The World of Computer Software/World_Of_Computer_Software-02-387-Vol-3of3.iso/s/sba93_1a.zip/F110.SBE

Text File | 1993-01-27 | 11KB | 216 lines

@185 CHAP 2

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

@Q      "Being boss doesn't make you right; it just makes
@Q       you boss." -- Milton Metz

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.

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.

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 prefer to use a corporation rather than a
proprietorship or partnership.  Unlimited personal liabil-
ity is perhaps the major disadvantage of operating a busi-
ness 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.  Similarly, if there is a profit, the income
may be taxed at a lower rate than in an incorporated busi-
ness, since corporate rates are now higher than individual
federal income tax rates.  The maximum corporate rate is
34% vs. a maximum individual tax rate of 31% on high levels
of income.  (At certain "phase-out" levels of income, cor-
porate rates go up to 39% and individual rates to 32% or
somewhat more, depending on number of personal exemptions
phased-out, itemized deduction phased-out, etc.)


For certain professionals, such as lawyers, physicians, ac-
countants, architects, etc., whose corporations are subject
to a flat tax rate of 34% if incorporated, a sole proprie-
torship is now generally a much more attractive legal form
of doing business.  Since the former advantages of corpor-
ate pension and profit sharing plans vs. Keogh plans for
unincorporated firms are now virtually non-existent, and
since professional corporations usually do not provide pro-
tection from malpractice liability in most states, there
are fewer and fewer reasons for professionals to incorpor-
ate 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 $1,500 (ignoring any FICA tax on his or
her income).

      ┌───────────────────────────────────────────────────┐
      │ EXAMPLE 1:    Your business  generated an  annual │
      │ profit of $50,000 in 1991.  As a sole proprietor, │
      │ you would pay joint income taxes of $11,391, 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 $18,456.   If, │
      │ instead, your business were a C corporation  (but │
      │ not a "qualified  personal  service  corporation" │
      │ subject to a flat 34% 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 $23,122 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  $5,380.  Accordingly, if you │
      │ had incorporated,  total tax liability  would be: │
      │                                                   │
      │           Corporate income tax           $ 3,463  │
      │           Personal income tax              5,380  │
      │           FICA (on you and corp.)          3,825  │
      │                                           ------  │
      │           Total current tax liability    $12,668  │
      │                                           ======  │
      └───────────────────────────────────────────────────┘

       Thus, in this example, using a "C" corporation
       to split income would save $5,788, or over 30%, in
       current taxes, as compared to a sole proprietorship.
       (Note that even if the corporation were subject to
       the flat 34% tax rate, there would still be a tax
       savings of $1,390.)

      ┌───────────────────────────────────────────────────┐
      │ 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  $41,447│
      │ of income tax and  $10,247 of self-employment tax,│
      │ or a total of $51,694.   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│
      │ 1991 taxable income would be $75,000 - FICA tax of│
      │ $4,398 = $70,602.   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 $12,651 and│
      │ your individual income tax  would be $19,464.  Ac-│
      │ cordingly, if incorporated,  the total tax liabil-│
      │ ity would have been as follows:                   │
      │                                                   │
      │          Corporate income tax           $12,651   │
      │          Personal income tax             19,466   │
      │          FICA (on you and corp.)          8,796   │
      │                                          ------   │
      │          Total current tax liability    $40,913   │
      │                                          ======   │
      └───────────────────────────────────────────────────┘

       Thus, in this example, using a "C" corporation
       to split income would save $10,781, or more than
       20%, in current taxes, as compared to a sole pro-
       prietorship.  (But note that in this case, if the
       corporation were subject to the flat 34% tax
       rate, there would be a $573 tax DISadvantage if
       incorporated, versus doing business as a propri-
       etorship.)

      ┌───────────────────────────────────────────────────┐
      │  EXAMPLE 3:  Assume this time that you really hit │
      │  it big, and that the business made $500,000 pre- │
      │  tax in 1991, before paying you a salary of, say, │
      │  $100,000.   This time (regardless of whether the │
      │  corporation  is  a "qualified  personal  service │
      │  corporation") the total current tax liability is │
      │  $171,119 if incorporated, versus $161,207 if you │
      │  had remained a  sole proprietor.  Thus,  at this │
      │  high income level, being a corporation COSTS you │
      │  almost $10,000 in additional federal tax, rather │
      │  than saving taxes!                               │
      └───────────────────────────────────────────────────┘

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.

Another DISadvantage of sole proprietorships (and partner-
ships and S corporations) is that they cannot obtain a num-
ber 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 as a C corporation.