November 24, 2014

Small Business Taxes: How Business Structure Impacts Allowable Deductions

Whether they’re looking to avoid that ‘double taxation’ conundrum or reduce self-employment and payroll taxes, business owners wonder which legal structure is right for their business, financial situation, and taxes.

money collage

The issue of double taxation and the S Corporation and LLC’s pass-through tax treatment is a key factor when analyzing business structures. But there are other tax implications involved when picking a business structure. Read on to learn how business deductions and employee benefits are affected by your legal structure:

Health Care Deductions

It’s no secret that health care costs are a major expenditure for businesses and individuals alike. A C Corporation is able to deduct 100% of the health insurance it pays for its employees, including those employees who are shareholders. A corporation can also fully deduct the costs of any medical reimbursement plan. And employees of a C Corporation are not taxed on the health benefits they receive.

It’s a different story for the S Corporation or LLC that has elected pass-through tax treatment. In these structures, 2% or greater shareholders are not considered employees. What’s a 2% or greater shareholder? It’s someone who directly or indirectly owns more than 2% of the corporation’s stock or owns stock with more than 2% of the voting power, at any time during the year.

The health insurance of a 2% shareholder can be deducted by the S Corporation only if it is included on the shareholder-employee’s W2 form. This means that these shareholders will need to pay taxes on their medical benefits, although they may be entitled to deduct those medial expenses on their personal tax returns.

If you’re in this situation, it’s imperative that you set up your policy and reimbursements correctly. For example, the healthcare policy should be in the name of the S Corporation and the S Corporation can pay the premiums and report the premium amounts as W2 wages. Or, if the policy is in your own name (and you pay the premiums yourself), the S Corporation must reimburse you and report the premium amount on the W2 wages.

In addition, be aware that an S Corporation needs to make the same coverage benefits to all employees within the same classification. You can offer different plans to different classes of employees (i.e. full-time workers, part-time workers, salaried workers, hourly workers), but you must treat everyone within the same classification consistently. This holds true for retirement plans and other benefits as well.

Retirement Plans

C Corporations and S Corporations (and LLCs electing pass-through treatment) may offer retirement plans to employees, including shareholder employees. Specific plans include:

  • SEP plans (where the Corp can make large contributions to employee IRAs)
  • Simple IRAs (with low employee contributions and employer matching contributions)
  • 401K (with higher contribution limits)

Be aware that with the S Corporation, shareholder-employees receive retirement plan benefits based on earned W2 income, and not their shares of the corporation profit.

Miscellaneous Fringe Benefits

Employees of S Corporations and LLCs must treat certain fringe benefits as taxable income, while employees of C Corporations may receive these benefits tax-free. Examples of these fringe benefits are:

  • Moving expense reimbursements
  • Employer-provided term insurance
  • Some transportation expenses (i.e. parking, public transportation passes)
  • Meals and lodging for employer’s benefits
  • Qualified achievement awards

Employee Education

A C Corporation is able to deduct qualified employee education costs. The S Corp can also deduct certain education costs by considering them a ‘working condition fringe benefit.’ For example, if an employee would benefit from specific classes or technical schooling, the employer can pay for this education. In this case, the expense is considered a working condition fringe benefit, and the S Corp can deduct the cost and the employee is not taxed on the value of the benefit.

Corporation Losses

The S Corp (and LLC electing pass-through treatment) is more attractive to those individuals who want to claim business losses on their personal income returns. In the C Corporation, losses are held and aren’t passed through to shareholders. Even with the S Corp, keep in mind that you can personally deduct only corporate losses that you fund. Any losses that are funded by the bank in a direct loan from the bank to the corporation are not deductible on your personal income statement.

Summary

When you’re deciding on business structures, remember that the key reason to incorporate or form an LLC is to limit the liability of the owners and shield personal finances from that of the business. Of course, questions about incorporating eventually will focus on taxes. As with any transaction that can have significant tax and legal consequences, you should always check with a qualified tax professional or CPA before embarking.

While the C Corporation does offer more advantages for deducting fringe benefits, other factors ? namely potential double taxation and more complex reporting requirements ? may counter any advantage. Your decision in business structure will ultimately depend on all the unique aspects of your business, employees, and financial needs.


Money Collage Photo via Shutterstock

2 Comments ▼

Nellie Akalp


Nellie Akalp Nellie Akalp is CEO of CorpNet, her second incorporation filing service based on her strong passion to assist small business owners and entrepreneurs in starting their business. Free guides, advice and videos on small business legal topics are available at her Small Biz Corner.

2 Reactions

  1. Business structure we choose will impact how our company is taxed, whether as an LLC, S or C corporation.

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