There
can’t be a business without individuals who own it and run it. Any talk of the taxation of businesses must
therefore include a word or two about the taxation of individuals. We’ll just do the fundamentals now. Businesses compute income for tax purposes
about the same way. But then how the business
is treated for tax purposes varies based on what form it uses. The Internal Revenue Service has two
different taxation methods described as “corporate” and “partnership” taxation. Corporate income taxation is described in
Subchapters C and S, while partnership income taxation is found in Subchapter
K.
(a)
Corporate Tax Rates
Corporations
are subject to a progressive tax with the highest marginal rate starting at
about $18 million in income. That top
rate is 35%. Er, the highest rate is 39%...hootie what? It’s not purely progressive, and it’s not
purely regressive either. What’s the
deal?
(b)
Individual Tax Rates
These
tax rates are more complex! There are
lots of different tables to look at and different deductions that can be applied. Marginal tax rates went super high around
World War II and leading right up to the 1980’s. Now the top marginal tax rate is lower, but
it’s been tending to rise over the years.
(c)
The Taxation of Capital
Gains or Losses
The
capital gains tax rate is much lower than the top marginal tax rate! So there’s a big incentive to convert income
into long-term capital gains. But your capital
gains must be long-term. If they’re
short-term, they’ll just get taxed at regular income tax rates!
(d)
Estate Taxes
When
a business owner dies, they have to pay taxes that are assessed based on the
value of the business. This can make
succession plans difficult. It provides
an incentive to sell a business while you’re alive rather than leave it to your
heirs. There has been reductions in the
estate tax in the last couple of years.
However, they may cause an unforeseen consequence: the Alternative
Minimum Tax may kick in for more middle and upper-middle class people.
Here
are some vocabulary words. It would be
hard to get the definitions shorter for the purposes of these notes. Basis, adjusted basis, amount realized, and
gain…
(e)
The Taxation of Partnerships
and Corporations
(1) Proprietorships
If
someone wholly owns a business in their own name, their profit or loss is
simply reported on their own tax return.
They have to file the long-form 1040 and Schedule C. They must pay an extra self-employment tax.
(2) Unincorporated Business Forms
These
will usually fall under Subchapter K of the Internal Revenue Code unless the
entity chooses to be treated as a corporation.
Partnerships don’t pay tax themselves, but rather pass through income to the partners, who then pay regular old
personal income tax. This seems simple,
but it might not be as simple as it sounds.
(3) C Corporations
These
corporations have their own tax schedule.
And they get double-taxed! The corporation
gets taxed on income, and then the dividends get taxed when they’re
distributed!
(4) S Corporations
This
form was created to provide relief from double taxation. A corporation must elect to use this
form. An S corporation is like a C corporation
in all respects except for tax differences.
An S corporation must not have more than 75 shareholders. There are some other requirements as well. Most S corporations are small and only have
one shareholder.
(f)
Business tax planning
strategies
When
you set up a corporation, you have to think about both taxation and tort liability. Not everyone will be sued, but everyone has
to pay taxes. So tax planning may be of
more importance than liability concerns.
You are allowed to try to reduce your tax liability as much as possible
legally, but you can’t illegally evade taxes.
You need to focus on the marginal tax rate rather than the average rate. Most people have enough income to already be
in the higher tax brackets.