Stacey Small has a small salon that she has run for a few years as a sole propri
ID: 2477538 • Letter: S
Question
Stacey Small has a small salon that she has run for a few years as a sole proprietorship. The proprietorship uses the cash method of accounting and the calendar year as its tax year. Stacey needs additional capital for expansion and knows two people who might be interested in investing. One would like to practice hairdressing in the salon. The other would only invest.
Stacey wants to know the tax consequences of incorporating the business. Her business assets include a building, equipment, accounts receivable and cash. Liabilities include a mortgage on the building and a few accounts payable, which are deductible when paid.
Write a memo to Stacey explaining the tax consequences of the incorporation. As part of your memo examine the possibility of having the corporation issue common and preferred stock and debt for the shareholders’ property and money.
Explanation / Answer
Date: December 06, 2015
From: XYZ, CPA
Re: Incorporation of business and their tax consequences
Facts
The facts that are known for the taxpayer Stacey Small and their relevance. Stacy is a sole proprietor form of a business of running a small salon for a few years. She follows the cash method of accounting and consider calendar year. She want to raise the additional capital for expansion and she knows two people can be interested in investing. One of the person likes to practice hairdressing in the salon. The other would only invest and won’t do any work. She had following assets a building, equipment, accounts receivable and cash and her liabilities include a mortgage on the building and a few accounts payable, which are deductible when paid.
Issues
There are two type of corporation best for Stacy, S Corporation or C Corporation, is a matter of judgment on part of the taxpayer. The S Corporation would require taxation at the individual stockholder after pass through of profits. The C Corporation would require taxation of profits to the corporation, before the taxpayer received dividend payments or capital gains on sale of stock shares.
Applicable Law
Section 11 of the United States Tax Code (Chapter 26) states the rate of taxation for a corporation as,
The amount of the tax imposed by subsection (a) shall be the sum of—
(A) 15 percent of so much of the taxable income as does not exceed $50,000,
(B) 25 percent of so much of the taxable income as exceeds $50,000 but does not exceed $75,000,
(C) 34 percent of so much of the taxable income as exceeds $75,000 but does not exceed $10,000,000, and
(D) 35 percent of so much of the taxable income as exceeds $10,000,000.
Analysis
1. Incorporation would provide the taxpayer an entity easier for expansion into issuing equity and different kinds of stock later, yet with a greater tax burden, taxation both to the corporation and individual taxpayer. This would not be so under a sole proprietorship.
2. The taxpayer could conveniently provide investment into stock ownership as an active employee and passive investor under a corporation. This would not be the case under a sole proprietorship.
3. The C Corporation would enable the investor to control profits received and resulting tax liability, whereas the S Corporation would permit less control by the taxpayer over their individual taxable profits.
4. Even as a corporation, the taxpayer could instead receive a loan from the individual investors, rather than granting stock ownership, providing them a guaranteed rate of annual return. This would provide the capital desired by the taxpayer without relinquishing ownership of the company.
5. The taxpayer would have an increased burden of filing Form 1120, which is not required as a sole proprietorship.
6. The taxpayer would have opportunity to separate legal liability of the corporation from personal liability to the individual, an opportunity that would be attractive with increased investment and ownership in the company.
7. A corporation permits deductibility of owner salary, as well as deductibility of retirement matching and public transit expenses. A sole proprietorship does not.
8. Dividends distributed to shareholders of a C corp. can be taxed as qualified dividends and are taxed to the individual shareholder at 15%.
Conclusions
It is my recommendation that Stacy should incorporate as an S Corporation.
Date: December 06, 2015
From: XYZ, CPA
Re: Incorporation of business and their tax consequences
Facts
The facts that are known for the taxpayer Stacey Small and their relevance. Stacy is a sole proprietor form of a business of running a small salon for a few years. She follows the cash method of accounting and consider calendar year. She want to raise the additional capital for expansion and she knows two people can be interested in investing. One of the person likes to practice hairdressing in the salon. The other would only invest and won’t do any work. She had following assets a building, equipment, accounts receivable and cash and her liabilities include a mortgage on the building and a few accounts payable, which are deductible when paid.
Issues
There are two type of corporation best for Stacy, S Corporation or C Corporation, is a matter of judgment on part of the taxpayer. The S Corporation would require taxation at the individual stockholder after pass through of profits. The C Corporation would require taxation of profits to the corporation, before the taxpayer received dividend payments or capital gains on sale of stock shares.
Applicable Law
Section 11 of the United States Tax Code (Chapter 26) states the rate of taxation for a corporation as,
The amount of the tax imposed by subsection (a) shall be the sum of—
(A) 15 percent of so much of the taxable income as does not exceed $50,000,
(B) 25 percent of so much of the taxable income as exceeds $50,000 but does not exceed $75,000,
(C) 34 percent of so much of the taxable income as exceeds $75,000 but does not exceed $10,000,000, and
(D) 35 percent of so much of the taxable income as exceeds $10,000,000.
Analysis
1. Incorporation would provide the taxpayer an entity easier for expansion into issuing equity and different kinds of stock later, yet with a greater tax burden, taxation both to the corporation and individual taxpayer. This would not be so under a sole proprietorship.
2. The taxpayer could conveniently provide investment into stock ownership as an active employee and passive investor under a corporation. This would not be the case under a sole proprietorship.
3. The C Corporation would enable the investor to control profits received and resulting tax liability, whereas the S Corporation would permit less control by the taxpayer over their individual taxable profits.
4. Even as a corporation, the taxpayer could instead receive a loan from the individual investors, rather than granting stock ownership, providing them a guaranteed rate of annual return. This would provide the capital desired by the taxpayer without relinquishing ownership of the company.
5. The taxpayer would have an increased burden of filing Form 1120, which is not required as a sole proprietorship.
6. The taxpayer would have opportunity to separate legal liability of the corporation from personal liability to the individual, an opportunity that would be attractive with increased investment and ownership in the company.
7. A corporation permits deductibility of owner salary, as well as deductibility of retirement matching and public transit expenses. A sole proprietorship does not.
8. Dividends distributed to shareholders of a C corp. can be taxed as qualified dividends and are taxed to the individual shareholder at 15%.
Conclusions
It is my recommendation that Stacy should incorporate as an S Corporation.
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