What is a Corporation?

Your friends keep telling you that you should incorporate your business, but you brush them off. You own a small business; corporations are giant entities like GE and Apple.

The truth is, you can incorporate your business regardless of its size.  The question is instead whether it makes sense for you and your business to incorporate.

Picture borrowed from www.cgglobal.com

You have to answer that question for yourself, perhaps with the help of a trusted adviser, but in order to make an informed decision you need to have a general understanding of what a corporation is and what the tax implications are to incorporating your business.

The goal of this blog post is to give you an overview of what a corporation is.  I strongly recommend talking to a business transactions attorney if you are considering forming a corporation as there are many important details not discussed here.

As opposed to a sole proprietorship, a corporation is a legal entity that is separate and distinct from you as its owner (shareholder).  There is, essentially, a legal fiction that a corporation is its own person.  What exactly that means has been the subject of many Supreme Court cases and continues to evolve, but for purposes of our discussion it means that the corporation can: enter into contracts, purchase assets, loan and borrow money, sue or be sued, and pay taxes.

Corporations are organized under state law, and must recognize certain formalities.  These vary to some degree from state to state, and for purposes of this discussion I will be discussing the formalities that California corporations are subject to.  Again, this is a very general discussion and I strongly recommend discussing this with a business transactions attorney.   Some of the formalities include:

• Filing Articles of Incorporation with the California Secretary of State;
• Electing a Board of Directors;
• Enacting Corporate Bylaws;
• Holding Board meetings at least once a year;
• Holding shareholder meetings at least once a year;
• Maintaining separate bank accounts for the corporation; and
• Maintaining corporate records.

This is not an exhaustive list of the corporate formalities that must be followed by a California corporation.

As mentioned in my previous post, Why Form a Business Entity?, one of the primary benefits of forming a corporation is that it has limited liability protection.  Because of the importance of limited liability, it will be discussed in the next blog post.  For now, the general rule is that your financial risk is limited to the amount of your investment.

Another benefit of the corporate form of business ownership is that your ownership interests can, relative to other forms of business ownership, be easily transferred to another individual.  Your ownership interest in the corporation is represented through shares of stock, and generally there are no restrictions on you in transferring your ownership of the stock to another person.  To be clear, this does not necessarily mean that there is an active market for your stock, but once there is a buyer the sale process is much simpler than, for example, the sale of a partnership interest.

However, one of the main drawbacks to the corporate form of business ownership is double-taxation. As I mentioned, a corporation is a separate legal entity that is subject to taxation.  That means that any income that the corporation earns will be taxed first at the corporate level.  If that income is then distributed to the shareholders, it may be taxed again at the individual level (the taxation of distributions will be discussed further in a future blog post).

It is possible to for a shareholder to take money out of the corporation and only have it be subject to one level of taxation if that owner is also an employee.  An owner-employee is paid wages or a salary, and that is W-2 income to the owner-employee but a valid deduction to the corporation. However, as W-2 income it is subject to payroll taxes.  Any additional distributions (i.e., money taken out of the corporation that is not run through payroll) is again taxable at the corporate and individual level.

This hopefully will give you a general understanding of what a corporation is, what formalities it is subjected to, and some of its benefits and drawbacks.  If you are interested in a referral to a business transactions attorney or if you have any questions about the tax implications of corporate ownership, please send me an e-mail.

Why Form a Business Entity?

Congratulations!  You decided to turn your passion into a business, and you are doing everything you can to make sure that it is a success.  You've heard people talk about incorporating their business or forming a partnership or LLC, and now you are wondering if that is the right thing for your business.

Table borrowed from www.strategicofficesupport.com

The answer is...maybe.  It is a cliche, but every business and every business owner is different and has different needs that must be considered.

However, there are some factors that impact this decision.

One factor is whether you would like your company to have limited liability protection. Corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) all provide limited liability protection.  Sole proprietorships and general partnerships do not.

Limited liability protection will be discussed in great detail in a future blog post, but in very general terms it means that only the entity's assets (i.e., not your personal assets) are at risk of loss.  For example, let's say that your business has $10,000 worth of assets and you have $250,000 of personal assets outside of the business.  If your business is sued, the plaintiffs can only attempt to collect on the $10,000 of business assets and cannot seize your personal assets.

You may feel that it is very unlikely that you will be sued or that if you are that is the reason why you have insurance.  You may be right, but you also want to keep in mind that your business is not only potentially liable for your actions but for the actions of your employees.  For many business owners, the desire to hire employees makes having limited liability protection a more significant factor to consider.

Another factor that you must consider is whether the business will have multiple owners.  The general rule is that if a business has multiple owners and no action has been taken to form a different type of entity (such as a corporation or LLC), it is a general partnership.  In a general partnership, each partner is personally liable for the actions of every other partner, their employees, and the business.  While for various reasons it may make sense to you to be in a general partnership, you want to make sure that it is a conscious decision and not simply the default because your business has multiple owners.  Therefore, if your business has multiple owners generally it will be an entity, so the decision then is what type of entity.

A third factor to consider are the tax implications to either operating your business as a sole proprietorship or as a business entity.  There are a number of different tax implications, not the least of which is whether or not you are then considered "self employed" and subject to the self-employment tax, that are outside of the scope of this blog post.  The important thing to remember is that there are a number of tax implications to how you choose to structure your business.  I would recommend talking to a CPA to discuss the specific impact that operating your business as a sole proprietorship versus a partnership, corporation, S-corporation, or LLC will have on your tax situation.

The final factor to consider when deciding to operate your business as a sole proprietor or as a separate business entity is the likelihood of an IRS audit.  There is a widespread belief among tax professionals, for various reasons, that a sole proprietorship is more likely to be subjected to an IRS audit than a business entity.  This is not to say that business entities are not audited by the IRS- they are all the time- but many tax professionals believe that sole proprietors are audited more frequently.  Of course you will be filing your taxes properly, but an IRS audit can be expensive for taxpayers even if the IRS does not make any changes to your tax return.

I highly recommend talking to a business transactions attorney about whether forming a separate entity for your business makes sense for you.  Please also feel free to e-mail me if you have any questions about the tax implications of how you structure your business.

What Type of Business Entity is Right for My Business?

Are you considering starting your own business?

According to data released from the U.S. Small Business Administration, hundreds of thousands of businesses are created  in the United States every year.  Every one of these new business owners must decide whether they want to operate as a sole proprietorship or whether they would prefer to operate the business as a separate entity.  Then, they have to decide what type of business entity best serves their needs.

Over the following weeks, I will assist you in answering these critical questions by discussing the factors that business owners should consider in determining whether they should form an entity, and the differences that exist between corporations, S-corporations, partnerships, and limited liability companies (LLCs).

If you are currently going through this process, I would be happy to talk to you about the tax implications of forming a business and to refer you to a business transaction attorney to answer any legal questions you may have.  Just send me an e-mail.

2014 Tax Changes: No More Mortgage Debt Forgiveness Exclusion

Note: On December 19, 2014, Congress retroactively extended the mortgage debt forgiveness exclusion through the end of 2014.  It has expired again as of January 1, 2015.

With 2014 quickly coming to an end, you may be looking at ways to reduce your income tax liability. The first step in any good tax planning is understanding how the law changed from 2013 and how that affects you.

In this series, 2014 Tax Changes, I will give you an overview of the changes in the tax law that may affect you.  If you haven't already, please feel free to read the earlier posts in this series:

• Individual Mandate- discussing the Affordable Care Act's individual mandate that is now in effect;
• Pease Limitation- discussing how your itemized deductions may be limited; and
• Goodbye IRA Charitable Rollovers- discussing the expiration of a special rule that allowed seniors to roll over their IRA's minimum required distributions to a qualified charitable organization without negative tax consequences.

No More Mortgage Debt Forgiveness Exclusion

The general rule in the Internal Revenue Code is that when you owe someone money and that person forgives the debt, you are treated as having received income equal to the amount of forgiven debt.  This type of income is called "cancellation of indebtedness (COD) income".

While there are several exclusions that could potentially protect taxpayers from having to recognize COD income, one of the most popular was the mortgage debt forgiveness exclusion for individuals who had debt forgiven on their principal residence.  Unfortunately, this exclusion expired at the end of 2013.

As always, please leave your feedback in the comments section below.

2014 Tax Changes: Goodbye IRA Charitable Rollovers

Editor's Note: The IRA Charitable Rollover was extended retroactively for the 2014 tax year on December 19, 2014, but has expired again as of January 1, 2015.

There are less than 2 months left in 2014, and if you are going to minimize your income tax liability you need to understand what changes were made in the tax law.

In this series, 2014 Tax Changes, I will give you an overview of the changes in the tax law that may affect you.  If you haven't already, feel free to read the first post in this series, Individual Mandate, discussing the Affordable Care Act's individual mandate that is now in effect, or the second post, Pease Limitation, discussing how your itemized deductions are being limited.

Goodbye IRA Charitable Rollovers

Through 2013, seniors who would otherwise have to take a "minimum required distribution" from their IRA and report that amount as income could instead rollover up to $100,000 to a charitable organization of their choice.

I am sure you are wondering why this was a tax benefit.  As you may already know, when you make a charitable contribution you are allowed to deduct the contribution as an itemized deduction.  Wouldn't this mean that the $100,000 of income from the minimum required distribution would, effectively, be netted against the charitable contribution itemized deduction so that there would not be any net increase in taxes?  Well, sometimes, but not always.

You have to remember that there are limits on the amount of charitable contributions that you are allowed to take.

First, you may only deduct, as a charitable contribution, up to 50% of your adjusted gross income.  That means if your only income is the minimum required distribution, then even if you give 100% of the distribution to your favorite charity you are only allowed to take up to half of that amount as a charitable deduction.  Yes, you will carry forward the excess contributions to the next year, but if your only income is from the IRA minimum required distributions and you are donating 100% of it to charity every year then you will never be able to take full advantage of the charitable deduction.

The second limitation is that not every senior takes itemized deductions.  I was using $100,000 as an example of the amount that may be distributed as part of an IRA's minimum required distribution, but in most cases this amount will be much less.  If, for example, a senior has $8,000 of minimum required distributions from his IRA and contributes 100% of it to a charity, then he would have $4,000 of itemized deductions.  Assuming that he did not have any other itemized deductions, despite making the charitable contribution he would not itemize his deductions and therefore would not receive any tax benefit from making the charitable contribution.

Finally, as you read about in my last post, the Pease Limitation, reduces the benefit of charitable contributions.  If you are affected by the Pease Limitation, the value of your charitable contribution deduction is limited.

The special rule that expired at the end of the 2013 eliminated these problems by ensuring that a senior that made a direct rollover of his/her IRA minimum required distributions to a qualified charitable organization would not pay any federal income taxes on the distribution because the distribution would not be recognized as income (and the contribution would not be allowed as a deduction).

Unfortunately, without this special tax rule seniors may pay more in taxes or will have to engage in different tax planning strategies.  And sadly this may also have an impact on the amount of charitable contributions made this year.

If you are interested in learning more about 2014 tax changes, please send me an e-mail.

2014 Tax Changes: Pease Limitation

With only 2 months left in 2014, you have to act fast to put yourself in the best position to minimize your income taxes.

In this series, 2014 Tax Changes, I will give you an overview of the changes in the tax law that may affect you.  If you haven't already, feel free to read the first post in this series, Individual Mandate, discussing the Affordable Care Act's individual mandate that is now in effect.

You may already be familiar with the Pease Limitation from your 2013 tax return.  The Pease Limitation was first introduced in 1990 as a way of limiting popular itemized deductions, such as the home mortgage interest deduction and the charitable contribution deduction, indirectly.  This controversial item was phased out between 2006 and 2010, but came back in full force in 2013.

The Pease Limitation is subject to inflation, so for 2014 it will only affect individuals with incomes of $254,200 or more and married couples filing jointly with incomes of $305,050 or more.

How does the Pease Limitation work?

As I mentioned above, the Pease Limitation only affects individuals with incomes above a certain applicable amount, which in 2014 is $254,200 for single individuals and $305,050 for married couples filing jointly.

The Pease Limitation reduces the amount of applicable itemized deductions taxpayers are entitled to take by the lesser of:

• 3 percent (%) of the adjusted gross income above the applicable amount; or
• 80 percent (%) of the amount of the itemized deductions otherwise allowable for the tax year.

Example

Assume a married couple has adjusted gross income of $800,000 and total itemized deductions of $100,000.  In this case, the amount of itemized deductions they would be eligible to claim would be reduced by $14,849 to $85,151.

How did I arrive at that number?

1. This couple has adjusted gross income of $800,000 and the applicable threshold for married couples filing jointly is $305,050, so the amount that the adjusted gross income exceeds the applicable amount is $494,950.  3% of that amount is $11,848.50.
2. The couple has $100,000 of itemized deductions that would otherwise be allowable, and 80% of that amount is $80,000.
3. Because $11,848.50 is less than $80,000, the allowable itemized deductions is reduced by $11,849.

Example

Assume a single individual has adjusted gross income of $300,000 and total itemized deductions of $20,000.  In this case, the amount of itemized deduction that he would be eligible to claim would be reduced by $1,374 to $18,626.

How did I arrive at that number?

1. This individual has adjusted gross income of $300,000 and the applicable threshold for single individuals is $254,200, so the amount that the adjusted gross income exceeds the applicable amount is $45,800.  3% of that amount is $1,374.
2. This individual has $20,000 of itemized deductions that would otherwise be allowable, and 80% of that amount is $16,000.
3. Because $1,374 is less than $16,000, the allowable itemized deductions is reduced by $1,374.

If you believe that you may be affected by the Pease Limitation and would like to learn more about how it operates and would like to see how you can attempt to minimize its impact on you, please feel free to send me an e-mail.

As always, I appreciate your feedback in the comment section below.

2014 Tax Changes: Individual Mandate

The individual mandate that we have been hearing about for years is finally in effect.  What does that mean?

Beginning in 2014, taxpayers must have insurance that provides "minimum essential coverage."  A list of what health care plans that qualify as providing minimum essential coverage is provided on the healthcare.gov website.

If you do not have insurance that provided "minimum essential coverage", you are subject to a penalty.

In 2014, the penalty is the greater of:

• 1 percent (%) of your yearly household income; or
• $95 per adult and $47.50 per child under the age of 18.

In 2015, the penalty increases to the greater of:

• 2 percent (%) of your yearly household income; or
• $325 per adult and $162.50 per child under the age of 18.

In 2016, the penalty increases to the greater of:

• 2.5 percent (%) of your yearly household income; or
• $695 per adult and $347.50 per child under the age of 18.

After 2016 the penalty is adjusted annually for inflation.

Are there any exemptions from having to pay the penalty?

Yes, there are several exemptions available based upon your circumstances.  There are exemptions for the following situations:

1. You are uninsured for less than 3 months of the year;
2. The lowest-priced coverage available to you would cost more than 8% of your household income;
3. You don't have to file a tax return because your income is too low;
4. You are a member of a federally recognized tribe or eligible for services through an Indian Health Services provider;
5. You are a member of a recognized health care sharing ministry;
6. You are a member of a recognized religious sect with religious objections to insurance, including Social Security and Medicare;
7. You are incarcerated (either detained or jailed), and not being held pending disposition of charges;
8. You are not lawfully present in the United States; or
9. You qualify for a hardship exemption.

But I thought I heard that the implementation of the Individual Mandate has been delayed?

The Obama Administration announced earlier this year that it is delaying the implementation of the individual mandate until October, 2016 for millions of Americans who have lost their insurance coverage.  If you believe you qualify, you will want to discuss your situation with an expert in the medical insurance field and potentially apply for the "hardship" exemption.