Small Business Tax briefs
Tax-wise ways to take cash from your corporation while avoiding dividend treatment
If you want to withdraw cash from your closely held corporation at a low tax cost, the easiest way is to distribute cash as a dividend. However, a dividend distribution isn’t tax efficient since it’s taxable to you to the extent of your corporation’s “earnings and profits,” but it’s not deductible by the corporation.
5 different approaches
Thankfully, there are some alternative methods that may allow you to withdraw cash from a corporation while avoiding dividend treatment. Here are five possible options:
1. Salary. Reasonable compensation that you, or family members, receive for services rendered to the corporation is deductible by the business. However, it’s also taxable to the recipient(s). The same rule applies to any compensation (in the form of rent) that you receive from the corporation for the use of property. In either case, the amount of compensation must be reasonable in relation to the services rendered or the value of the property provided. If it’s excessive, the excess will be nondeductible and treated as a corporate distribution.
2. Fringe benefits. Consider obtaining the equivalent of a cash withdrawal in fringe benefits that are deductible by the corporation and not taxable to you. Examples are life insurance, certain medical benefits, disability insurance and dependent care. Most of these benefits are tax-free only if provided on a nondiscriminatory basis to other employees of the corporation. You can also establish a salary reduction plan that allows you (and other employees) to take a portion of your compensation as nontaxable benefits, rather than as taxable compensation.
3. Capital repayments. To the extent that you’ve capitalized the corporation with debt, including amounts that you’ve advanced to the business, the corporation can repay the debt without the repayment being treated as a dividend. Additionally, interest paid on the debt can be deducted by the corporation. This assumes that the debt has been properly documented with terms that characterize debt and that the corporation doesn’t have an excessively high debt-to-equity ratio. If not, the “debt” repayment may be taxed as a dividend. If you make cash contributions to the corporation in the future, consider structuring them as debt to facilitate later withdrawals on a tax-advantaged basis.
4. Loans. You may withdraw cash from the corporation tax-free by borrowing money from it. However, to avoid having the loan characterized as a corporate distribution, it should be properly documented in a loan agreement or a note and be made on terms that are comparable to those on which an unrelated third party would lend money to you. This should include a provision for interest and principal. All interest and principal payments should be made when required under the loan terms. Also, consider the effect of the corporation’s receipt of interest income.
5. Property sales. You can withdraw cash from the corporation by selling property to it. However, certain sales should be avoided. For example, you shouldn’t sell property to a more than 50% owned corporation at a loss, since the loss will be disallowed. And you shouldn’t sell depreciable property to a more than 50% owned corporation at a gain, since the gain will be treated as ordinary income, rather than capital gain. A sale should be on terms that are comparable to those on which an unrelated third party would purchase the property. You may need to obtain an independent appraisal to establish the property’s value.
If you’re interested in discussing any of these ideas, contact us. We can help you get the maximum out of your corporation at the minimum tax cost.
9 tax considerations if you’re starting a business as a sole proprietor
When launching a small business, many entrepreneurs start out as sole proprietors. If you’re launching a venture as a sole proprietorship, you need to understand the tax issues involved. Here are nine considerations:
1. You may qualify for the pass-through deduction. To the extent your business generates qualified business income, you’re currently eligible to claim the 20% pass-through deduction, subject to limitations. The deduction is taken “below the line,” meaning it reduces taxable income, rather than being taken “above the line” against your gross income. However, you can take the deduction even if you don’t itemize deductions and instead claim the standard deduction. Be aware that this deduction is only available through 2025, unless Congress acts to extend it.
2. You report income and expenses on Schedule C of Form 1040. The net income will be taxable to you regardless of whether you withdraw cash from the business. Your business expenses are deductible against gross income and not as itemized deductions. If you have losses, they’ll generally be deductible against your other income, subject to special rules related to hobby losses, passive activity losses and losses from activities in which you weren’t “at risk.”
3. You must pay self-employment taxes. For 2024, you pay self-employment tax (Social Security and Medicare) at a 15.3% rate on your net earnings from self-employment up to $168,600, and Medicare tax only at a 2.9% rate on the excess. An additional 0.9% Medicare tax (for a total of 3.8%) is imposed on self-employment income in excess of $250,000 for joint returns, $125,000 for married taxpayers filing separate returns and $200,000 in all other cases. Self-employment tax is imposed in addition to income tax, but you can deduct half of your self-employment tax as an adjustment to income.
4. You generally must make quarterly estimated tax payments. For 2024, these are due April 15, June 17, September 16 and January 15, 2025.
5. You can deduct 100% of your health insurance costs as a business expense. This means your deduction for medical care insurance won’t be subject to the rule that limits medical expense deductions.
6. You may be able to deduct home office expenses. If you work from a home office, perform management or administrative tasks there, or store product samples or inventory at home, you may be entitled to deduct an allocable part of certain expenses, including mortgage interest or rent, insurance, utilities, repairs, maintenance and depreciation. You may also be able to deduct travel expenses from a home office to another work location.
7. You should keep complete records of your income and expenses. Specifically, you should carefully record your expenses in order to claim all the tax breaks to which you’re entitled. Certain expenses, such as automobile, travel, meals, and home office expenses, require extra attention because they’re subject to special recordkeeping rules or deductibility limits.
8. You have more responsibilities if you hire employees. For example, you need to get a taxpayer identification number and withhold and pay over payroll taxes.
9. You should consider establishing a qualified retirement plan. The advantages are that amounts contributed to it are deductible at the time of the contributions and aren’t taken into income until they’re withdrawn. You might consider a SEP plan, which requires minimal paperwork. A SIMPLE plan is also available to sole proprietors and offers tax advantages with fewer restrictions and administrative requirements. If you don’t establish a retirement plan, you may still be able to contribute to an IRA.
Turn to us
Contact us if you want additional information regarding the tax aspects of your business, or if you have questions about reporting or recordkeeping requirements.
Update on IRS efforts to combat questionable Employee Retention Tax Credit claims
The Employee Retention Tax Credit (ERTC) was introduced back when COVID-19 temporarily closed many businesses. The credit provided cash that helped enable struggling businesses to retain employees. Even though the ERTC expired for most employers at the end of the third quarter of 2021, it could still be claimed on amended returns after that.
According to the IRS, it began receiving a deluge of “questionable” ERTC claims as some unscrupulous promotors asserted that large tax refunds could easily be obtained — even though there are stringent eligibility requirements. “We saw aggressive marketing around this credit, and well-intentioned businesses were misled into filing claims,” explained IRS Commissioner Danny Werfel.
Last year, in a series of actions, the IRS began cracking down on potentially fraudulent claims. They began with a moratorium on processing new ERTC claims submitted after September 14, 2023. Despite this, the IRS reports that it still has more than $1 billion in ETRC claims in process and they are receiving additional scrutiny.
Here’s an update of the other compliance efforts that may help your business if it submitted a problematic claim:
1. Voluntary Disclosure Program. Under this program, businesses can “pay back the money they received after filing ERTC claims in error,” the IRS explained. The deadline for applying is March 22, 2024. If the IRS accepts a business into the program, the employer will need to repay only 80% of the credit money it received. If the IRS paid interest on the employer’s ERTC, the employer doesn’t need to repay that interest and the IRS won’t charge penalties or interest on the repaid amounts.
The IRS chose the 80% repayment amount because many of the ERTC promoters charged a percentage fee that they collected at the time (or in advance) of the payment, so the recipients never received the full credit amount.
Employers that are unable to repay the required 80% may be considered for an installment agreement on a case-by-case basis, pending submission and review of an IRS form that requires disclosing a significant amount of financial information.
To be eligible for this program, the employer must provide the IRS with the name, address and phone number of anyone who advised or assisted them with their claims, and details about the services provided.
2. Special withdrawal program. If a business has a pending claim for which it has eligibility concerns, it can withdraw the claim. This program is also available to businesses that were paid money from the IRS for claims but haven’t cashed or deposited the refund checks. The tax agency reported that more than $167 million from pending applications had been withdrawn through mid-January.
Commissioner Werfel said the disclosure program “provides a much-needed option for employers who were pulled into these claims and now realize they shouldn’t have applied.”
In addition to the programs described above, the IRS has been sending letters to thousands of taxpayers notifying them their claims have been disallowed. These cases involve entities that didn’t exist or didn’t have employees on the payroll during the eligibility period, “meaning the businesses failed to meet the basic criteria” for the credit, the IRS stated. Another set of letters will soon be mailed to credit recipients who claimed an erroneous or excessive credit. They’ll be informed that the IRS will recapture the payments through normal collection procedures.
There’s an application form that employers must file to participate in the Voluntary Disclosure Program and procedures that must be followed for the withdrawal program. Other rules apply. Contact us for assistance or with questions.
Tax-favored Qualified Small Business Corporation status could help you thrive
Operating your small business as a Qualified Small Business Corporation (QSBC) could be a tax-wise idea.
Tax-free treatment for eligible stock gains
QSBCs are the same as garden-variety C corporations for tax and legal purposes — except QSBC shareholders are potentially eligible to exclude from federal income tax 100% of their stock sale gains. That translates into a 0% federal income tax rate on QSBC stock sale profits! However, you must meet several requirements set forth in Section 1202 of the Internal Revenue Code, and not all shares meet the tax-law description of QSBC stock. Finally, there are limitations on the amount of QSBC stock sale gain that you can exclude in any one tax year (but they’re unlikely to apply).
Stock acquisition date is key
The 100% federal income tax gain exclusion is only available for sales of QSBC shares that were acquired on or after September 28, 2010.
If you currently operate as a sole proprietorship, single-member LLC treated as a sole proprietorship, partnership or multi-member LLC treated as a partnership, you’ll have to incorporate the business and issue yourself shares to attain QSBC status.
Important: The act of incorporating a business shouldn’t be taken lightly. We can help you evaluate the pros and cons of taking this step.
Here are some more rules and requirements:
- Eligibility. The gain exclusion break isn’t available for QSBC shares owned by another C corporation. However, QSBC shares held by individuals, LLCs, partnerships, and S corporations are potentially eligible.
- Holding period. To be eligible for the 100% stock sale gain exclusion deal, you must hold your QSBC shares for over five years. For shares that haven’t yet been issued, the 100% gain exclusion break will only be available for sales that occur sometime in 2029 or beyond.
- Acquisition of shares. You must acquire the shares after August 10, 1993, and they generally must be acquired upon original issuance by the corporation or by gift or inheritance.
- Businesses that aren’t eligible. The corporation must actively conduct a qualified business. Qualified businesses don’t include those rendering services in the fields of health; law; engineering; architecture; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; businesses where the principal asset is the reputation or skill of employees; banking; insurance; leasing; financing; investing; farming; production or extraction of oil, natural gas, or other minerals for which percentage depletion deductions are allowed; or the operation of a hotel, motel, restaurant, or similar business.
- Asset limits. The corporation’s gross assets can’t exceed $50 million immediately after your shares are issued. If after the stock is issued, the corporation grows and exceeds the $50 million threshold, it won’t lose its QSBC status for that reason.
2017 law sweetened the deal
The Tax Cuts and Jobs Act made a flat 21% corporate federal income tax rate permanent, assuming no backtracking by Congress. So, if you own shares in a profitable QSBC and you eventually sell them when you’re eligible for the 100% gain exclusion break, the 21% corporate rate could be all the income tax that’s ever owed to Uncle Sam.
Tax incentives drive the decision
Before concluding that you can operate your business as a QSBC, consult with us. We’ve summarized the most important eligibility rules here, but there are more. The 100% federal income tax stock sale gain exclusion break and the flat 21% corporate federal income tax rate are two strong incentives for eligible small businesses to operate as QSBCs.
Giving gifts and throwing parties can help show gratitude and provide tax breaks
The holiday season is here. During this festive season, your business may want to show its gratitude to employees and customers by giving them gifts or hosting holiday parties. It’s a good time to review the tax rules associated with these expenses. Are they tax deductible by your business and is the value taxable to the recipients?
Many businesses want to show their employees appreciation during the holiday time. In general, anything of value that you transfer to an employee is included in his or her taxable income (and, therefore, subject to income and payroll taxes) and deductible by your business.
But there’s an exception for noncash gifts that constitute a “de minimis” fringe benefit. These are items small in value and given so infrequently that they are administratively impracticable to account for. Common examples include holiday turkeys or hams, gift baskets, occasional sports or theater tickets (but not season tickets), and other low-cost merchandise.
De minimis fringe benefits aren’t included in your employees’ taxable income yet they’re still deductible by your business. Unlike gifts to customers, there’s no specific dollar threshold for de minimis gifts. However, many businesses use an informal cutoff of $75.
Key point: Cash gifts — as well as cash equivalents, such as gift cards — are included in an employee’s income and subject to payroll tax withholding regardless of how small they are and infrequently they’re given.
If you make gifts to customers or clients, they’re only deductible up to $25 per recipient, per year. For purposes of the $25 limit, you don’t need to include “incidental” costs that don’t substantially add to the gift’s value, such as engraving, gift wrapping, packaging or shipping. Also excluded from the $25 limit is branded marketing collateral — such as small items imprinted with your company’s name and logo — provided they’re widely distributed and cost less than $4 each.
The $25 limit is for gifts to individuals. There’s no set limit on gifts to a company (for example, a gift basket for all of a customer’s team members to share) as long as the cost is “reasonable.”
A holiday party
Under the Tax Cuts and Jobs Act, certain deductions for business-related meals were reduced and the deduction for business entertainment was eliminated. However, there’s an exception for certain recreational activities, including holiday parties.
Holiday parties are fully deductible (and excludible from recipients’ income) so long as they’re primarily for the benefit of employees who aren’t highly compensated and their families. If customers, and others also attend, a holiday party may be partially deductible.
Sending holiday cards is a nice way to show customers and clients your appreciation. If you use the cards to promote your business, you can probably deduct the cost. Incorporate your company name and logo, and you might even want to include a discount coupon for your products or services.
Boost morale with festive gestures
If you have questions about giving holiday gifts to employees or customers or throwing a holiday party, contact us. We can explain the tax implications.