Q:

Subject: Sub S Corp Question

Mr. Kerstetter,

First, I would like to thank you for your informative web site.  You have effectively detailed many of the pros and cons of incorporating. 

My question is, do expenses such as buying a company car offset any income acquired by the corporation?  I was reading about the man who earned 300k but only took out 30k for himself on your website.  Didn’t the corporation make the 300k profit?  If so, and it was retained within the corporation for operating capitol, why did he have to show it as income?

A friend and I are considering forming a Sub S Corp and I am trying to learn as much as I can prior to beginning the process.  As things are, I will own 49% of the stock and Eric will own 51%.  We have the potential to generate well over 500k within the first year and a half to two years.  After that, there is the potential to make literally millions.  For this to work, we will need to keep a majority of the profits within the company for the second and third phase of our business plan.  We will only be taking out 30k to 35k apiece.  Is there any way to keep the income within the company without having to pay through the nose for income that we are not seeing the benefit of?

Eric is strongly in favor of the Sub S because he says that the dividends that we are paid are not subject to social security tax.  I am concerned that he is being a little short sighted.

Thank you so much for your time.

A:

While I do appreciate the fact that you are doing research on the issues surrounding working with corporations, there is no book or online reference (including any of mine) that can substitute for the real world services of a qualified tax professional who can thoroughly analyze your particular circumstances.

You do seem to be very confused about the workings of pass-through entities, such as S corps, partnerships, and LLCs that elect to be taxes as partnerships or S corp.  For Federal income tax purposes, these entities do not pay any income taxes.  Their net income or loss is passed through to the income tax returns of the shareholders, who are required to include it on their 1040s regardless of how much actual cash (if any) the shareholders received.  The example to which you referred is a very common situation, where the S corp has a very large net taxable profit, but doesn't distribute any actual cash to the shareholders because of investment or operating requirements.  The shareholders are still required to pay income taxes on that income and come up with the cash to pay them from whatever sources they can utilize.

Depreciation and Section 179 expensing of business equipment, including some kinds of vehicles, can reduce the corp's taxable income.

A C corp pays income tax on its net taxable income, which could be high if excess cash revenues aren't spent on deductible things.

There is no easy one size fits all answer to your needs.  You should also be open to the fact that you may not want one entity to cover every aspect of your business.  Multiple C and S corps may very well work out best for you and your business partner.

Again, it can get very complicated and is something that you definitely need to work on with a competent tax pro.

Good luck.

Kerry Kerstetter

 

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- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 4/06/2006 12:03:00 PM Send this post: