Choosing the Best Business Entity for Tax Advantages

School: Southern New Hampshire University - Course: TAX 650 - Subject: Accounting

FINAL PROJECT TAX 655 increase his business expenditures, especially if he has to hire a bookkeeper or accountant to prepare the business' financial statements or prepare tax returns. Additional costs are likely given that S corporations are more complex than sole proprietorships or limited liability companies. Accurate records must be maintained, which include: registers of fixed assets, depreciation schedules, share issuances, financial statements, payroll records, expense reports, etc. Although a sole proprietorship may be able to maintain these records using less-sophisticated software, such as Microsoft Excel, an S corporation may find that a more robust accounting software is necessary to fulfill the documentation requirements, streamline preparation of financial statements, and also facilitate the process of preparing the company's tax returns. Limited Liability Protections Owners of S corporations enjoy limited liability protections in that they do not personally bear the obligations of the company's liabilities. As an example, if an S corporation defaults on its debts to a supplier or vendor, the assets of an S corporation's owners are not at risk of being liquidated in order to satisfy the obligation. However, this type of liability protection does not apply to criminal activity, intentional negligence, or any type of willful abandonment of an agent's fiduciary duties (Bowman, 2013). Other business entities that enjoy limited liability protection include LLCs, S corporations, and C corporations. Although owners' assets may be protected, an adequate level of corporate governance is paramount to ensuring that shareholder (principal) wealth is not unnecessarily jeopardized by risky decisions or agent misconduct. Tax Effects One of the most apparent advantages an S corporation enjoys is tax treatment of the corporation's net income. This net income is not treated as self-employment earnings, thus 3 avoiding self-employment tax. However, when making the decision on how to compensate the owners and shareholders of an S corporation, there are some important factors to consider. One of the most critical considerations is the reasonableness of compensation relative to the work or services performed. Documentation is essential in that compensation structures, bonuses, fringe benefits, etc. are spelled out in a logical and defensible manner. According IRS FS-2008-25, other factors that must be considered include analyses of what comparable businesses pay their officers (2008). Assuming the annual salaries of $180,000 and $70,000 for Bob and his daughter, respectively, are considered reasonable, the tax effect would essentially be determined by their personal income tax brackets. Using the 2015 personal exemption and standard deductions amount for single filers of $4,000 and $6,300; the tax liabilities for Bob and his daughter would be calculated as $37,951 for Bob and $9,248 for his daughter. The total tax liability incurred by both Bob and his daughter would be $47,199. However, in paying these cash salaries, the business must pay employment taxes. If the owners of an S corporation elect to pay dividends in lieu of salaries, they must do cautiously. Attorneys and financial planners warn against circumventing employment taxes in this manner so as not to trigger an IRS investigation (Fishman, 2016). Although distributing the $180,000 and $70,000 as dividends would result in a significant lower tax liability in aggregate; the "hidden costs" of doing so would certainly materialize in the form of penalties, fees paid to professionals to defend the audit, lost time, and other negative or otherwise unquantifiable consequences. Ownership Interest As an S corporation, ownership interest would take the form of the percentage of corporate shares held by each shareholder. In Bob's case, this figure may easily be inferred, since4 he IRS restricts S corporations to one class of stock (IRS, 2016). Assuming Bob and his daughter are the only two shareholders, and assuming they take their entire salaries as dividends (not recommended) and back-into their shares owned, the "ownership interest" for Bob and his daughter would be 72% and 28%, respective. Again, distributing the entire amount of the proposes salary as dividends is not suggested unless there exists a clear breakdown on the company's compensation structure. Even so, this action may still be ill-advised as it may increase the corporation's propensity to be subjected to an IRS audit. Taxes and Strategic Estate Planning Estate planning refers to advanced guidelines or directions regarding the distribution of a deceased person's property and assets. For many individuals, this can be accomplished by creating a legal document called a will or testament. However, for high-wealth individuals, such as business owners, capitalists, or real property owners, a simple will may not be a sufficient means of strategic planning when factoring certain tax implications the beneficiaries may have to contend with. According to the American Bar Association, 55% of Americans die without a will or estate plan. The ABA also recommends that individuals seek out guidance from professionals primarily due the complex nature of tax treatment of estates (American Bar Association [ABA], 2016). Proper planning of estates can produce tax savings from inheritors, which is especially important during times of mourning. Emotional family members may not be in a rational state of mind. A well-written and legally sound document may help the survivors of the deceased cope with the recent loss while ensuring that property and assets are distributed in a manner that incurs the lowest tax burden. Additionally, proper planning can certainly mitigate interference by creditors and other external parties who may attempt a claim against the deceased's property and