Tax Tips for Proprietors, Partnerships

In January I pointed out inconsistencies in builders' knowledge about their own companies.

By Stan Ehrlich, Contributing Editor | February 28, 2003


Stan Ehrlich


In January I pointed out inconsistencies in builders' knowledge about their own companies. Specifically, I noted that business owners should know their corporate structure before they can understand pay and benefit options. To enable everyone to take advantage of tax laws that encourage retirement saving, let's address benefit plans for different corporate entities.

Most small builders probably fall under one of the following corporate entities: proprietorships, partnerships or S corporations. In terms of benefit planning, of critical importance is how the owner is treated for tax purposes.

For proprietorships and partnerships, for example, owners are technically not employees. (Proprietorships are businesses with one owner; partnerships have multiple owners.) Net income (or losses) for proprietorships and partnerships are added to (or subtracted from) an owner's adjusted gross income on his/her income tax form. Thus, all expenses are deductions and are not subject to floors (e.g., 2% of adjusted gross income). All income is taxed at the owner's income tax rate.

A key point for owners of proprietorships and partnerships is that except for contributions to their own retirement plans, expenditures for their other (personal) benefits are not deductible as business expenses. (Expenses for benefits to other company employees are, however, legitimate business expenses.) Deductions for employee benefits for owners are not deductible because proprietorships and partnerships are essentially extensions of their owners, thus making a benefit plan for retirement a critical portion of income tax planning.

In terms of retirement plans, owners of proprietorships and partnerships can select across the entire spectrum. Recent tax law changes, however, make profit-sharing plans especially attractive to business owners.

But be warned: Owners can no longer treat themselves to extravagant plan contributions while denying them to their employees. If a company owner has employees, they must receive the same benefits in terms of type of plan or percentage of contribution as the owner.

For companies with no employees, or when the employees are significantly younger than the owner, a defined benefit plan should be given serious consideration. A defined benefit plan guarantees a certain future dollar benefit to the owner. Thus, the owner may choose an option that allows for a pension based on years of employment multiplied by a certain amount (e.g., $500) commencing at age 65.

In terms of contributions, significant sums of money must be set aside to fund this type of plan for an older owner. (For com-panies with no employees, all dollars set aside ultimately will benefit the owner.) While this type of retirement plan is more costly to administer, it offers huge tax-deferral benefits to a company owner.

Finally, self-employed individuals operating as proprietorships or partnerships also should understand the term earned income. Net income of their business is their earned income, and retirement plan benefit calculations are based on that amount as opposed to any weekly salary or draw they might receive.

Spend time learning about your business; the tax savings and future benefits might prove very rewarding.


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