How to lower your tax burden
By Roman Basi I.t’s tax season. And that means that taxpayers and entrepreneurs want to pay as little money as possible to the federal government. Tax deductions, tax credits, and other means of reducing your tax burden are good all year round. But when was the last time you evaluated your entity’s tax structure?
While some small businesses are under a sole proprietorship (where income is listed on an individual’s Schedule C) or partnerships (where income is reported on a company’s Form 1065), others may prove more favorable to S- status. corporation or C corporation with the Internal Revenue Service in an effort to minimize their tax burden.
S corporations are entities that choose to pass corporate income, losses, deductions, and credits on to their shareholders for federal tax purposes. Shareholders of S corporations report the flow of income and losses on their personal tax returns and are taxed at their individual income tax rates. This allows S corporations to avoid double taxation on corporate income. S corporations are responsible for taxes on certain built-in profits and passive income at the entity level.
To qualify for S corporation status, the company must meet the following requirements:
- Be a domestic company
- Have only ‘permitted’ shareholders (this can be individuals, certain trusts and estates, but no partnerships, corporations or non-resident foreign shareholders)
- Do not have more than 100 shareholders
- Only have one class of shares
- Not being an ineligible company (i.e. certain financial institutions, insurance companies and domestic international sales companies)
- Submit a Form 2553 (election by a small business)
Structure of a C corp
C companies operate very differently. In forming a company, potential shareholders exchange money or property (or both) for the share capital of the company. A business generally takes the same deductions as a sole proprietorship to calculate its taxable income. A company can also record special deductions. For federal income tax purposes, a C corporation is recognized as a separate taxable entity. A company conducts business, realizes net income or loss, pays taxes, and distributes profits to shareholders. All C forces pay a fixed tax rate of 21% on the net company income.
A company’s profits are taxed to the company when it is earned, and then taxed to shareholders when they are paid as dividends. This creates a double burden. The company does not receive a tax deduction when it pays dividends to shareholders. Shareholders cannot deduct any loss from the business.
While the C corporate profits are taxed twice, the C corporate taxes are fixed at 21% since the 2017 Tax Deductions and Jobs Act was signed. Individual federal income tax rates can be as high as 37%. Another change with the 2017 tax law is that owners of pass-through entities such as S corporations may be able to deduct 20% of business income from their individual tax returns. Owners of C corporations don’t get that luxury. If a person’s personal tax rate is above 21% it may be worth considering converting to a C corporation.
If you are running a small business and have questions about tax structure, please contact The Center for Financial, Legal and Tax Planning at 618.997.3436.
Roman Basi is a lawyer and CPA at the firm of Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. He co-wrote the article with Deputy Attorney Michael Hampleman. For more information, please visit taxplanning.com.