They say nothing in life is certain except for death and taxes. In most parts of the world, taxes are part of life and certainly part of running an engine building business. In the US, large expenses associated with running an engine building business are federal, state and local taxes. This article will focus on the United States’ tax system but similar ideas may be applicable to similar businesses in other countries as well.
Please note, however, this article should be seen as informational but shouldn’t take the place of professional tax guidance. The rules are always in flux – perhaps more recognizably this year than in almost any other – and your CPA or other financial planner should be consulted about any tax question you may have.
One of the largest advantages to the US tax system is that profits are taxed after expenses are deducted.
This means that most expenses associated with building or running your business do not get taxed. Smaller businesses may only require a sole proprietorship but larger businesses may require a corporation. What are the differences?
For tax filing purposes, a sole proprietorship is the simplest form of business. It can consist of a single person or a married couple. Annual accounting is required and the owner is liable for all taxes. Profit should be shown for a minimum of two out of five years. Retirement contributions and medical expenses are usually not part of business expenses and are done according to personal 1040 tax filing rules.
In basic terms, the following formula is used for calculating business taxes:
Gross sales – cost of sales – expenses = Net profit that is put on your US 1040 tax return.
Cost of sales is from your inventory that was sold. Added inventory is not deductible for that year. Business liability for many cases is attributable directly to the owner.
Once the business reaches a larger volume of sales transactions, a sole proprietorship is not ideal for operating purposes, nor for tax purposes.
Forming a corporation is the next step. This can provide less business liability to the owner and with different accounting that sets up the business as a separate entity. Various forms of corporations exist. An attorney or accountant should be consulted to find the right corporation for your needs. The following information is based on our experiences running a C-corp.
In a C-corp, ownership of a business is established by issuing shares of stocks to a person or group of people. Investors who want to remain non-employees, such as family members, can be issued stock. Legal and accounting rules are used to establish the value of the stock, which can also be sold to other owners or investors. Company ownership can be proportioned in different ratios to more than one owner using different numbers of shares of stock. The entire company can be sold through the sale of stock if that becomes necessary, or shares of stock can be willed to heirs avoiding probate.
C-corps can be set up with a fiscal year different than the calendar year.
Fiscal year sales dollars, expenses, and retirement contributions can be moved forward or backward, from one calendar year to another. That can provide added income to the owner.
Book keeping and accounting are more extensive for a C-corp. All three of the following factors are used to make up a balanced corporate tax return.
Gross sales – cost of sales – expenses = profit; profit is taxed at a corporate rate
2. Assets accounting
3. Liabilities accounting.
A balanced corporate tax return, by its very nature, provides more accounting for the business operation and, as such, is a lower tax audit risk.
Owners who work in their C-corp are paid as W2 employees just like the other staff. W2 wages are subject to federal tax, state tax, local tax, disability, social security, and medicare withholdings. Retirement contributions can usually be made through the corporation that may be in greater amounts than for 1040 filers. Medical expenses are usually fully deductible. Other business expenses are fully deductible such as travel to motorsports events and facility lease and typical maintenance costs.
One of the biggest advantages of forming a corporation is that liability from business transactions is usually limited to corporate assets. These can include the equipment and corporate stock. The owner is responsible for limited indemnification. In the event of liability involving the business, the business is responsible for the liability cost to the limit of the assets. The owner’s personal assets such as savings, investments, home or auto usually are not included.
Cars and trucks can be leased to the corporation. Insurance for the business use of cars and trucks can also be charged to the corporation. There was no insurance distinction between regular cars and sports cars that were owned by our corporation.
This can make insurance costs lower for younger employees who may want to drive a hot rod.
At the time of our C-corp, we could take a research credit for our technical research expenses. We averaged $2,000 per year for those expenses which gave us approximately $500 of corporate tax credit after research credit tax computations. Research was defined as expenses for the development of technology in our field. For engine builders, it could be testing or dynamometer expenses for a new combination with more power, better mileage, or new EFI technology.
Even though accounting is more extensive, it was a window into the health of the business. As a result, it was easier to secure a larger line of credit, business liability insurance, and worker’s compensation insurance.
Operating as a corporation also made it easier to get on bid lists for large accounts.
For engine builders, this could include city, county, or state government vehicle contracts. It could also lead to fleet accounts or international engine building markets.
At the time that we formed our corporation, it cost approximately $1,000 in corporate attorney fees to write up “articles of incorporation.” These were filed with the state to establish a corporate identity according the laws of our state.
There was a minimum corporate tax payment to the state of a few hundred dollars every year. Accounting fees were around $600/year for preparing our corporate tax return. There were many business lessons to be learned in preparing a balanced tax return that taught us discipline in business structure.
Pride of ownership of a C-corp was enjoyed at the SEMA show, car shows and motorsports events.
When the corporation is liquidated, existing assets that were not deducted during the course of the business can be capitalized. That could include machinery, tools, promotional racecars or boats, off-road vehicles, motorcycles and other tangible assets accumulated in the course of running the business that were not deducted. These capital expenses may be shown as a loss that is beyond the closing revenue of the corporation. That loss may be assigned to the owner that can be carried forward to offset future income.
During the year of closing, owners may qualify for unemployment insurance to provide compensation when sales are shutting down.
A corporation is a living entity that is beyond the owners and employees. It shows an identity to customers, business associates, landlord, bank, and creditors that can go beyond the wealth, value, or image of the owner. Come tax time, great benefits can result.
Remember – your tax advisor should be consulted about these and any questions you may have about your business finances. Don’t guess – know what’s right for your situation.