Small Business Tax briefs
Choosing a business entity? Here are the pros and cons of a C corporation
If you’re launching a new business venture, you’re probably wondering which form of business is most suitable. Here is a summary of the major advantages and disadvantages of doing business as a C corporation.
A C corporation allows the business to be treated and taxed as a separate entity from you as the principal owner. A properly structured corporation can protect you from the debts of the business yet enable you to control both day-to-day operations and corporate acts such as redemptions, acquisitions and even liquidations. In addition, the corporate tax rate is currently 21%, which is lower than the highest noncorporate tax rate.
In order to ensure that a corporation is treated as a separate entity, it’s important to observe various formalities required by your state. These include:
- Filing articles of incorporation,
- Adopting bylaws,
- Electing a board of directors,
- Holding organizational meetings, and
- Keeping minutes of meetings.
Complying with these requirements and maintaining an adequate capital structure will ensure that you don’t inadvertently risk personal liability for the debts of the business.
Since the corporation is taxed as a separate entity, all items of income, credit, loss and deduction are computed at the entity level in arriving at corporate taxable income or loss. One potential disadvantage to a C corporation for a new business is that losses are trapped at the entity level and thus generally cannot be deducted by the owners. However, if you expect to generate profits in year one, this might not be a problem.
Another potential drawback to a C corporation is that its earnings can be subject to double tax — once at the corporate level and again when distributed to you. However, since most of the corporate earnings will be attributable to your efforts as an employee, the risk of double taxation is minimal since the corporation can deduct all reasonable salary that it pays to you.
Providing benefits, raising capital
A C corporation can also be used to provide fringe benefits and fund qualified pension plans on a tax-favored basis. Subject to certain limits, the corporation can deduct the cost of a variety of benefits such as health insurance and group life insurance without adverse tax consequences to you. Similarly, contributions to qualified pension plans are usually deductible but aren’t currently taxable to you.
A C corporation also gives you considerable flexibility in raising capital from outside investors. A C corporation can have multiple classes of stock — each with different rights and preferences that can be tailored to fit your needs and those of potential investors. Also, if you decide to raise capital through debt, interest paid by the corporation is deductible.
Although the C corporation form of business might seem appropriate for you at this time, you may in the future be able to change from a C corporation to an S corporation, if S status is more appropriate at that time. This change will ordinarily be tax-free, except that built-in gain on the corporate assets may be subject to tax if the assets are disposed of by the corporation within 10 years of the change.
The optimum choice
This is only a brief overview. Contact us if you have questions or would like to explore the best choice of entity for your business.
2023 limits for businesses that have HSAs — or want to establish them
No one needs to remind business owners that the cost of employee health care benefits keeps going up. One way to provide some of these benefits is through an employer-sponsored Health Savings Account (HSA). For eligible individuals, an HSA offers a tax-advantaged way to set aside funds (or have their employers do so) to meet future medical needs. Here are the key tax benefits:
- Contributions that participants make to an HSA are deductible, within limits.
- Contributions that employers make aren’t taxed to participants.
- Earnings on the funds in an HSA aren’t taxed, so the money can accumulate tax-free year after year.
- Distributions from HSAs to cover qualified medical expenses aren’t taxed.
- Employers don’t have to pay payroll taxes on HSA contributions made by employees through payroll deductions.
Eligibility and 2023 contribution limits
To be eligible for an HSA, an individual must be covered by a “high deductible health plan.” For 2023, a “high deductible health plan” will be one with an annual deductible of at least $1,500 for self-only coverage, or at least $3,000 for family coverage. (These amounts in 2022 were $1,400 and $2,800, respectively.) For self-only coverage, the 2023 limit on deductible contributions will be $3,850 (up from $3,650 in 2022). For family coverage, the 2023 limit on deductible contributions will be $7,750 (up from $7,300 in 2022). Additionally, annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits for 2023 will not be able to exceed $7,500 for self-only coverage or $15,000 for family coverage (up from $7,050 and $14,100, respectively, in 2022).
An individual (and the individual’s covered spouse, as well) who has reached age 55 before the close of the tax year (and is an eligible HSA contributor) may make additional “catch-up” contributions for 2023 of up to $1,000 (unchanged from the 2022 amount).
If an employer contributes to the HSA of an eligible individual, the employer’s contribution is treated as employer-provided coverage for medical expenses under an accident or health plan. It’s also excludable from an employee’s gross income up to the deduction limitation. Funds can be built up for years because there’s no “use-it-or-lose-it” provision. An employer that decides to make contributions on its employees’ behalf must generally make comparable contributions to the HSAs of all comparable participating employees for that calendar year. If the employer doesn’t make comparable contributions, the employer is subject to a 35% tax on the aggregate amount contributed by the employer to HSAs for that period.
HSA withdrawals (or distributions) can be made to pay for qualified medical expenses, which generally means expenses that would qualify for the medical expense itemized deduction. Among these expenses are doctors’ visits, prescriptions, chiropractic care and premiums for long-term care insurance.
If funds are withdrawn from the HSA for other reasons, the withdrawal is taxable. Additionally, an extra 20% tax will apply to the withdrawal, unless it’s made after reaching age 65, or in the event of death or disability.
HSAs offer a flexible option for providing health care coverage and they may be an attractive benefit for your business. But the rules are somewhat complex. Contact us if you have questions or would like to discuss offering HSAs to your employees.
Inflation means you and your employees can save more for retirement in 2023
How much can you and your employees contribute to your 401(k)s next year — or other retirement plans? In Notice 2022-55, the IRS recently announced cost-of-living adjustments that apply to the dollar limitations for pensions, as well as other qualified retirement plans for 2023. The amounts increased more than they have in recent years due to inflation.
The 2023 contribution limit for employees who participate in 401(k) plans will increase to $22,500 (up from $20,500 in 2022). This contribution amount also applies to 403(b) plans, most 457 plans and the federal government’s Thrift Savings Plan.
The catch-up contribution limit for employees age 50 and over who participate in 401(k) plans and the other plans mentioned above will increase to $7,500 (up from $6,500 in 2022). Therefore, participants in 401(k) plans (and the others listed above) who are 50 and older can contribute up to $30,000 in 2023.
SEP plans and defined contribution plans
The limitation for defined contribution plans, including a Simplified Employee Pension (SEP) plan, will increase from $61,000 to $66,000. To participate in a SEP, an eligible employee must receive at least a certain amount of compensation for the year. That amount will increase in 2023 to $750 (from $650 for 2022).
Deferrals to a SIMPLE plan will increase to $15,500 in 2023 (up from $14,000 in 2022). The catch-up contribution limit for employees age 50 and over who participate in SIMPLE plans will increase to $3,500 in 2023, up from $3,000.
Other plan limits
The IRS also announced that in 2023:
- The limitation on the annual benefit under a defined benefit plan will increase from $245,000 to $265,000. For a participant who separated from service before January 1, 2023, the participant’s limitation under a defined benefit plan is computed by multiplying the participant’s compensation limitation, as adjusted through 2022, by 1.0833.
- The dollar limitation concerning the definition of “key employee” in a top-heavy plan will increase from $200,000 to $215,000.
- The dollar amount for determining the maximum account balance in an employee stock ownership plan subject to a five-year distribution period will increase from $1,230,000 to $1,330,000, while the dollar amount used to determine the lengthening of the five-year distribution period will increase from $245,000 to $265,000.
- The limitation used in the definition of “highly compensated employee” will increase from $135,000 to $150,000.
The 2023 limit on annual contributions to an individual IRA will increase to $6,500 (up from $6,000 for 2022). The IRA catch-up contribution limit for individuals age 50 and older isn’t subject to an annual cost-of-living adjustment and will remain $1,000.
Current high inflation rates will make it easier for you and your employees to save much more in your retirement plans in 2023. The contribution amounts will be a great deal higher next year than they’ve been in recent years. Contact us if you have questions about your tax-advantaged retirement plan or if you want to explore other retirement plan options.
Employers: In 2023, the Social Security wage base is going up
The Social Security Administration recently announced that the wage base for computing Social Security tax will increase to $160,200 for 2023 (up from $147,000 for 2022). Wages and self-employment income above this threshold aren’t subject to Social Security tax.
Basics about Social Security
The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees and self-employed workers. One is for the Old Age, Survivors and Disability Insurance program, which is commonly known as Social Security. The other is for the Hospital Insurance program, which is commonly known as Medicare.
There’s a maximum amount of compensation subject to the Social Security tax, but no maximum for Medicare tax. For 2023, the FICA tax rate for employers is 7.65% — 6.2% for Social Security and 1.45% for Medicare (the same as in 2022).
For 2023, an employee will pay:
- 6.2% Social Security tax on the first $160,200 of wages (6.2% of $160,200 makes the maximum tax $9,932.40), plus
- 1.45% Medicare tax on the first $200,000 of wages ($250,000 for joint returns; $125,000 for married taxpayers filing a separate return), plus
- 2.35% Medicare tax (regular 1.45% Medicare tax plus 0.9% additional Medicare tax) on all wages in excess of $200,000 ($250,000 for joint returns; $125,000 for married taxpayers filing a separate return).
For 2023, the self-employment tax imposed on self-employed people is:
- 12.4% Social Security tax on the first $160,200 of self-employment income, for a maximum tax of $19,864.80 (12.4% of $160,200), plus
- 2.9% Medicare tax on the first $200,000 of self-employment income ($250,000 of combined self-employment income on a joint return, $125,000 on a return of a married individual filing separately), plus
- 3.8% (2.9% regular Medicare tax plus 0.9% additional Medicare tax) on all self-employment income in excess of $200,000 ($250,000 of combined self-employment income on a joint return, $125,000 for married taxpayers filing a separate return).
Employees with more than one employer
What happens if one of your employees works for your business and has a second job? That employee would have taxes withheld from two different employers. Can the employee ask you to stop withholding Social Security tax once he or she reaches the wage base threshold? Unfortunately, no. Each employer must withhold Social Security taxes from the individual’s wages, even if the combined withholding exceeds the maximum amount that can be imposed for the year. Fortunately, the employee will get a credit on his or her tax return for any excess withheld.
Contact us if you have questions about 2023 payroll tax filing or payments. We can help ensure you stay in compliance.
Providing fringe benefits to employees with no tax strings attached
Businesses can provide benefits to employees that don’t cost them much or anything at all. However, in some cases, employees may have to pay tax on the value of these benefits.
Here are examples of two types of benefits which employees generally can exclude from income:
- A no-additional-cost benefit. This involves a service provided to employees that doesn’t impose any substantial additional cost on the employer. These services often occur in industries with excess capacity. For example, a hotel might allow employees to stay in vacant rooms or a golf course may allow employees to play during slow times.
- A de minimis fringe benefit. This includes property or a service, provided infrequently by an employer to employees, with a value so small that accounting for it is unreasonable or administratively impracticable. Examples are coffee, the personal use of a copier or meals provided occasionally to employees working overtime.
However, many fringe benefits are taxable, meaning they’re included in the employees’ wages and reported on Form W-2. Unless an exception applies, these benefits are subject to federal income tax withholding, Social Security (unless the employee has already reached the year’s wage base limit) and Medicare.
Court case provides lessons
The line between taxable and nontaxable fringe benefits may not be clear. As illustrated in one recent case, some taxpayers get into trouble if they cross too far over the line.
A retired airline pilot received free stand-by airline tickets from his former employer for himself, his spouse, his daughter and two other adult relatives. The value of the tickets provided to the adult relatives was valued $5,478. The airline reported this amount as income paid to the retired pilot on Form 1099-MISC, which it filed with the IRS. The taxpayer and his spouse filed a joint tax return for the year in question but didn’t include the value of the free tickets in gross income.
The IRS determined that the couple was required to include the value of the airline tickets provided to their adult relatives in their gross income. The retired pilot argued the value of the tickets should be excluded as a de minimis fringe.
The U.S. Tax Court agreed with the IRS that the taxpayers were required to include in gross income the value of airline tickets provided to their adult relatives. The value, the court stated, didn’t qualify for exclusion as a no-additional-cost service because the adult relatives weren’t the taxpayers’ dependent children. In addition, the value wasn’t excludable under the tax code as a de minimis fringe benefit “because the tickets had a value high enough that accounting for their provision was not unreasonable or administratively impracticable.” (TC Memo 2022-36)
You may be able to exclude from wages the value of certain fringe benefits that your business provides to employees. But the requirements are strict. If you have questions about the tax implications of fringe benefits, contact us.
What local transportation costs can your business deduct?
You and your small business are likely to incur a variety of local transportation costs each year. There are various tax implications for these expenses.
First, what is “local transportation?” It refers to travel in which you aren’t away from your tax home (the city or general area in which your main place of business is located) long enough to require sleep or rest. Different rules apply if you’re away from your tax home for significantly more than an ordinary workday and you need sleep or rest in order to do your work.
Costs of traveling to your work location
The most important feature of the local transportation rules is that your commuting costs aren’t deductible. In other words, the fare you pay or the miles you drive simply to get to work and home again are personal and not business miles. Therefore, no deduction is available. This is the case even if you work during the commute (for example, via a cell phone, or by performing business-related tasks while on the subway).
An exception applies for commuting to a temporary work location that’s outside of the metropolitan area in which you live and normally work. “Temporary,” for this purpose, means a location where your work is realistically expected to last (and does in fact last) for no more than a year.
Costs of traveling from work location to other sites
On the other hand, once you get to the work location, the cost of any local trips you take for business purposes is a deductible business expense. So, for example, the cost of travel from your office to visit a customer or pick up supplies is deductible. Similarly, if you have two business locations, the costs of traveling between them is deductible.
If your deductible trip is by taxi or public transportation, save a receipt if possible or make a notation of the expense in a logbook. Record the date, amount spent, destination and business purpose. If you use your own car, note miles driven instead of the amount spent. Note also any tolls paid or parking fees and keep receipts.
You’ll need to allocate your automobile expenses between business and personal use based on miles driven during the year. Proper recordkeeping is crucial in the event the IRS challenges you.
Your deduction can be computed using:
- A standard mileage rate (58.5¢ per business mile driven between Jan. 1 and June 30, 2022, and 62.5¢ per business mile driven between July 1 and Dec. 31, 2022) plus tolls and parking, or
- Actual expenses (including depreciation, subject to limitations) for the portion of car use allocable to the business. For this method, you’ll need to keep track of all costs for gas, repairs and maintenance, insurance, interest on a car loan and any other car-related costs.
Employees versus self-employed
From 2018 – 2025, employees, may not deduct unreimbursed local transportation costs. That’s because “miscellaneous itemized deductions” — a category that includes employee business expenses — are suspended (not allowed) for 2018 through 2025. However, self-employed taxpayers can deduct the expenses discussed in this article. But beginning with 2026, business expenses (including unreimbursed employee auto expenses) of employees are scheduled to be deductible again, as long as the employee’s total miscellaneous itemized deductions exceed 2% of adjusted gross income.
Contact us with any questions or to discuss the matter further.
Worried about an IRS audit? Prepare in advance
IRS audit rates are historically low, according to a recent Government Accountability Office (GAO) report, but that’s little consolation if your return is among those selected to be examined. Plus, the IRS recently received additional funding in the Inflation Reduction Act to improve customer service, upgrade technology and increase audits of high-income taxpayers. But with proper preparation and planning, you should fare well.
From tax years 2010 to 2019, audit rates of individual tax returns decreased for all income levels, according to the GAO. On average, the audit rate for all returns decreased from 0.9% to 0.25%. IRS officials attribute this to reduced staffing as a result of decreased funding. Businesses, large corporations and high-income individuals are more likely to be audited but, overall, all types of audits are being conducted less frequently than they were a decade ago.
There’s no 100% guarantee that you won’t be picked for an audit, because some tax returns are chosen randomly. However, the best way to survive an IRS audit is to prepare in advance. On an ongoing basis you should systematically maintain documentation — invoices, bills, cancelled checks, receipts, or other proof — for all items to be reported on your tax returns. Keep all records in one place.
It also helps to know what might catch the attention of the IRS. Certain types of tax-return entries are known to involve inaccuracies so they may lead to an audit. Here are a few examples:
- Significant inconsistencies between tax returns filed in the past and your most current return,
- Gross profit margin or expenses markedly different from those of other businesses in your industry, and
- Miscalculated or unusually high deductions.
Certain types of deductions may be questioned by the IRS because there are strict recordkeeping requirements for them — for example, auto and travel expense deductions. In addition, an owner-employee’s salary that’s much higher or lower than those at similar companies in his or her location may catch the IRS’s eye, especially if the business is structured as a corporation.
If you receive a letter
If you’re selected for an audit, you’ll be notified by letter. Generally, the IRS doesn’t make initial contact by phone. But if there’s no response to the letter, the agency may follow up with a call.
Many audits simply request that you mail in documentation to support certain deductions you’ve claimed. Only the strictest version, the field audit, requires meeting with one or more IRS auditors. (Note: Ignore unsolicited email or text messages about an audit. The IRS doesn’t contact people in this manner. These are scams.)
The tax agency doesn’t demand an immediate response to a mailed notice. You’ll be informed of the discrepancies in question and given time to prepare. Collect and organize all relevant income and expense records. If anything is missing, you’ll have to reconstruct the information as accurately as possible based on other documentation.
If you’re audited, our firm can help you:
- Understand what the IRS is disputing (it’s not always clear),
- Gather the specific documents and information needed, and
- Respond to the auditor’s inquiries in the most effective manner.
The IRS normally has three years within which to conduct an audit, and an audit probably won’t begin until a year or more after you file a return. Don’t panic if the IRS contacts you. Many audits are routine. By taking a meticulous, proactive approach to tracking, documenting and filing your company’s tax-related information, you’ll make an audit less painful and even decrease the chances you’ll be chosen in the first place.