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With Phil's advice that good advice from a tax pro should be a required part of starting up a business, here's some thoughts to help you prepare for that first meeting.

... my long term plan is a to amass extensive experience in the field of urban architecture ...

That will likely take time. You've heard the saying: good judgement comes from experience, and experience comes from bad judgement. IMHO, to "amass extensive experience" in any field is something like a 10 year project. So there's a lot of time to do your tax research. And more importantly, there's a lot of time for Congress to change the tax laws.


... corporations have this Retained Earnings account whose balance is computed during the closing of every accounting cycle and all cost of goods, returns, allowances, General/Sales and Administrative expenses are deducted from Revenue. After dividends are subtracted from the net gain or [loss] you get the RE balance and list that in the owner's equity section of the balance sheet.

Well - you're close. Retained Earnings at any point in time (in the simpler cases, anyway) is simply the total earnings of a firm since inception, less any dividends paid to the owners.

What is the difference between RE and Income for a fiscal year?

Retained Earnings (RE) at the end of a year is figured by taking the RE at the beginning of the year, adding in the net income for the year, and subtracting off the dividends paid during the year. It is pretty much exactly what it says: earnings that have been retained in the business instead of being paid out to the owners.

Does not a business need to pay income tax on both?

No. A business pays tax on it's income. After it pays it's taxes, the remaining income is added into RE.

Secondly, my cousin had advised me to form a S Corporation if I was doing business on my own for several reasons:

Could be a good idea - or perhaps not. Let's look at the reasons.

Limited Liability because a corporation is considered a separate legal entity, the shareholders have limited liability for the corporation's debts.

Correct - to a point. I believe that most states will let an architecture firm incorporate only as a professional corporation. Mainly, that means that the professionals can't use the corporation to protect themselves from liability for their professional conduct. If the architect does something (in their capacity as an architect) that harms a client, the architect remains personally liable for the damages.

Further, for any small business, no one will loan money to the corporation without the shareholders personally guaranteeing the loan. So the limited liability aspect of a corporation really doesn't exist for smaller businesses.

Corporate Tax Treatment. Since a corporation is a separate legal entity, it pays taxes separate and apart from its owners (at least in the typical C corporation).

Right. But your cousin suggested an S corporation, not a C corporation. With an S corp, the shareholders pay the tax on the corporation's income.

Owner/Employee. A business owner who works in his or her own business may become an employee and thus be eligible for reimbursement or deduction of many types of expenses, including health and life insurance.

Health insurance - yes, but only with a C corp. But it really doesn't matter now. Tax laws have changed and a sole proprietor can also deduct all of their medical insurance without itemizing deductions. S corp shareholders get the same treatment as sole proprietors - as long as they pay themselves a salary.

Life insurance is not deductible for the owners of a business.

Perpetual Existence. A corporation continues to exist until the shareholders decide to dissolve it or merge with another business.

Freely Transferable Shares. Shares of corporations are generally freely transferable because as a separate entity, the existence of a corporation is not dependent upon who the owners or investors are at any one time. A corporation continues to exist as a separate entity and is not terminated or dissolved even when shareholders dies or sell their shares.

Yep. But so what? With a professional corp, the corp is tied intimately to the professionals who own it. The shares can only be transferred to another professional.


But the drawbacks include:

Fees. It costs money to incorporate. There are typically four types of fees, including: a fee to file the articles of incorporation with the secretary of state; a first year franchise tax prepayment; fees for various governmental filings; and attorney fees.


Yes. I'd plan on about $2000. You can do much of the work yourself, and save on the legal fees, but remember the quality of the lawyer you're hiring when you do that.

Formalities. The proper corporate formalities of organizing and running a corporation must be followed in order to receive the benefits of being a corporation.

Yep. Annual meetings, and minutes, and notices and so on.

Paperwork. A huge aspect of the corporate formalities that must be followed consists of paperwork. Reports and tax returns must be compiled and filed in a timely fashion; business bank accounts and records must be maintained etc etc ...

Yes again. But most of that will need to be done no matter what legal form your business takes.

Tax Consequences. C corporations have potential double tax consequences-once when the company makes its profit, and a second time when dividends are paid to shareholders. S corporations can mitigate this tax issue if I am not mistaken.

Yes. But with a small business, the C corp probably isn't going to pay much tax anyway. The profits are typcially paid to the shareholder(s) as wages and deducted, leaving the C corp with little or no taxable income.

Where the S corp shines is in it's ability to limit your social security taxes.

I think the main difference between type S and C is the number of permissible shareholders, disclosure requirements, scope of liability, dissolution procedures & ability to issue different types of stocks.

Not quite. The differences between S and C corporations are entirely taxation differences. There is no difference between them for any other purposes.

So, yes to the number of shareholders (although I suspect that the 75 shareholder limit won't be a problem for you). Disclosures are the same. Liability and dissolution are the same. S Corps can have only one class of stock - so no preferred shares are allowed.

I was checking the IRS's website for Self employment taxes and it seems that with the current self-employment tax rate at 15.3 percent, many business owners choose to form an S corporation rather than an LLC.

An LLC is not a tax choice. LLC's are taxed as either a sole proprietor, a partnership, or a corporation. Single member LLCs are sole proprietors for tax purposes unless they elect to be taxed like a corporation. LLCs with more than one member are partnerships by default. They can also choose to be taxed like a corp. And if an LLC chooses to be taxed like a corporation, it can also elect to be taxed like an S corp.

The decision of LLC vs. S corp is a complicated one, with many things to consider. There are often differences at the state level that will have a big influence on your decision.

In an S corporation, only shareholders are required to pay self-employment taxes on money paid to them as compensation for services.

No. Money paid to the shareholder of an S corp for their services is wages, not self-employment income. So the corp must withhold FICA, and pay the employer's share of FICA. And the S corp will issue a W-2 to that shareholder.

Also, profits from an S corporation are not taxed.

Wrong again. Profits from an S corp are taxed on the shareholders' returns.

S Corps can beneficial in that:

1. If your corporation desires to retain earnings, S corporation status can be used to avoid penalty taxes that could be imposed on an unreasonable accumulation of earnings.


Yes. Although if a C corp needs to retain earnings for business reasons, that is not an unreasonable accumulation of earnings and there is no penalty tax.

2. Tax savings can be realized on all taxable income of the corporation because individual tax rates are lower than corporate tax rates; S corporation status dramatically reduces the potential problem of IRS claims of excessive compensation of shareholder-employees.

Instead, it raises the issues of inadequate compensation. Out of the frying pan and into the fire. And the top tax rates for C corps and individuals are nearly the same at the moment. You'd need an awful lot of income for the small marginal difference to be an issue. And Congress can change that difference on a whim.

3. If your corporation expects to generate capital gain income, the S corporation can make distributions to its shareholders and pass the "capital gain character" of the income directly to shareholders instead of distributions to shareholders otherwise taxed as dividend income.

C coprs do not have a preferential rate for long term capital gains. And distributions to S Corp shareholders are not income (unless the distributions exceed the shareholder's basis). The shareholder pays tax on the S corp's income whether it is distributed or not.

In a balance sheet, a company will list under or in the current assets sections, various investments and there is also an outflow section in the Statement of cash flows for Investment activities. I was thinking that if one is the sole shareholder of a S Corp they can derive tremendous investment potential by writing off acquisition of stocks as an 'investment outflow of cash' to acquire a 'long term investment'.

Now your confusing financial accounting with tax issues. There is absolutely no difference in the way an individual and a corporation figure their income from investments. And the statement of cash flows is not an income statement. It does not calculate net income.

Instead it explains how net income was converted into cash. In a sense, the statement of cash flows is a reconciliation of net income for a year to the net change in cash during the year.

You basically defer income taxes by recycling Retained Earnings into an investment expense: buying stocks of other corporations.

That way you have access to money that is pre tax income as opposed to making a withdrawal, paying income taxes and than investing that money.

No. Not for a C corp, and not for an S corp.

It makes a helluva of a difference as your business grows and you begin to earn top dollar for your expertise.

Except there's no "helluva a difference" to be had.

Basically you save whatever the tax rate is because it is a business expense and that money compounded over time will result in gains that are multiplicatively greater than when you withdraw the money as income and then use a portion of it to invest after paying the income taxes.

No.

Is this legally permissible and something that is compliant with GAAP?

Sure. Its perfectly legal. But compliance with GAAP has NOTHING to do with taxes. They are two separate and distinct accounting methods.

--Peter
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