Sole proprietors, partnerships and corporations
It is not easy to understand how multi-national corporations work, but we can relate to a smaller version. Many businesses we know or patronize in everyday life are run as one of three entities: Sole proprietor, partnership or corporation.
The easiest one to comprehend is the sole proprietor. The owner earns his net business income and pays his income tax, including his own Social Security and Medicare tax. In the case of a sole owner, this latter tax is known as “self-employment tax.” That rate is 15.3 percent of net business income and is capped off with a changing level periodically.
Had he been an employee of a corporation, the firm would have deducted Social Security and Medicare tax of 7.65 percent from his salary, and matched that amount before remitting to the IRS. Since there is no one to match these withholdings, the self-employed owner winds up paying the entire amount.
In a partnership, there is no income tax paid but the net profit is charged to the partners individually according to their ownership ratio. This “pass through” income is reported for income tax purposes and can also be subject to self-employment tax.
We have previously established that a corporation is a separate entity from the shareholder. The owner(s) wear two hats, one as an employee and the other as a shareholder. The owner(s) must use diligence in operating the business and not run it like it was his own piggy bank. All income and expenses must be properly reported and certain rules and regulations must be followed by law.
There are certain advantages to operating as a corporation and the prime reason is the limit of liability it can afford. The individual’s assets are separated from the corporation’s and are not available for creditors’ claims.
The tax treatment of the corporation is a double-edged sword, as you will see further down. The main difference of the tax is that it is separate from an owner’s tax liability. As an employee, you only pay tax on the money that you actually take out of the corporation. It can be a salary, a dividend, a commission or something similar. At the same time, the corporation pays its own taxes and that can present a problem.
The following example explains the main disadvantage of being a corporation or double taxation. Let’s suppose that My Own Corporation (MOC) earned $50,000 profit after deducting all expenses, including a reasonable salary to the officer-shareholder. After paying a federal tax of $7,500, the net difference of $42,500 changes its name and becomes known as retained earnings.
This is the account that all large and small corporations pay out dividends to their stockholders. As we all know, that becomes taxable to the recipient. Therefore, the theory of double taxation is formulated. All of this is in the area of a the company with an unlikely nickname of a “C” corporation.
Another example of how the double tax becomes a problem exists in the event the MOC or any other corporation is audited. Suppose there are expenses deducted on the tax return that were deemed to be personal in nature of the main shareholder. They will be disallowed to MOC and they will pay additional income tax. In addition, the IRS will then tax the officer-shareholder.
Is there a way to eliminate the double taxation issue? Yes.
Stayed tuned for the answer.
Observation: We all work for the government; the trick is to get paid for it.
Edward J. Loughrey, CFE, EA, LPA, may be reached at firstname.lastname@example.org or at 843-705-7258.