Small businesses Essay Example

Small businesses Essay Example Small businesses Essay Small businesses Essay Small businesses can be defined as those businesses which have a small number of employees. In the United States, the legal definition of small implies less than 100 employees. The SBA (US Small Business Administration), which is an independent agency of the US government that protects the legitimate interests of small businesses, specifies size standards for a small business that pertain to its affiliation, number of employees, revenue etc. and are used to determine whether a business is small or not. 1Common examples of small businesses are restaurants, solicitors, hairdressers, accountants, tradesmen, photographers, guest houses etc. There are various forms of businesses; sole proprietorships, partnerships, corporations. Therefore it is important to know why a particular business is registered as a small business or otherwise, and what are the advantages, drawbacks, and legal implications of these decisions. Scott Holmes (2001) opines that the motivations for Small Business Owners are Economic factors as well as Social/Psychological factors. He goes onto argue that small firms can maximize relative returns by minimizing key costs, especially the cost of monitoring managers, who in traditional firms, are separated from the owners. It is obvious that in order to sustain this very advantage, small firms do not grow beyond a certain size.2There are various advantages of operating a small business. The most obvious advantage is that a small business can be initiated at a low cost, and it can be managed on a part-time basis as well. Compared to large businesses, small businesses take lesser time in reacting to customer complaints, and thus the small size enables them to give better customer service. This aspect is missing in large corporations, which, due to their elaborate chain of command, take a long time in reacting to customer complaints and objections. Karen, 2000, states that large firms often don’t seem to care whether the customer does business wit h them or not. On the other hand, the small businesses can win the day because they know the customer personally and value their relationship with the customer, and show them you care by offering sincere personal attention. In addition to that, decisions in small businesses are not subservient to a lengthy chain-of-command, therefore the decision making process is much faster in a small business, making them more flexible in managing new product decisions, inventory, billing policies etc.3 Operating a small business also has a distinct advantage in that it enables the owner to take more risks, and to more quickly to satisfy a newly emerging market niche. This makes a small business particularly well suited to internet marketing.However, the advantages not-withstanding, a small business owner also has to take care not to fall into several traps; the most important of which is undercapitalization. According to a rule of thumb, the owner must have available with him funds equal to the projected revenues of the first year of business plus the expenses for that period. Not meeting this requirement might result in the owner being liable for the business debts in case of bankruptcy. According to SBA, poor management is the major reason most small businesses fail, followed by ill-advised financing. The financing should be a balanced mix of equity and debt financing, based on the ratio of equity to debt for the firm.4Sole proprietorships are a form of business where the legal existence of the business is not separate from the owner himself. According to IRS, a sole proprietor is someone who owns an unincorporated business, including an LLC, by himself. 5 Thus, the rules of limited liability do not apply, and the owner himself is liable for the companys debts. Technically speaking, there can be only one owner of a sole proprietorship. This is the type of business entity to which the least amount of government regulations apply. Over 80 of the small businesses in the US operate as sole proprietorships.6 On the other side of the bargain, the owner faces a challenge in raising finances as a sole proprietorship cannot issue shares. And as the business grows, more and more owners look to convert their businesses into other types of business entities.To understand the taxation and legal consequences of sole proprietorships, it is important to note that all the profit made by the business entity is treated as the income of the owner. Thus the form 1040 of the IRS (Internal Revenue Service) is used to report the income and expenses of the business. The profit and loss information of the business is filled out in Schedule C, which is attached with form 1040. The sole proprietors are required to pay a Self-Employment tax on their profit if it exceeds $400. This tax is equivalent to 15.3% of the net profit made by the business. The form Schedule SE is required to be filed for this purpose. The Self -Employment tax is apart from the income tax which has to be paid separately on the combined income of the owner.7 Sole proprietors are required to pay quarterly tax liabilities to the state and federal government. Legitimate business expenses can be deducted from the income while calculating the taxes.8According to the definition of IRS, a Partnership is the relation between two or more persons who join to carry on a trade or a business. Although a written partnership agreement is not a legal obligation, but it is generally recommended to formalize the business relationship, specifying the profit sharing, business contribution of the partners etc. The liability issues in a partnership are similar to those of a sole proprietorship, but an added element here is that a partner is not only liable for the business debts and liabilities, but also for the business-related conduct of his other partners. Generally the profit sharing is based on the percentage of ownership of a particular partner.9The taxation issues in a partnership are also similar to that of a sole proprietorship. The income of a partner is not considered to be separate from his personal income. The income is taxable in the year its earned. The partnership is required to file annual information return to inform the IRS about its income, losses, etc. But the partnership does not pay income tax. Instead, the profits (or losses) are passed through to the partners and they include this amount on their respective tax returns. The partners submit Schedule K-1 (Form 1065) along with the Form 1065. The individual partners who are liable for income tax and self-employment tax may file Form 1040.10A Corporation is significantly different than the two types of business entities discussed earlier. It is created under state law, and is a complete business entity separate from its directors and shareholders. Thus, the corporation continues to exist even after the founders pass away, or the shareholders transfer their shares. The main benefit that the shareholders gain fro m corporations is Limited Liability, i.e. they are shielded from the business obligations to its creditors even if the business goes bankrupt. There are various types of Corporations. The type under discussion here is the C Corporation (S Corporations are discussed in the next section).11Corporations are treated as C Corporations unless they are approved as S Corporations. The C Corporation pays taxes under the Subsection C of the tax code. A C Corporation is under obligation to file an annual tax return. The taxable income consists of the Retained Earnings and the dividends paid to the shareholders. Corporations also involve more government regulations and red tape than the earlier discussed business entities. They are also required to pay franchise taxes (which S Corporations are exempted from). The bane of double taxation is also attached with corporations as Corporations pay income tax on their earnings, and furthermore the shareholders are required to pay income tax on the divi dends that they receive from the corporation.12An S Corporation is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of IRS (Internal Revenue Code). In other words, an S Corporation is a standard corporation that has a special tax status elected by the IRS.A short overview of how the taxing system in S Corporations works is as follows. The S Corporation doesn’t pay corporate taxes on its profits. Instead, the shareholders who hold distributive shares for the Corporation, pay the income taxes on their proportionate income. This payment must be done irrespective of whether the shareholders receive distributions from the S Corporation or not.In order to form an S Corporation, the following conditions must hold: the company must be an eligible entity (a domestic corporation, LLC or partnership), it should not have more than 75 shareholders, all the shareholders must be American citizens, it should have only one type of stock and the profits and losses to the shareholders should be proportionate to their share in the business.13If the business meets the above stated requirements, the shareholders of the business can file the form 2553 of the IRS: Election by a small Business Corporation, in order to be taxed under Subchapter S.14 This form must be signed by all the shareholders of the business. If a corporation that has been elected as an S Corporation ceases to fulfill one of the above stated conditions, i.e. its shareholders exceed 125, or it acquires a foreign shareholder, then its status as an S Corporation would be rescinded and would be treated as a regular C Corporation.Before moving on to discuss the taxation issues in detail, it would be appropriate to consider the pros and cons of having an S Corporation. The biggest and most obvious advantage of having an S Corporation is the tax advantage. The profits (and losses) of the S Corporation pass through to the owner, as is the case in sole proprietorships, partnershi ps and LLCs. Thus the S Corporation itself doesn’t pay any taxes. This means there is no double taxation. Also, when the business is sold, the taxable gain on the sale of business is less than what it would have been if the business was operating as a regular corporation. Another positive of S Corporations applies to a new business which has lots of expenses and losses. In a regular corporation, these losses get locked up within the corporation, but in an S Corporation, these losses are offset against the owners personal incomes, enabling them to write off start-up losses. Another benefit of operating an S-Corporation is that it offers limited liability protection. Although the liability protection is not as complete as that in a corporation, it is still better than that in sole proprietorships and partnerships. Other advantages include less frequent auditing for S Corporations, certain business expenses being tax-deductible, and customers perceiving an S Corporation as a mor e professional body than sole proprietorships and partnerships.But along with the above stated benefits, an S Corporation also has some drawbacks. The S Corporation is limited to issuing only one type of stock, i.e. distributive stock. Thus the business has less control over the company and the stock value is also limited.15In order to grow rapidly, a company needs to attract finances, and venture capitalists usually do not prefer to finance a company that has an unconventional tax setup, and has an upper limit of 75 on the shareholders. So if a business would need to attract venture capitalists, it would be better suited to a C Corporation. Secondly, although an S Corporation is exempted from paying corporate taxes, it still has to file annual tax returns. A liability in time also needs to be considered, as the S Corporation is still a corporation and has the requirement of conducting regular meetings and the maintenance of minutes of the meetings. An interesting downside to S Corp orations is with respect to the Tax Treatment of Benefits. If an employee is a shareholder as well, and the company provides health and accident insurance premiums, then the corporation deducts these items, but then these expenses are added to the gross income again.16As mentioned in the text earlier, S Corporations are generally exempted from paying corporate taxes, and for income tax purposes, the net earnings of the corporation are attributed to the individual shareholders, who pay the income tax in proportion to the share that they hold in the corporation. Thus when this income is distributed to the shareholders in the form of dividends, the shareholders are not required to pay income tax (the very concept of no double taxation). The interesting part here is that this arrangement gives the shareholders an incentive to enter into arrangements with the corporation to treat their incomes as dividends rather than treating them as compensation for services. This would result in the s hareholders paying lesser taxes.In this scenario, the position that the IRS holds is that if the corporation pays a shareholder in the form of dividends, for the services he performed for the corporation, these dividends would really be considered as wages paid to the employee, and not as dividends. Thus they would be taxable under FICA. This position of IRS holds weight as it has been upheld by the courts. E.g. in Joseph Radtke, S.C. v. United States, 1990, a lawyer was the only shareholder of an S Corporation, and was paid $18,225 as dividends in 1982, and no amount as wages for the services that he rendered for the organization during that period. The court ruled that the payment was in fact wages, and came under the tax bracket under FICA and FUTA.17Another case serves to highlight this issue, Spicer Accounting, Inc. v. United States. This case involves an accountant who was simultaneously the President, treasurer and Director of an S Corporation. There was no formal employment agreement between him and the corporation, and he offered his services to the organization free of cost, but at the same time, using his status as stockholder, withdrew dividends. The Court ruled in favor of IDS, and declared that the dividend earning was in fact remuneration for the services he performed for the S Corporation, and therefore subject to FICA taxes. 18There are several other such cases too, but the above two cases provide us enough proof that there exists a precedent for treating dividends paid to employees of an S Corporation in return for their services to the corporation, as wages (or compensation of services).19That brings us to the next logical question: What is the right amount of compensation for an S Corporation Employee? The US Tax Court opinion of 2001 does provide an insight into this very question, but it is not a binding precedent as it was unpublished, but tax advisors agree that it can be used as reliable guidance.20The court cites one case in particula r. The case deals with a CPA, Wiley Barron, who created an S Corporation to practice public Accounting in Arkansas. He was paid a large chunk of the profits by the firm, but only $2,000 of the amount, paid during one quarter, was treated as taxable compensation. IRS intervened, citing Internal Revenue Code Section 3121(d), which states that a corporate officer is an employee21. Thus, it came out that Mr. Barron was the only CPA at the company and was providing full-time service to the company. Compared to that, the amount of compensation that he was being paid was not appropriate. The court thus ruled in favor of IRS, declaring that Mr. Barron was using the S Corporation to avoid paying employment tax. Based on several variables, the Court decided that reasonable compensation for a CPA in Arkansas for the relevant years was in the range of $45,000 $49,000.The case of Tribune Company is also illustrative of this phenomenon. Sam Zell took advantage of a loophole in a minimum wage bil l, and thus ended up paying zero income tax, post-buyout, on Tribune. He combined the S Corporation and the ESOP (Employee Stock Ownership Plan) and thus turning Tribune into an S Corporation completely owned by this ESOP and paying no taxes. The rule that Zell took advantage of here, is that like pension funds, an ESOP pays no taxes on its income. This provision was part of a minimum wage increase bill that was passed by the Congress 11 years ago.22To avoid complications and to stay within the legal limits prescribed by the government and the IRS, Milani and Wittenbach, 2005, have the following suggestions to minimize the probability of an IRS objection: Develop a comprehensive wage policy and compensate all employees with respect to that policy; while setting a compensation level, consider the following factors: qualification of employee, scope and extent of work, nature of business, financial implications of the business, market rates. By documenting these wages, the company woul d have a strong defense that the payments paid to shareholders are not wages, but dividends.23In conclusion, it can be said that every business professional should make the important choice of the business format after carefully discussing the pros and cons with their lawyers and tax professionals.