $100,000 from other income.

Otherwise, is a capital loss. Does not affect profit if company succeeds.

There also are NON-tax sides to the form of a business: Owners' liability. Licensing. Usury laws. Managerial convenience, etc. Sometimes these dictate the choice, regardless of taxes. Ask your lawyer.

Small businesses often start unincorporated, then incorporate as they become established and successful. This can be a tricky move, for the switch can be tax free or taxable, depending on how it is handled. A tax-free move requires each owner of an unincorporated business to use same cost for company shares that owner had for assets turned over. A taxable move may be better in some cases ... when firm's property has appreciated in value. The owners then will sell it to a corporation and pay tax on their gain, with the firm's depreciation based on its cost.

• Unincorporated owners may have to pay tax on past deductions or credits.
• Or you can unincorporate ... and arrange to pay a tax or not.
• Or split your business ... to aid in management of the enterprise.
• Or change the ownership arrangement ... for estate planning reasons.

Smart business owners review their form of business every so often as a check on themselves to be sure that they're not overlooking anything.

Given the frequency of tax changes, such reviews are necessary.

• The ‘74 pension law altered some corporate – non-corporate criteria.
• The ‘76 tax reform law tightened many of the partnership rules.
• The ‘78 tax revision made scads of tax changes for businesses.
• The ’81 tax law cut the top personal rate to 50%. Had been 70%.
• In ‘83, a slew of easing for S corporations went into effect.
• In ‘84, a series of changes altered many ways of taxing business.
• In ‘86, major tax reforms and hefty tax rate reductions scrambled the tax principles that had long guided choices on the form of business.
• In ‘87, ‘88 and ‘89, still more changes in business tax rules.
• In ‘90, Congress raised the top marginal tax rate on individuals.
• In '93, it raised both individual and corporate tax rates.
• In ‘96, Congress added medical savings accounts and SIMPLE
• And the '97 law softened the minimum tax and taxes on capital gain as well as eased the federal estate tax burden on family owned businesses.

Further tax changes will certainly be weighed in the future. Business is always a target for raising revenue ... it is easier to tax business than individuals. More than enough reason to stay abreast of what you must know for business planning, whatever form you operate in.