subject: Construction Contractors May Reduce Taxes & Lower Irs Audit Risk By Electing To Be An S-corporation [print this page] As the upcoming presidential election approaches, there is significant amount of debate going on about changing tax laws. Substantial changes in the tax laws being proposed by the democrats should have construction contractors in Connecticut holding onto their wallets. The biggest issue facing these contractors may be a change in limitations on self-employment taxes (Social Security and Medicare).
The self-employment tax issue is important because how much self-employment tax you pay is based on what kind of business structure you use to operate your business. Also, each type of business structure has a different level of risk associated with being audited by the Internal Revenue Service. A quick example of how this works.
Jim is a construction contractor in Connecticut who works on commercial projects. He is the sole owner of the company which has 10 employees on payroll and is organized as a limited liability company (LLC). He earns about $200,000 per year before taxes.
Charlie runs a different construction contracting business in Connecticut that is very similar to Jim's except his company is organized as an S Corporation. He earns approximately the same $200,000 per year before taxes.
Here some amazing facts-- Charlie pays $6,000 less in taxes every year compared to Jim. Plus, Charlie's risk of getting audited by the IRS is far less than Jim. According to a recent IRS study, contractors operating as a one-owner limited liability company are six times more likely to be audited than those contractors operating as an S-Corporation.
Why? According to an IRS spokesperson interviewed for this article, it is because the IRS has determined through extensive studies that anyone who reports gross income on Schedule C of Form 1040 in excess of $100,000, (the business form within a person's individual income tax return where LLC owners report their business income and expenses), is more likely to be "cheating" on their taxes. As a result of this IRS study, they have allocated more audit resources to businesses operating as limited liability companies.
Here's another fact. Contractors (by the nature of their business and a few bad apples) are already open to greater audit risk. If they are using a business entity such as sole proprietorship or single member LLC that requires them to report all of their income and expenses on Schedule C of their individual income tax return, they are exposing themselves to maximum audit risk.
What a nightmare! An "audit" by the Internal Revenue Service or State Tax Authority is a painful, time-consuming, money draining event that all business owners should be happy to avoid.
John, a Connecticut construction contractor is a perfect example of why you do not want to be audited. He operated as a limited liability company which increased his chance of being audited six-fold. He received a letter from the Internal Revenue Service that he had been selected for an audit. The letter included a three page list of all the documentation he was required to put together.
John spent a whole week gathering this information (about 4 file boxes full), spent $5,000 in professional fees to have his CPA assist him with the information gathering and represent him at the audit, and was interviewed by an IRS auditor.
John subsequently was found to have committed no wrongdoing and no additional taxes were required to be paid. It could have been much worse. John was fortunate that he was honest, kept good records, and operated his business properly. However, it cost him a lot of wasted time, energy and money.
How can this be avoided?
It starts by making an election to be taxed as an S Corporation.
Here's the information that construction contractors in Connecticut need to know! 7 Reasons why most construction contractors should be taxed as an S-Corporation:
1. Your annual net income from your S-Corporation appears on one line of Schedule E of your individual income tax return. Accordingly, there is no income or expense detail showing up that would trigger a "red flag" like there is on a Schedule C used for a single member limited liability companies (LLC).
2. There is no disclosure of home office expense similar to that used on a Schedule C. On an S-Corporation tax return, home office expenses are combined with other expenses and no separate disclosure is required.
3. If you are a subcontractor for another construction contractor, use of the S-Corporation will help you avoid being issued a 1099-MISC which detailed the income you received from the other business. As a sole proprietor, that 1099-MISC is sent to both you and the Internal Revenue Service giving them an opportunity to match-up your income.
4. The typical "red flags" such as travel, entertainment, and automobile expense receive less attention on an S-Corporation return because the audit rate for S-Corporations is substantially lower that for individuals.
5.The Internal Revenue Service is paying less attention to S-Corporation returns currently because of the limited number of auditors they have. Most of the audit resource for corporations is being directed towards big corporations because of the opportunity to extract larger amounts of tax dollars.
6.You can substantially reduce the amount of self-employment taxes paid with an S-Corporation. A LLC requires that the owner pays self-employment taxes on all of the net income. An S-Corporation is allowed to pay its shareholders a reasonable salary and the remainder of the net income can be taken by the shareholder free of self-employment taxes. This is the reason Charlie (the S Corporation contractor) paid $6,000 less tax than Jim (the LLC contractor).
7.It is easier for an owner of an S-Corporation to sell the business because there is no corporate level tax to be paid upon the sale similar to a C-Corporation.
To summarize, construction contractors who are currently organized as an LLC or a Sole Proprietor can reduce their risk of a painful Internal Revenue Service audit and save a significant amount of taxes by electing to be taxed as an S-Corporation.
