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IRS Audit: Schedule C Can Equal Financial Ruin – Incorporation Is Your Tax Shield To Personal Liability

Many small business owners set up their businesses for federal tax purposes as a sole proprietorship – the so-called dba, by filing a “doing business as” form, which is called an assumed name business certificate in many counties. These budding entrepreneurs then go about running their new business hoping to find jobs and make money, while leaving the tax stuff to an accountant they talk to once a year.

This type of business structure has some small advantages such as low cost to establish and less forms to fill out and file annually. However, the exposure to a tax audit, in my view, far out-weighs these slim savings.

As all sole proprietors should be aware, all of their business income and expenses are reported on their personal income tax returns – their Schedule C. Thus, when the IRS audits the business, any negative consequences of that audit land right on their personal tax returns (and the personal returns of their spouses). If the audit goes very, very, bad, then the sole props’ assets, income and their spouse’s assets and income will be subject to the IRS’ powerful enforced collection actions. For example, the IRS will file a notice of tax lien against the house and other assets of the owner (and the owner’s spouse), and the IRS may levy (seize) the income, bank accounts, or other assets of the owner (and the owner’s spouse).

There is a relatively simple solution to this problem. Don’t file a Schedule C, don’t file a dba and don’t be a sole prop. In my opinion, all businesses, especially the small ones, should be either a corporation or an LLC (limited liability company). Why? The answer is in the title of an LLC – limited liability. These entities, however, will cost more to form and they do have additional financial obligations. For example, in New York there is an annual franchise fee that must be paid. Also, additional tax returns or forms will have to be prepared and that can cost more.

Forming a corporation or LLC – under state law – is relatively easy and inexpensive. There are numerous services and companies that – for a fee – will file the paper work necessary to establish your company.
Generally, once your business is incorporated, and the IRS audits “your business” and the audit goes bad, the corporation – and not you – will owe the money. Thus, the IRS should not be able to reach the assets and income of the shareholders (owners).

There are some more complicated issues. For example, if you chose an LLC as your business structure – you must tell the IRS how the LLC will be taxed. If you do not tell the IRS to tax your LLC as a corporation, the IRS will tax you as a “disregarded entity,” which means you are back to a schedule C. So make sure you file the appropriate election with the IRS regarding how the company will be taxed when you form it.

Also, corporations (and LLCs taxed as corporations) can elect to be taxed either as a C corporation or an S corporation. Make sure you understand the implications of both prior to formation. Basically, in a C corp – the company files its own income tax return and it is liable for its own income tax liability. An S corp files its own tax return but the shareholder (owner) pays any tax due. Beware, that an audit of an S corp can result in a greater amount of income “flowing through” to the shareholder. Thus, if the audited S corp has its net income increased due to the audit, that increase can flow through to the shareholder’s personal return. Thus, the shareholder could owe more tax on the corporation’s increased income.

Therefore, make sure you do plenty of research prior to the formation of your business structure so that you can make an informed, strategic decision on how your company should be taxed. While there is a cost associated with choosing a business entity other than a sole proprietorship, in my opinion, it is worth it for peace of mind.
If you do find yourself under audit – no matter what the business structure or issue – call Winspear Law, PLLC for a free consultation.

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