| When
you form a small business, you have many options. For starters,
you can set up your business as a Sole Proprietorship, C-Corporation,
S-Corporation, LLP (Limited Liability Partnership) or an LLC (Limited
Liability Company).
How can you narrow down these possibilities?
You may want to decide against a C-Corporation, because C-Corps
generate two levels of federal income tax. The C-corporation pays
one level of tax when it files its federal corporate tax return,
Form 1120. A second layer of tax is imposed when the C-Corporation’s
profits are distributed to the shareholders as dividends. Those
dividends are reported and taxed on the individual’s federal
tax return, Form 1040. Together, these two levels of taxes are
referred to as “double taxation.” In addition, state
taxes also typically apply to both C-corporation profits and distributed
dividends. All in all, the tax picture for C-corps is far from
ideal for small businesses. Even the reduced tax rate on dividends
in the 2003 Tax Act does not completely do away with the disadvantages
of double taxation.
Becoming a sole-proprietor eliminates
the double taxation curse. There are no corporate taxes to pay,
since no corporate entity exists. In other words, you only pay
individual taxes on your net profits, which are typically reported
on Federal Form 1040, Schedule C. However, as a sole proprietor,
you lack the legal protection that corporate status gives you.
Owners of corporations enjoy limited liability, but sole proprietors
do not. Simply stated, if you’re a sole-proprietor, your
personal assets are at risk if the business is sued—very
risky indeed!
That leaves LLCs, LLPs and S-Corporations.
LLPs and LLCs are similar in many ways. One key difference is
that LLPs must be owned by more than one individual. Remember,
the “P” in LLP stands for partnership---by definition
a single individual can’t own a partnership. So if you had
an LLP with two owners and one dies, serious problems that could
even cause the business to close may result.
The remaining choice has now been
narrowed. S-Corporation or LLC? Which is more appropriate for
your business?
Well, they share one crucial tax
attribute in common; they are “pass-through” entities.
That means both S-corporations and LLCs allow you to avoid double
taxation and operate a business without paying corporate taxes.
As with a sole proprietorship, net profits are attributed to the
owners and are taxed when you file your individual tax return.
When choosing between an S-Corporation
and an LLC you need to consider many things. What may be appropriate
under one set of circumstances may not be in another. For example,
just because your friend formed an S Corporation doesn’t
automatically mean that you should form one as well. Every business
is different, and every owner has different needs and expectations.
Overview
The S Corporation
Created in 1958, the S Corporation was, for many years, the standard
form of organization for conducting a small business. S Corporation
status provides a way for you to avoid the double taxation (business
& personal taxes) imposed upon C Corporations. One advantage
of the S Corporation is that income is taxed personally to the
shareholders. However, your personal risk remains limited to your
investment. In other words, double taxation is avoided and you
get the protection of limited liability.
Your corporation chooses “S-Status”
by filing a special election form. Bear in mind that the “S”
status of the Corporation only impacts taxes. Shareholders of
S Corporations have all of the same legal protections as those
in C Corporations. But as once said by a famous Tax Court judge,
“a corporation is like a lobster pot. It’s easy to
get into…difficult to get out of.” In other words,
once you have established an S Corporation, it would first have
to be liquidated if you wanted to change to an LLC.
The Limited Liability Company (LLC)
LLCs started in 1977 in Wyoming and have quickly become the preferred
manner of doing business across the country. By default, LLCs
with more than one owner (member) are taxed as Partnerships, while
single-member LLCs are taxed as sole proprietorships. As with
S corporations, with an LLC you only pay taxes with your personal
return. However, if you decide to do business as an LLC, you are
not stuck with it. Through special arrangements, an LLC can be
set up to become an S Corporation without having to liquidate.
There is little risk of triggering a tax by changing from this
form of doing business.
Setting Up Shop
Establishing an S corporation is relatively simple and inexpensive.
An attorney, or even you, can form a corporation by completing
a series of “boilerplate” documents. These forms require
you to complete the following information: who will own the business,
the business’s activity, address, and other miscellaneous
details. Aside from being registered as an “Inc., Co. or
Corp.”, a corporation can also be registered as P.C. (Professional
Corporation). This designation is for professionals who choose
to operate in corporate form and is popular with doctors, lawyers,
and accountants.
An LLC requires a bit more work
to get started. Articles of Organization, to be filed with the
state and an Operating Agreement (like a Partnership Agreement),
must be drafted by a lawyer. In addition, business information
about the LLC must be placed in a published ad to give notice
to the public that the company is being started. An LLC can choose
to be registered as a P.L.L.C. (Professional Limited Liability
Company) when its owners are licensed by the state to engage in
a professional practice -- doctors, lawyers, accountants, and
so forth.
Distinguishing Characteristics
An S Corporation can often be more
restrictive than an LLC. There can’t be more than 75 shareholders
in an S Corporation. In addition, only individuals, estates &
qualifying trusts can qualify as shareholders. An S Corporation
may not have any non-resident alien shareholders. There can only
be one class of stock ownership. Adding a second category or class
of ownership terminates the “S” Election, which could
lead to unintended and unexpected tax consequences. The income
and expenses from an S Corporation are allocated on a per-share/per-day
basis. However, your businesses’ net income would be exempt
from self-employment taxes on your individual return.
The amount of your investment in
the S Corporation---your cost basis--is comprised of:
1) Your contributions of cash &
property
2) Your share of loans made directly to the Corporation
This “Basis” calculation
is important because it is your tax cost. The more you have invested,
the more losses you are entitled to claim against your investment.
In other words, bigger basis means more “write-offs when
there are losses.”
LLCs offer more flexibility than
S Corporations. They can have an unlimited number of owners and
any person, business or trust can be a member. With an LLC you
can choose to allocate particular types of income and expenses
between the owners. Doing this can get pretty complicated, so
be sure to speak with our office about "special allocations."
In addition, note that the business’s net income will be
subject to Self-Employment taxes.
The amount of your basis in an LLC
(your tax cost basis) is comprised of:
1) Your contributions of cash &
property
2) Your share of the LLCs debts to others. (In an LLC, loans to
the company can increase your tax basis if they are guaranteed
by you. In an S corporation, only direct loans to the company
by you can increase your tax basis.)
Note: LLCs provide more ways to increase your tax cost basis.
This illustrates a significant advantage of LLCs over S Corporations.
Because of the way these calculations are done, your cost basis
may be higher for an investment in an LLC than if you set up shop
as an S Corporation.
So when it comes to cost basis,
why is bigger better?
Like we said before, because bigger
basis means more “write-offs” when there are losses.
Bear in mind, these “write-offs”
are not permanent. They are merely a deferral. The more you “write-off”
now, the bigger your eventual gain will be when you dispose of
your investment in the business. However, with current write-offs
you still get to:
Take advantage of the time value
of money - A deduction allowed now puts money in your pocket today
and isn’t taxed until tomorrow. This allows you to use the
funds in the interim.
Beat the rate game –The tax
deduction now (maximum 35%) could be at a higher rate than the
capital gains tax rate (maximum 15%) that could be imposed when
the business is disposed of.
The Bottom Line
So which is better, the LLC or the S-Corporation? It depends.
LLCs are often preferable when setting up leveraged ventures such
as a real estate or investments. They may also be better for businesses
that would like to allocate specific items of income and expense
to specific owners.
S Corporations may be better when
the business is not a service-oriented venture. Non-service S
Corporations do not have the obligation to pay out all profits
as wages. This allows the shareholders to distribute profits without
being subjected to payroll taxes. S Corporations may also utilize
rules in the Tax Code (Section 144) which allow increased deductions
if the business fails.
The ultimate decision as to which
entity is best for you is not an easy one. In addition to the
points mentioned here, there are also estate planning, pension
and state tax implications.
These laws are complicated and mistakes
can prove extremely costly. We are highly experienced with these
issues. Please feel free to consult our office if you have any
questions.
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