It is commonly heard around the truck stop, that owner-operators will save thousands of dollars after they incorporate their business. You could save from incorporating, but you should not rush into this important step in the life of your business.
The legal form under which you set up your business can have a significant impact on:
- The way you run your operation
- The costs of running your operation
- How you are taxed
It is critical to understand the business structure options available to you and when each is most appropriate for your business. Owner liability and income taxation are two main factors that determine which business structure to choose. The most common forms of business are sole proprietorship, corporation, S corporation and limited liability company (LLC). Because each business structure comes with different tax consequences, you will want to make your selection wisely and choose the structure that most closely matches your business's needs. Contact a business service provider, such as ATBS, to discuss your needs to help you choose the best option for your business.
Below is a list of the most popular business structures:
- Sole-Proprietor. The simplest structure is the sole proprietorship, which usually involves just one individual who owns and operates the enterprise. If you intend to work alone, this structure may be the way to go.
The tax aspects of a sole proprietorship are pleasing because the expenses and your income from the business are included on your personal income tax return. Your profits and losses are recorded on a form called Schedule C, which is filed with your 1040. This is can be desirable because business losses you suffer may offset the income you have earned from your other sources.
Some of the disadvantages of operating as a sole proprietor is that you need to calculate how much self-employment tax you owe. You pay both employee and employer portions of employment taxes on your self-employed income, which can add up to a large amount depending on your net profit. Selecting the sole proprietorship business structure means you are personally responsible for your company's liabilities. As a result, you are placing your assets at risk, and they could be seized to satisfy a business debt or a legal claim filed against you.
In addition to paying annual self-employment taxes, you must make estimated tax payments if you expect to owe at least $1,000 in federal taxes for the year after deducting your withholding and credits, and your withholding will be less than the smaller of: 1) 90 percent of the tax to be shown on your current year tax return or 2) 100 percent of your previous year's tax liability. The federal government permits you to pay estimated taxes in four equal amounts throughout the year on the 15th of April, June, September and January.
Some advantages of the sole proprietorship are that your business earnings are taxed only once, unlike other business structures. The employer portion of the self-employed tax paid is deductible above the line, which reduces your taxable income. Also, health insurance costs for you, your spouse, and dependents can be deducted up to your net self-employment income as an above the line deduction.
- C Corporations. The corporate structure is more complex and expensive to set up than most other business structures. A corporation is an independent legal entity, separate from its owners, and requires complying with more regulations and tax requirements.
The biggest benefit for a business owner who decides to incorporate is the liability protection he or she receives. A corporation's debt is not considered that of its owners, so if you organize your business as a corporation, you are not putting your personal assets at risk. A corporation also can retain some of its profits without the owner paying tax on them.
A C Corporation does have some negative aspects. C Corporations are formed under the laws of each state with its own set of regulations and must follow more complex rules and regulations than a sole proprietorship. Another downside to forming a corporation is the owners of the corporation pay a double tax on the business's earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.
A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. However, the IRS has limits on what it believes to be reasonable compensation.
- S Corporations. The S corporation is more attractive to small-business owners than a regular (or C) corporation. That's because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there's just one level of federal tax to pay.
S corporations do come with some disadvantages. S corporations are subject to many of the same rules corporations follow, which also involve higher legal and tax service costs. They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. The legal and accounting costs of setting up an S corporation are also similar to those for a regular C corporation. A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. However, the IRS has limits on what it considers to be reasonable.
To become an S Corporation and be treated as one for income tax purposes, the shareholders need to make an election with the federal government to be taxed as an S Corporation, which is an election that is frequently missed. By not filing the S election, you will be taxed as a C Corporation and subject to double taxation rules.
- Limited Liability Company (LLC’s). Limited Liability Companies have become one of the more popular structures in recent years especially with entrepreneurs.
LLC’s were created to provide business owners with the liability protection that corporations benefit from without the double taxation. Earnings and losses pass through to the owners and are included on their personal tax returns. If there is only one member in the LLC it is considered a disregarded entity and is taxed the same way as a sole-proprietorship unless you elect to be taxed as an S Corporation.
To set up an LLC, you must file articles of organization with the secretary of state in the state where you intend to do business. Some states also require you to file an operating agreement, which is comparable to a partnership agreement.
Even after you settle on a business structure, remember that the conditions that make one type of business structure favorable are always subject to changes in the laws. It makes sense to re-examine your form of business from time to time to make sure you are using the one that provides the most benefit to you, which your ATBS Business Consultant can assist you with.
Depreciation and Section 179. Section 179 doesn’t increase the total amount you can deduct, but it allows you to get your entire depreciation deduction in one year, rather than taking it a little at a time over the term of an asset’s useful life. This is called first-year expensing or Section 179 expensing. (Expensing is an accounting term that means currently deducting a long-term asset.)
- Example: In 2013, Bill buys a $25,000 trailer for his trucking business. Under the regular depreciation rules, Bill would have to deduct a portion of the cost each year over its five-year useful life. By deducting the trailer under Section 179, Bill can deduct the entire $25,000 expense from his income taxes in 2013. So he gets a $25,000 deduction in 2013 under Section 179, instead of the normal deduction he would get using regular depreciation methods.
- What Property Qualifies. You qualify for the Section 179 deduction only if you buy long-term, tangible personal property that you use in your business more than 50% of the time. Under Section 179, you can deduct the cost of tangible personal property (new or used) that you buy for your business. Examples of tangible personal property include computers, business equipment and machinery, trucks and trailers.
- Property Used Primarily (51%) for Business. To deduct the cost of property under Section 179, you must use the property primarily for your business. The deduction is not available for property you use solely for personal purposes or to manage investments or otherwise produce non-business income.
You can take a Section 179 deduction for property you use for both personal and business purposes, as long as you use it for business more than half of the time. The amount of your deduction is reduced by the percentage of your personal use. You’ll need to keep records showing your business use of the property. If you use an item for business less than half the time, you will have to use regular depreciation instead and deduct the cost of the item over several years.
Another limitation regarding the business use of property is that you must use the property over half the time for business in the year in which you buy it. You can’t convert property you previously used for personal use to business use and claim a Section 179 deduction for the cost.
- Annual Deduction Limit. There is a limit on the total amount of business property expenses that you can deduct each year under Section 179. The limit was increased in 2013 to $500,000. In 2014, the Section 179 limit is scheduled to go to $25,000.
You don’t have to claim the full amount, it’s up to you to decide how much to deduct under Section 179. Whatever amount you don’t claim under Section 179 must be depreciated instead over the life of the asset.
- Advantages and Disadvantages of Taking Section 179. The main advantage of Section 179 is it lets you take a higher deduction immediately. By receiving a higher depreciation deduction today, a business will reduce its current tax bill. This deduction is especially helpful for new businesses that may be having cash-flow troubles. Section 179 lets businesses maximize deductions today and avoid delaying deductions to the future when the business may no longer exist.
Two of the major disadvantages are as your income increases, it will move into a higher tax rate. By accelerating your business's deductions, you will have fewer options in the future to reduce your taxes when you business may be in a higher tax bracket.
Another disadvantage of the accelerated method, is it has a greater risk of recaptured depreciation. You may decide to sell a long-term asset before it is considered worthless according to its depreciation schedule. If you sell the asset for more than its current accounting value, your profit will be considered recaptured depreciation. The IRS will take back your depreciation deductions as the asset did not lose value as quickly as planned. Your recaptured depreciation profits will be taxed as income. Accelerated systems have a higher cost of recaptured depreciation because they recognize more depreciation upfront.
Proper planning can help you make the best possible decision on depreciation. Call a business service provider, such as ATBS, or read our recent eBook "How to Decide Which Business is Right for your Business" to discuss your current situation and your future business plans in order to make a sound decision on depreciating your business assets.