John W. Adams, CPA, Tax Services

The Business Owner

Tax Accounting Methods

Your business' choice of an accounting method has significant tax impact. There are two basic methods: cash and accrual. Under the cash method, a business reports income when it is received and reports expenses when cash is disbursed. Under the accrual method, a business reports income when the business has the right to receive the income and reports expenses when all events which create the liability have occurred and the amount of the expense is reasonably determinable.

In general, your business must use the accrual method if it is a Corporation (other than an S Corporation) of a partnership with at least one partner which is a regular C Corporation. Exceptions exist for farming businesses, qualified personal service Corporations and entities with average annual gross receipts of less than $5 million for the prior 3 tax years. The accrual method is generally mandatory for purchases and sales where inventories must be used.

At year end, an accrual-basis entity can delay shipment of products or providing services until the beginning of the next year. If a shipment will be made close to the end of the year, consider shipping F.O.B destination instead of F.O.B. shipping point. You will not recognize income until title passes, presumably in the next tax year.

A cash-basis business will want to delay year-end billing so that payment will not be received until the next tax year. The cash-basis business will also want to incur any planning expenditures into the current tax year, rather than wait until the following year.

Your Business Status

Whether your business is incorporated or not and your chose of business entity (Partnership, Corporation, LLC, LLP, etc.) will largely determine how your business income will be taxed.

The "C" Corporation - Operating as a regular C Corporation may provide numerous tax advantages. The graduated corporation tax rates are often a plus. As you can see from the accompanying rate table, Corporation income may be taxed at a rate lower than your personal income.

Also, owners employed by the Corporation can take advantage of several tax-free fringe benefits not available to individuals who own unincorporated businesses.

$0 to $50K 15%

$50K to $75K 25%

$75K to $100K 34%

$100K to $335K 39%

$335K to $10 million 34%

Despite these advantages, C corporation owners also face the potential of double taxation. C corporations pay corporation-level taxes on their earnings. Then, when the Company distributes those earnings to owners as dividends, the owners pay tax on the dividends at their tax rates.

The Company can deduct a reasonable salary it pays you for your work in the business. Although you have to pay income tax on the salary, the company can deduct the payments as an expense.

Another way to get income from a Company is to purchase land, a building, or equipment and lease it back to your company. The rent must be reasonable. Your company deducts the rent expense and you pay tax on the rental income.

Consider a "charitable bailout" if the value of your solely owned Corporation has increased substantially over the years and you plan on making a sizable charitable contribution in 1997. Instead of donating cash, you could give that charity shares of stock in your Company. You'll be able to deduct the value of the contributed stock on your tax return. Moreover, you will retain the cash you would have contributed for other personal use. Your Company can later buy back the stock, so you'll still own all the Company yourself.

"S" Corporations - operating as an S Corporation generally avoids the problem of double taxation. With an S Corporation, shareholders report all Corporation income, losses, deductions, and credits on their personal tax returns. Income is reportable whether or not it is acutely distributed.

If you're considering an S Corporation, you'll want to take into account several new tax law changes. For tax years beginning after 1996, the maximum number of shareholders is increased form 35 to 75 and an additional type of trust, an "electing small business trust," may be a shareholder. Also, an S Corporation can now own 80% or more of the stock of a regular C Corporation and can own a "qualified subchapter S subsidiary." The parent S Corporation must own 100% if the stock of the S subsidiary.

What if you terminated your S Corporation status and would like to switch back in 1997? Under the new S Corporation rules, a Corporation that terminated its subchapter S election for 1996 or earlier tax year may re-elect S status without Internal Revenue Service consent and without the waiting period.

Paying taxes on your share of the company's undistributed income helps you when you eventually sell your S Corporation stock. That's because the income increases your adjusted tax basis in the Company stock.

if you think your Company may show a loss for 1997, make sure you have sufficient basis in your shares to deduct the loss on your personal return. Loans you make to the Company can increase your basis.

S Corporation shareholders can take distributions from the business without withholding income or paying payroll taxes on them. Be sure to pay yourself a reasonable salary if you work in the business, however. The Internal Revenue Service is always on the lookout for active shareholders attempting to avoid FICA taxes by taking distributions rather than salary.

Limited Liability Companies - Many business owners seeking to limit their personal liability for debts and obligations of the business have elected to operate as LLCs. When all requirements are met, an LLC is taxed as a partnership instead of a Corporation for federal tax purposes. However, in contrast to a partnership, an LLC may allow all owners to be involved in managing the business without exposure to personal liability. A partnership must have at least 1 general partner who remains personally liable.

All LLC income, losses, deductions, and credits "flow through" to the owners, who report their respective shares or these items in their personal tax returns. Unlike an S Corporation, which must divide these items pro rata among shareholders, an LLC has the flexibility to specifically allocate selected items to certain owners. This option can give you considerable planning flexibility.

Below is a chart outlining the various characteristics of these 3 types of entities:

C Corporation vs. S Corporation vs. LLC

Characteristic	Shared By
Limited Liability	C,S,LLC
Entity-Level Tax	C
Double Taxation	C
Income/Expense Allocations	S (pro-rata), LLC (flexible)
Ownership restrictions	S
Self-employment tax on business income	LLC

Business Equipment

No matter what form of business you choose to operate under, chances are you will expend money on equipment purchases. Take the time to plan you acquisitions to ensure the best tax results

Buy or Lease - All kinds of leasing deals are available on all kinds of equipment. With a true lease, you can deduct your business-related lease payments in full. If your lease more closely resembles an installment purchase, you have to treat it as such. In that case, your write-offs take the form of depreciation deductions and interest expense. You have to "run-the-numbers" to decide which is better.

Every year, you can "expense" (write off all at once instead of depreciating) within limits, the cost of business equipment or other eligible personal property you acquire and use in your business. The limit for 1996 is $17,500 in 1997 it will be $18,000. This is often referred to as the "Section 179" tax deduction - in reference to the Internal Revenue Service code section. Due to recent tax legislation, this deduction will be increase in stages to $25K by the year 2003.

Business Deduction and Credits

Businesses can deduct many, but not all, of the costs of doing business. In addition many valuable tax credits are available.

Deduction timing - Corporations that use an accrual basis of accounting should pay bonuses and vacation pay related to their current tax year within 2 and one half months after the close of the tax year. Otherwise, the expense generally won't be deductible until actually paid. A similar rule applies to charitable contributions.

Regular "C" Corporations may have a special tax savings opportunity when they contribute inventory to a qualified charitable organization for the use in caring for the ill, the needy, or infants. When all the requirements are met, the Company generally can deduct the inventory's cost plus one half of the mark-up.
Your Corporation has until the extended due date of its tax return to make deductible profit sharing contributions for the previous tax year. Waiting to make the contribution can give the business use of the money for a possible 8.5 months after the end of the year.

Business Bad Debts - amounts owed you that you can't collect are deductible when you have an actual loss of money or when you have already reported the amount you were to be paid in income. A business bad debt has to closely relate to your business activity.

Meals and Entertainment Expense - When all requirements are met, your business may deduct only half the cost of ordinary and necessary expenses for entertaining a client or customer.

The Self-employed - The most over looked area of expenses for the self-employed has to do with "cross-over" expenses such as business use of personal auto and other personal assets as well as the home. It is critical that the small business owner not forget personal assets that have been used in the production of income. Allocate the expense of these assets into the "Schedule C."

The Work Opportunity and Research & Experiment Credit - the Work Opportunity Credit replaces the targeted jobs credit. The new credit generally is equal to 35% of qualified first year wages. It is available on an elective basis for employers hiring individuals from specific targeted groups. The R&D credit is reinstated for the period 7/1/96 through 5/31/97.

Disabled Access Credit - "Eligible small businesses" can claim a tax credit of up to $5K for costs associated with making the business more accessible to disabled individuals. Various requirements must be met.

Vehicle expenses - You are allowed to use either the Internal Revenue Service standard 31 cents a mile or depreciation and actual expenses. Which is more advantageous depends on how many miles you drive. Also keep in mind that there is a direct connection between car usage and the home office. It is difficult to argue the case for a home office if the auto deduction shows excessive auto mileage. The Internal Revenue Service allowance takes the place of fixed operating costs such as gas, oil, repairs, license and tags, insurance, and depreciation. To use the allowance at all the election must be made in the first year of the business use. If you start out taking actual expenses you must stay with that method. If you start out taking the allowance method you may switch to the actual method in later years if it is beneficial. Auto depreciation is limited by the so called "luxury auto limitations." This rule caps the amount of deprecation expense that can be taken in the first 5 years.

This can be overcome by putting the company logo or name on the side of the vehicle. Another way of avoiding the Luxury auto limitations is by the purchase of so called sports utility vehicles (SUV's). Many of these vehicles pass the weight limit that the Internal Revenue Service uses to judge "Luxury Autos" (5000 lb.).

Be sure to consult your CPA!

If you feel any of the matters discussed in this seminar might concern you or your business: this is not intended to be the complete story. Also, be sure your tax advisor is one of our area's many qualified Certified Public Accountants or Enrolled Agents. Last year only 3% of the tax preparer penalties assessed by the Internal Revenue Service was given to C.P.A.'s or E.A.'s, the balance, 97%, was assessed on so-called independent "tax preparers." Be smart, entrust this very important job to a qualified professional !

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