YOU may choose to do business as a corporation. A corporation is a legal fiction. It exists only in contemplation of law. It has a separate legal identity. That entity, not you, operates the business. It owns the business assets, owes business debts, collects business revenues, and pays business expenses. It possesses characteristics such as continuity of life, centralized management, free transferability of ownership, and that limited liability that we all look for in our business dealings.
There are two basic types of corporation:
1. C corporations (regular corporations).
2. S corporations (corporations that elect to be taxed as “S’ corporations).
The “C” and “S” refer to code sections of the Internal Revenue Code that govern taxation in the U.S.
Let’s enumerate the benefits and drawbacks of regular C corporations in this article.
A. Benefits:
1. Limited liability – business problems can be kept in the corporation without exposing personal assets; likewise, personal problems do not have to put the business in jeopardy.
2. Limited liability – is enjoyed since it is a corporation, a separate entity.
3. It has a lower audit profile than sole proprietors.
4. Income splitting – between family members is possible as spouse and children can work for and get paid by the corporation.
5. Passive activity losses – can be deducted in full. Closely held C corporations may offset passive losses and credits against active business income (but not portfolio income).
6. Exclusion of capital gain – by investors who hold qualified business stock for five years are able to exclude 50% of gain from sale of stock.
7. Dividend received exclusion – of 80% from another domestic corporation.
8. Multiple corporations – can be used, subject to some limitations.
9. Election of fiscal year – can choose fiscal year ends from January to November.
10. Trust Fund – Discuss with your tax adviser how you can save on the employer’s portion of problematic delinquent payroll taxes.
B. Drawbacks:
1. Double taxation – Corporations pays tax on net income. Shareholders pay tax again later upon receipt of dividends. New law reduces this disadvantage by taxing dividends at a very low rate of 15%. Traditional tax planning ideas of “zeroing out” bottom lines should be re-examined to consider leaving net income that can be distributed later as dividends. Along the same lines, S corporations with accumulated earnings and profits from prior years of operating as regular C corporations should consider declaring and distributing dividends at the low rate of 15%.
2. Constructive dividends – can be asserted for personal use of assets in an IRS audit.
3. Accumulated earnings tax – 20% (15% through the year 2012) can be assessed on accumulated earnings in excess of reasonable needs. This is in addition to regular income tax.
4. Personal holding company tax – 20% (15% through the year 2012) applies to undistributed personal holding company income in addition to the regular income tax.
5. Alternative minimum tax – 20% applies to taxpayers who would otherwise escape taxation.
6. Accrual method of accounting – is generally required. The cash basis, of course, is easier to operate, as one does not have to account for receivables, payables and inventory.
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Victor Santos Sy graduated Cum Laude from UE with a BBA and from Indiana State University with an MBA. Vic worked with SyCip, Gorres, Velayo (SGV – Andersen Consulting) and Ernst & Young before establishing Sy Accountancy Corporation in Pasadena, California.
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He has 50 years of experience in defending taxpayers audited by the IRS, FTB, EDD, BOE and other governmental agencies. He is publishing a book on his expertise – “HOW TO AVOID OR SURVIVE IRS AUDITS.” Our readers may inquire about the book or email tax questions at [email protected].