Question: I drive a cab part-time but am thinking about doing it as a full-time job. If I am self-employed, what is best for taxes, be a simple business owner or incorporate? I have a house and a family. — Johnathan of Boston
Answer: Stockholders are not liable for corporate debts. This is the most important advantage of a corporation. In a sole proprietorship and partnership, the owners are personally liable for the debts of the business. If the assets of the sole proprietorship or partnership cannot satisfy the debt, creditors can go after each owner’s personal assets to make up the difference. On the other hand, if a corporation runs out of funds, its owners are usually not responsible.
Under certain circumstances, however, an individual stockholder may be liable for corporate debts. This is sometimes known to as “piercing the corporate veil.” Those circumstances include:
• If a stockholder personally guarantees a debt.
• If personal funds are intermingled with funds of the corporation.
• If a corporation fails to have director and shareholder meetings.
• If the corporation has minimal capitalization or minimal insurance.
• If the corporation fails to pay state taxes or otherwise violates state tax law.
The life of a corporation, unlike that of a business partnerships and sole proprietorship, does not expire upon the death of its stockholders/directors or officers. Ownership interests in a corporation may be sold to third parties without disturbing the continued operation of the business. The business of a sole proprietorship or partnership, on the other hand, cannot be sold whole; instead, each of its assets, licenses and permits must be individually transferred, and new bank accounts and tax identification numbers are required.
Corporations cost more to set up and run than a sole proprietorship or partnership. For example, there are the initial formation fees, filing fees and annual state fees. These costs are partially offset by lower insurance costs. A corporation can only be created by filing legal documents with the state. In addition, a corporation must adhere to technical formalities. These include holding director and shareholder meetings, recording minutes, having the board of directors approve major business transactions and corporate record-keeping. If these formalities are not kept, the stockholders risk losing their personal liability protection. While keeping corporate formalities is not difficult, it can be time-consuming. On the other hand, a sole proprietorship or partnership can commence and operate without any formal organizing or operating procedures — not even a handwritten agreement.
Self Employment Tax Savings. Earnings from a sole proprietorship are subject to self-employment taxes, which are currently a combined 15.3%. With a corporation, only salaries (and not profits) are subject to such taxes. This advantage is most significant for stockholder-employees who take a salary of less than $72,600.
Unemployment tax. A stockholder-employee of a corporation is required to pay unemployment insurance taxes on his or her salary, whereas a sole proprietor or partner is not. Currently, the federal unemployment tax is 6.2% of the first $7000 of wages paid.
As a sole proprietor, you would report net income or loss from your business on your personal income tax return. However, there are several important rules that you should be aware of:
(1) For income tax purposes, you will report your income and expenses on Schedule C of your Form 1040. The net income will be taxable to you regardless of whether you withdraw cash from the business. Your business expenses will be deductible against gross income (i.e., “above the line,” and not as itemized deductions subject to the 2%-of-adjusted-gross-income floor or the 3%/80% reduction rules). If you have any losses, the losses will generally be deductible against your other income, subject to special rules relating to hobby losses, passive activity losses and losses in activities in which you weren’t “at risk.”
To report all tip income has always been the law. The IRS has put greater emphasis on reporting tip income over the past few years because a significant number of taxpayers are not reporting all tip earnings as income. The IRS provides the following publications and forms relating to tip income reporting. These materials can be downloaded from the IRS Web site at www.irs.ustreas.gov and ordered through the IRS by dialing 1-800-829-3676. (For TTY/TDD equipment access, dial 1-800-829-4059.)
(2) If you will be working from an office in your home, performing management or administrative tasks from a home office, you may be entitled to deduct an allocable portion of certain of the costs of maintaining your home. And if you have a home office, you may be able to convert nondeductible commuting expenses (of going from your residence to another work location) into deductible transportation expenses.
(3) You will also be required to pay self-employment taxes at a rate of 15.3% on your net earnings from self employment of up to $106,800 for 2009 ($102,000 for 2008), and at a rate of 2.9% on the excess. (The maximum amount will be reduced by any non-self-employment wages you earn.) One-half of your self-employment taxes will be deductible as a trade or business expense (that is, as a deduction against gross income, not subject to the limits that apply to itemized deductions).
(4) You will be allowed to deduct 100% of your health insurance costs as a trade or business expense. This means your deduction for medical care insurance won’t be limited by the normal 7.5%-of-AGI floor on itemized medical expenses.
(5) Your income won’t be subject to withholding tax. However, you will be required to pay estimated taxes quarterly. We can work with you to minimize the amount of your estimated tax payments while avoiding any underpayment penalty.
(6) You will have to maintain complete records of your income and expenses. In particular, you should pay attention to recording your expenses in order to be able to take the full amount of the deductions to which you are entitled. Certain types of expenses, such as automobile, travel, entertainment, meals, and home office expenses, are subject to special recordkeeping requirements or limitations on their deductibility and require special attention.
(7) If you hire any employees, you will have to get a taxpayer identification number and will have to withhold and pay various payroll taxes.
(8) You should consider establishing a qualified retirement plan. The advantage of a qualified retirement plan is that amounts contributed to the plan are deductible at the time of the contribution, and aren’t taken into income until the amounts are withdrawn. Because of the complexities of ordinary qualified retirement plans, you might consider a simplified employee pension (SEP) plan, which requires less paperwork. Another type of plan available to sole proprietors that offers tax advantages with fewer restrictions and administrative requirements than a qualified plan is a “savings incentive match plan for employees,” i.e., a SIMPLE plan. If you don’t establish a retirement plan, you may still be able to make a contribution to an IRA.
Circular 230 Disclosure: Pursuant to recently-enacted US Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly indicated, any federal tax advise contained in this communication, including attachments and enclosures, is not intended or written to be used, and may not be used for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code or (ii) promoting, or recommending to another party any tax related matters addressed herein.
Very best regards,