Monster Media 1996 #14/Monster Media No. 14 (April 1996) (Monster Media, Inc.).ISO/business/sba961.zip/F110.SBE

Text File | 1996-01-01 | 13KB | 251 lines

@185 CHAP 2

      ┌───────────────────────────────────────────────────┐
      │SOLE PROPRIETORSHIPS:  ADVANTAGES AND DISADVANTAGES│
      └───────────────────────────────────────────────────┘

The great advantage of operating a new business as a sole
proprietorship is that it is simple and does not require
any formal action to set it up.  You can start your busi-
ness today as a sole proprietor -- there is no need to wait
for an attorney to draft and file documents or for the gov-
ernment to bless them.  Of course, you will need a business
license in most cases -- and a few states require even a
sole proprietor to register in order to do business legally.
@IF901xx]Since your business is not in existence yet, the relative
@IF901xx]simplicity of starting out as a sole proprietorship is one
@IF901xx]key factor you may want to keep in mind when you start up
@IF901xx]your firm, @NAME.
@IF901xx]
@IF115NV]For example, Nevada requires that your sole proprietorship,
@IF115NV]@NAME, obtain a license.
@IF115WA]For example, the state of Washington requires that your sole
@IF115WA]proprietorship, @NAME, be licensed --
@IF115WA](in all but in a very few instances).

Another advantage of a sole proprietorship is that you can
shift funds in and out of your business account or withdraw
assets from the business with few tax, legal, or other lim-
itations.  By contrast, in a partnership you can generally
withdraw funds only by agreement, and in the case of a cor-
poration, a withdrawal of funds or property will usually be
taxable as a dividend or capital gain and may even violate
the state's corporation laws in some instances.

@IF121  ]NOTE:  Because your business is a corporation, you could in-
@IF121  ]cur a substantial taxable gain if you were to "liquidate" it
@IF121  ]in order to turn it into an unincorporated form of business
@IF121  ]entity.  The taxable gains could either be incurred by the
@IF121  ]owner(s), by @NAME, or by both.
@IF121  ]
@IF121  ]In short, it is much easier to get INTO a corporation, than
@IF121  ]to get out of one.
@IF121  ]
A sole proprietor is the sole owner of his or her business.
If married, however, one's spouse will usually have a one-
half ownership interest in the business in any of the
nine states which currently have community property laws.
@CODE: CA AZ NM NV WA ID TX LA
@STATE is one of the states that has community pro-
perty laws.
@CODE:OF
@CODE: WS
(Wisconsin adopted a community property system of marital
property law in 1986.)
@CODE:OF

As the owner of the business, the sole proprietor is per-
sonally liable for any debts or taxes of the business or
other claims (such as legal damages resulting from a law-
suit).  This is one reason why many entrepreneurs who have
substantial wealth that could be lost if their business
were to fail often prefer to use a corporation rather than a
proprietorship or partnership.  Unlimited personal liability
is perhaps the major disadvantage of operating a business in
the form of a sole proprietorship.

All of the profit or loss from a sole proprietor's business
is taxed to the owner and must be reported on the owner's
federal income tax return, usually on "Schedule C, Income
(or Loss) from a Business or Profession" of their Form
1040.  (Farmers generally report income on Schedule F.)
This can be an advantage, tax-wise, since any losses (un-
less the losses are from what is considered to be a "pas-
sive activity") should be deductible against other income
of the owner.

On the other hand, if there is a profit, the income may be
taxed at a lower rate than in an incorporated business,
since corporate rates are generally lower than individual
federal income tax rates.  The maximum corporate rate is
34% (35% on taxable income over $10 million) vs. a maximum
individual tax rate of 39.6% on taxable income of over
$250,000.  (At certain "phase-out" levels of income, cor-
porate rates go up to 39% and individual rates to somewhat
over 40%, depending on the number of personal exemptions
phased-out, itemized deductions phased-out, etc....)

For certain professionals, such as lawyers, physicians, ac-
countants, architects, etc., whose corporations are subject
to a flat tax rate of 35% if incorporated, a sole proprie-
torship is often a much more attractive legal form of doing
business.  Since the former advantages of corporate pension
and profit sharing plans vs. Keogh plans for unincorporated
firms are now virtually non-existent, and since professional
corporations usually provide little or no protection from
malpractice liability in most states, there are fewer and
fewer reasons for professionals to incorporate since the
1986 Tax Reform Act went into effect.

However, sole proprietorships do have some tax disadvanta-
ges.  For one thing, with a sole proprietorship you don't
have a separate taxpayer entity with which you can split
income, as is possible if you are incorporated.  (A C cor-
poration, by contrast, can still be used to split income
between owner and corporation.  For example, if the busi-
ness generates a $150,000 overall profit, and the profit
can be split evenly between owner and corporation by having
the owner draw $75,000 of salary for the year, there will
be a considerably lower tax bite, taking advantage of the
lower tax brackets for both the individual and the corpora-
tion, than if all the income is taxed to the owner as a
sole proprietor.)

Let us look at 3 examples, assuming in each that you are
married, your spouse earns a salary of $20,000 a year from
a job with an unrelated company, and you have no other in-
come, deductions (other than the standard deduction) or
dependent exemptions.  You and your spouse file joint re-
turns.  If you had no income, the tax on your spouse's in-
come alone would be $1,268 (ignoring any FICA tax on his
or her income).

      ┌───────────────────────────────────────────────────┐
      │ EXAMPLE 1:    Your business  generated an  annual │
      │ profit of $50,000 in 1995.  As a sole proprietor, │
      │ you would pay joint income taxes of $10,307, plus │
      │ self-employment tax on $46,175 of net S/E income, │
      │ or $7,065 ($50,000 - 3825 = $46175) (assuming the │
      │ income of the business is self-employment income) │
      │ so that the total tax liability is $17,372.   If, │
      │ instead, your business were a C corporation  (but │
      │ not a "qualified  personal  service  corporation" │
      │ subject to a flat 35% tax rate), and you drew on- │
      │ ly a $25,000 salary, the corporation is left with │
      │ $25,000 of taxable income,  less $1,913  FICA tax │
      │ it must pay on your salary, or $23,087 net.  Thus │
      │ the corporation would pay a corporate income tax  │
      │ of 15% of $23,087, or $3,463, and your individual │
      │ income tax would be  $5,018.  Accordingly, if you │
      │ had incorporated,  total tax liability  would be: │
      │                                                   │
      │           Corporate income tax           $ 3,463  │
      │           Personal income tax              5,018  │
      │           FICA (on you and corp.)          3,825  │
      │                                           ------  │
      │           Total current tax liability    $12,306  │
      │                                           ======  │
      └───────────────────────────────────────────────────┘

       Thus, in this example, using a "C" corporation
       to split income would save $5,066, or over 29%, in
       current taxes, as compared to a sole proprietorship.
       (Note that even if the corporation were subject to
       the flat 35% tax rate as a personal services corp-
       oration, there would still be a tax savings of $2,004
       in the above 1995 example.)

      ┌───────────────────────────────────────────────────┐
      │ EXAMPLE 2:  Let's assume in this example that your│
      │ business earns $150,000. As a sole proprietorship,│
      │ you and your spouse's  total tax would be  $39,875│
      │ of income tax and  $11,606 of self-employment tax,│
      │ or a total of $51,481.   If you were  incorporated│
      │ and took out half of the corporate pre-tax  profit│
      │ of $150,000 as a $75,000 salary, the corporation's│
      │ 1995 taxable income would be $75,000 - FICA tax of│
      │ $4,882 = $70,118.   At the graduated corporate tax│
      │ rates of only 15% on the first  $50,000 and 25% up│
      │ to $75,000, the corporate tax would be $12,530 and│
      │ your individual income tax  would be $18,296.  Ac-│
      │ cordingly, if incorporated,  the total tax liabil-│
      │ ity would have been as follows:                   │
      │                                                   │
      │          Corporate income tax           $12,530   │
      │          Personal income tax             18,296   │
      │          FICA (on you and corp.)          9,764   │
      │                                          ------   │
      │          Total current tax liability    $40,590   │
      │                                          ======   │
      └───────────────────────────────────────────────────┘

       Thus, in this example, using a "C" corporation
       to split income would save you $10,891, or over
       21%, in current taxes, as compared to a sole pro-
       prietorship.  (But note that in this case, if the
       corporation were subject to the flat 35% tax as
       a personal service corporation, there would be a
       $1,120 tax DISadvantage if incorporated, versus do-
       ing business as a proprietorship.)

      ┌───────────────────────────────────────────────────┐
      │  EXAMPLE 3:  Assume this time that you really hit │
      │  it big, and that the business made $500,000 pre- │
      │  tax in 1995, before paying you a salary of, say, │
      │  $100,000.   This time (unless the corporation is │
      │  a "qualified personal service corporation"), the │
      │  total current tax  liability is $170,428, if in- │
      │  corporated, versus $195,841 if you had  remained │
      │  a sole proprietor.   Thus,  at this  high income │
      │  level, being a corporation saves you $25,413  in │
      │  federal taxes! (And even if you were a qualified │
      │  personal service corporation  corporation,  your │
      │  savings would still be $21,465.) Note that prior │
      │  to the 1993 tax act, which didn't change corpor- │
      │  ate tax rates on income  under $10 million,  you │
      │  would have SAVED about $10,000 by not incorpora- │
      │  ting.  The difference now is the increase in in- │
      │  dividual tax rates to a new top rate of 39.6%.   │
      └───────────────────────────────────────────────────┘

Note that the three foregoing examples only compare CURRENT
tax liability.  Where a corporation is used to split in-
come, the net income that is left in the corporation (net
of tax paid on it) MAY result in additional individual tax
at some indeterminate time in the future, if paid out as a
dividend or in liquidation, or if the stock is sold.  Where
this double taxation occurs in the near future, the advan-
tages of income-splitting in Examples 1 and 2 may be les-
sened, or even non-existent, so you should understand that
income-splitting with a corporation is largely a matter of
tax DEFERRAL and not tax SAVING, for the most part.

Even more importantly, note that the Clinton administration
has recently raised the tax rates on higher-income individ-
uals to as high as 39.6%, versus an increase to only 35%
for corporations (still only 34% at income levels below $10
million).  This could be a further impetus for many busines-
ses to incorporate.

Another DISadvantage of sole proprietorships (also true for
partnerships, limited liability companies, and S corpora-
tions) is that they cannot obtain a number of significant
tax benefits regarding:

        . Group term life insurance coverage;

        . Long-term disability and accidental death
          insurance; and

        . Medical insurance and medical expense reim-
          bursement plans.

To qualify for favorable tax treatment (i.e., deductibili-
ty, without the deductible amount being taxed as wages to
the owners) in connection with such "fringe benefit" plans,
it is necessary to operate your business as a C corporation.
@IF117xx](As @NAME is, at present.)
@IF119xx]Since your firm @NAME is currently set
@IF119xx]up as a @ENTITY, you are losing these benefits.