Chapter 9
Taxes and your type of business

The legal classification of your business often affects certain key items on your financial statements and how they’re presented. Even bankers often don’t understand this point. The biggest issue is whether you record income taxes on your profit-and-loss statement.

Something as large as income taxes left entirely off your P&L? It happens all the time, and accountants do it on purpose. There are basically five types of tax returns that your trucking company might file, depending on your form of legal organization.

Of the legal entities listed in the table below, only C corporations are certain to have income taxes listed as an expense on the P&L and show an income tax payable liability on the balance sheet. C corporations compute the company’s tax on their own tax returns. For all the rest, chances are that income taxes aren’t presented in the financial statements or are very hard to find if they are.

For these other entities, the individual owners record the company’s income taxes on their own returns. The total taxable income or loss is computed on the company’s tax form and then “passed through” to the owner’s tax return.

Pass-through tax calculation
The tax expense of the company will be calculated on as many tax returns as the company has owners. Assume, for example, that an S corporation had four owners, each owning 25 percent, and the company profit was $100,000. One-quarter of the company’s taxable profit, or $25,000, is entered on each owners’ Schedule K-1, which is then reported on the owners’ Form 1040.
But Shareholder A may have a working spouse, and Shareholder B may have a large stock portfolio or other sources of income.

The owners of a company rarely have the same taxable income, so there could be four different tax rates on each $25,000 portion. Because company accountants can’t easily determine the tax in this situation, the tax expense cannot be stated on the company’s books. If this is the case, the accountant’ s report or the notes to the financial statements will note this situation.

Tax savings worth the trouble
“There better be a darn good reason for all this confusion,” you might be thinking. There certainly is. All the entities except C corporations are designed to avoid potential double taxation. When a C corporation earns a $100,000 pre-tax profit, it might pay $30,000 in corporate income tax (and could pay up to 45 percent in federal and state tax). If the remaining $70,000 were then paid to shareholders as salary or dividends, potentially another $25,000 to $30,000 in tax could be paid on the owners’ personal tax returns, bringing the total tax tab to between $55,000 and $60,000 on that $100,000 in income.

But by using a pass-through entity, the $100,000 is only taxed once. The total could be $30,000 to $40,000, resulting in overall savings of more than $25,000 on every $100,000. Wouldn’t you jump through some paperwork hoops to raise your after-tax take-home cash by this much? In our example below, on the same income of $100,000, C corporation owners hold perhaps $40,000 after taxes; the others hold perhaps $60,000.

Most companies still pay the tax, so as a shareholder you don’t have to swallow the company’s tax bill. Pass-through companies often distribute funds quarterly to the owners, who then are supposed to pay this to the IRS as quarterly tax estimate payments on Form 1040-ES.

Presentation of taxes in financial statements
If your trucking company is organized as a pass-through entity, where will the clever accountants hide the income tax expense? Since it’s not often an expense on the P&L, the P&L bottom line is a pre-tax number.

Recall that there are sections for retained earnings and equity items. If or when the company management pays out funds for these taxes, the payment often is shown as a distribution of profits or a drawing of profits. To find out how much a company has paid out in taxes, therefore, you might need to search these two places if taxes aren’t on the P&L immediately before net income.

On the balance sheet, you would want to know if your company owed a $35,000 debt at the end of the month. Yet pass-through entities rarely show a liability for income taxes for the same reason they rarely show income tax expense on the P&L. They choose instead to either show nothing at all or disclose the debt in a note to the financial statements.

Why does legal structure matter?
We have discussed at length the tax and financial-reporting differences among the various types of legal entities for businesses. What exactly are these entities and why does it matter which you choose? The following is a basic description of each:

Sole proprietorship. By far the simplest form of business is the sole proprietorship, which always has a single owner. It requires the least paperwork, but it also offers the least legal protection from creditors should the business fail. All you must do to set up a sole proprietorship is obtain a business license and “hang out your shingle.” Most owner-operators are independent contractors and likely are sole proprietors, since other forms of business require costly legal documents. Sole proprietors file “Schedule C” on their personal income tax returns. From a legal standpoint, all the assets of the sole proprietor are at risk should the business fail — even the home, cars, and savings accounts not related to the business.

General partnership. General partnerships are much like sole proprietorships, but they have two or more owners. The legal exposure is as great as with a sole proprietorship and perhaps a bit greater, because each partner may be liable for errors made by and contracts executed by his partners. A written partnership agreement, which is necessary, increases the cost and complexity. General partnerships must file partnership income tax return, but any profit or loss is allocated to the partners who report it on their personal tax returns.

Limited partnership. Some companies have two classes of partners: general and limited. Limited partnerships provide legal protection for the limited partners. Under some state laws, if a limited partnership goes bankrupt, the assets of both the partnership and the general partners are at risk. But partners holding the “limited” ownership interest can protect their personal assets and risk only losing the amount of the investment. But even a limited partnership won’t protect these individuals’ assets under certain conditions, such as when they sign bank loan guarantees.

Limited liability company. Limited liability companies were created to combine the best tax aspects of partnerships with the relative simplicity of the S corporation (see section at right). Each LLC owner can limit his or her risk to the amount invested, assuming they have signed no loan guarantees. The LLC has some advantages over S corporations. The “operating agreement” between the LLC owners allows for more flexibility in how profits and loss are shared; S corporations have strict limitations on this division.

C corporation. One of the oldest forms of legal organization, the C corporation has fallen out of favor with many business owners. C corporation owners can limit their liability to the amount invested and by limiting loan guarantees, if possible. But the C corporation is rarely used today for new business formation unless the owners plan to take a company public.

The chief reason C corporations are unpopular is that a company’s profits are at risk of “double taxation.” C corporations must pay tax at the company level. If they distribute any dividends to shareholders, shareholders pay income tax on that amount. This may not hurt much year to year, but it kills you if you try to sell the company or if you have real estate profits that you want to pay out to shareholders.

S corporation. The S corporation remains very popular because it allows for the partial or full avoidance of the C corporation’s double-taxation problem. A new or existing corporation “elects” to become an S corporation by filing Form 2553 with the IRS. Most elect at the date of incorporation, but you can do it later, and there are rules about how often it can be done. Although S corporations offer very beneficial “single taxation,” companies must follow strict IRS rules to retain the election. For this reason, the more popular choice now is the LLC.

In Summary
Whether your company is a C corporation, an S corporation, a partnership, a limited liability company or a sole proprietorship often affects certain key items on your financial statements and how they’re presented. Many accountants leave income taxes out of the P&L and balance sheet, and it’s entirely legal. When reading the financial statements of trucking companies, remember the important distinctions between types of companies to avoid overlooking significant financial obligations.