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In this section we present you with short newsletters containing
timely and useful information. |
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How should you set up your New business? |
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If you’re forming a small business, you face several choices: Sole
Proprietorship, Partnership, C-corporation, S-corporation, Limited
Liability Corporation. This newsletter explores the basic pros and
cons to help you ask the right questions. |
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.
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