For self-employed workers, the question of how to structure their small business has become a bit less perplexing with the advent of the new personal-income and small-business tax breaks.
Deciding whether to incorporate, and which business entity to choose, can be a challenge, because each entity comes with its own benefits and drawbacks. Now a slew of new tax breaks for individuals and small businesses has added another wrinkle to the process.
New lower income-tax rates will benefit many small-business owners, since most pay taxes on their profits as individual income. Thanks to the new tax law just passed, rates at higher income levels dropped by two percentage points, effective December 31, 2002. Also, small businesses will be allowed to expense as much as $100,000, up from $25,000, of new equipment annually, and receive a 50% bonus write-off for new equipment, up from 30% currently.
The Treasury Department has estimated that for 2003, some 23 million self-employed business people will receive tax cuts averaging $2,209, thanks to the package.
The tax breaks may not have a drastic impact on whether more small businesses choose to incorporate or not. Still, many in the tax community say the breaks provide even more incentive for small-business owners to forget about electing to incorporate as C corporations. Here's a look at some of the implications and options.
First, a rough comparison. When you think of C corps., think big. GM, IBM, 3M big. Big taxes, big administrative costs, big targets for lawsuits. By comparison, business entities like sole proprietorships, S corps. and limited liability companies are designed for freelancers and mom and pop shops, as well as businesses not looking to raise capital in the public markets.
With C corps., business owners are protected from personal liability for debts and court judgments, and owners don't pay tax on corporate profits, the corporation itself pays the taxes -- at a higher corporate rate. Owners pay personal income tax only on money they draw from the corporation in the form of salaries, bonuses and the like. C corps. and owners are double taxed on dividends that the company distributes, though the new tax law lowers the rate the individual pays.
Other legal business entities -- such as S corps., limited liability companies, and limited partnerships -- also provide a level of protection from personal liability, and earnings are passed on to the business owners and taxed at their individual rates.
While the trend away from C corps. for small-business owners has been ongoing for years, the new tax laws make that choice even more sensible.
The majority of self-employed business owners today are structured either as sole proprietors, partnerships, S corps. or LLCs, and the new lower income-tax rates make those legal structures more attractive, says Dennis Cohen, chair of the tax and tax litigation departments at law firm Cozen O'Connor. "With the new lower individual rates, some small business owners may pay less taxes," he says.
The corporate federal tax rates top out at 35%. Yet nearly 70% of small-business owners either paid a federal tax rate of 15% or didn't pay federal income taxes at all in 2001, according to labor-backed Washington, D.C., lobbying group Citizens for Tax Justice. The remainder for the most part are taxed at the highest personal income-tax rate, which will drop to 35% this year from 38.6% in 2002 for married couples filing jointly.
Note, however, that these individual tax rates don't account for other taxes self-employed business owners pay. In addition to federal taxes, sole proprietors and S corp. owners must pay self-employment taxes to the tune of 15.3% (self-employment taxes cover Medicare and Social Security taxes). Employees at corporations, on the other hand, get to split that cost -- the company pays half, and the employee pays half.
One investor benefit of the Bush tax package -- the much-ballyhooed dividend tax cut to 15% from 20% -- doesn't offer the same benefit for small-business owners. While C corps. can distribute dividends to principal owners, the owners must pay dividend taxes on the proceeds. But because dividends aren't tax deductible for corporations, the business also pays taxes on them.
So if you were thinking of side-stepping income-tax laws by incorporating as a C corp. -- and then paying all of your salary in dividends -- check yourself, says Paul Gada, small-business tax analyst with information provider CCH Inc. in Riverwoods, Ill. "The IRS rules are set up to try to prevent that kind of manipulation," he says.
Still, Joseph Anthony, an enrolled agent in Portland, Ore., says that the dividend tax break may make C corps. a more viable option for smaller investors if the Bush team succeeds in further reducing or eliminating the tax. (Enrolled agents are certified to negotiate with the IRS on the taxpayer's behalf.)
"Because of the double taxation, the new 15% rate on dividends and capital gains makes the C corp. a little more attractive than it used to be for smaller business, but it would be more so if they did away with dividend taxes altogether," he says.
Jeff Baddish, a partner with the accounting firm of Coltin, Baddish & Shapiro in Mineola, N.Y., notes that the dividend-tax cut may make C corps. more attractive in one surprising area -- tax audits.
"Most of the time when you have a dividend situation from a small business it arises from an audit -- the IRS finds some of your deductions aren't valid, the deduction is disallowed and the proceeds are distributed to the owner in the form of a dividend," he says. But thanks to the lower 15% dividend-tax rate, an IRS audit may not be as scary as for, say, an S corp., where earnings may be taxed at the higher personal income-tax rate, he says.
While in many ways the change in federal tax laws may make small-business entities even more attractive than C corps., whether you choose to incorporate should depend more on the nature of your business than on your income level, says Bob D. Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal written for tax professionals.
"If we form Terri's Technology Co. as a corporation, the only exit strategy is to sell or do an initial public offering, and if the seed money for the startup was coming from angel investors, all that would argue that you incorporate under a C corp.," he says. But if you're an interior decorator or working out of your home, you typically don't need to be encumbered by the additional paperwork, regulatory considerations, and liability issues involved in incorporating under a C corp.
Bottom line, while taxes are a chief concern for all small-business owners, they're not the only concern. It's important to weigh all your options, and your business's financial needs, before taking a leap into the corporate world.
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