Pros & Cons of Corporations

2008-03-05T06:34:00.002-08:00

Pros & Cons of C-Corporations, S-Corps, Ltd Liability Companies

What is a Limited Liability Corporation ?
How does it differ from a S-Corp ?
What’s The Best Corporate Structure For An Early Stage Company?
How to Legally Save Thousands of Dollars a Year in Taxes by Incorporating

In most states, you have three choices -- C-Corp, S-Corp, or LLC (Limited Liability Company)

C corporations get taxed on profits at corporate rates, and dividends are taxed to the shareholders. S corporations and LLCs (when approved by IRS, which approval is generally not hard to get) are taxed at personal rates, form 1040, Schedule C.

C corporations are subject to formal requirements, e.g., annual reports, board of director meetings, etc. S corporations also, possibly to a lesser extent. LLCs are exempt from these requirements, at least in many states.

S corporations are limited to 35 shareholders, and to domestic capitalization. LLCs are not so limited, at least in many states.

LLCs generally provide more accounting flexibility than either C or S corporations.

Bottom line, check your accountant, preferably a CPA, and your attorney for advice in your particular situation.

JOHN EDWARDS SHELTER
Mr. Edwards, John Kerry's running mate in 2004, ran into criticism for taking "only" $360,000 of salary from his S corporation law practice, talking the remaining $26 million or so as S corporation distributions. S corporation distributions are not subject to the federal FICA and Medicare tax, so Mr. Edwards saved about $738,000 on the 2.9% medicare tax.

While Mr. Edwards came under fire for this, his position probably isn't abusive under current practice. The only cases on this issue deal with professionals who take little or no salary from their S corporation to avoid both the 12.4% FICA tax and the 2.9% Medicare tax.

The compensation of corporate officers is also receiving increased scrutiny from IRS

One hopes the IRS won't force a start-up S corporation to pay its employee-owner an "adequate" salary while the company is struggling to get off the ground. S corporation professional practices will have to pay more of their earnings as salaries than other businesses because so much of their income is attributable to their owners' personal efforts.

S-corps fall under the same reporting requirements as C corps. Annual reporting and Board meeting requirements vary from state to state.

Corporations generally provide protection against personal liability of individual shareholders with respect to claims against the business. Sole proprietorships and partnerships do not.

Corporations generally provide continuity beyond that available to sole proprietorships and partnerships.

C-Corporations are taxed as separate entities, at corporate rates, and then shareholders are taxed, at their individual rates, on dividends.

S-Corporations are generally like C Corporations, except that they are limited to 35 shareholders, can only use domestic capitalization, and are taxed only to the shareholders at their individual rates -- Form 1040, Schedule C. They must close their books at the end of each year, and shareholders pay taxes on all profits in the year earned, whether or
not they are distributed. They are subject to IRS approval, in order to receive the individual tax treatment.

LLCs are new in the last 4 or 5 years. They are available in most but not all states. They are generally like S-Corporations, except that there are fewer formalities (e.g., no annual reports, no limitation to 35 shareholders, no limitation to domestic capital). They also are taxed to individual shareholders, provided IRS approval has been obtained. There may be more accounting flexibility -- see your accountant, preferably a CPA.

PRO'S OF INCORPORATION:

1. limited liability for shareholders; i.e. the shareholders are not individually liable for debts of the corporation, such as a lease
obligation or loan payback.

2. a corporation may exist perpetually; unfortunately, all persons eventually die.

3. multiple classes of ownership; by using common stock and preferred stock with different rights, terms and conditions, a person forming a
corporation has great latitiude in providing its shareholders a return on their investment.

4. eliminate self-employment tax, which is payable by individuals engaged in business and by active members in a limited liability
company.

5. some people think a corporation provides a much better image for conducting business operations, more sophistication, etc.

6. operating a corporation is relatively easy to understand; most of us are familiar with concepts of a board of directors, officers, and such.

7. incorporating a corporation can be done quickly if needed. I have done one in less than 24 hours.

8. in most states the corporation can take formal corporate action by written consent instead of holding a meeting of the board or the
shareholders, which simplifies and makes more inexpensive its operation.

9. the laws are mostly settled concerning corporations, both from a tax status and for the duties and liabilities of the officers and directors.
Most of the issues you would face in operating a corporation have already been dealt with and there will be a statute, case or
administrative ruling concerning it.

CON'S

1. Tax. The corporation's income is taxed at the corporate level. Then when you distribute earnings to the shareholders via dividend, the
shareholders include the dividend in their taxable income and are all taxed on that income again. This is commonly referred to as double
taxation.

2. Added administrative costs. You will now have a new set of accounting books to keep, bank accounts to balance, etc. However, the
fees paid to a CPA and/or bookkeeper may be deductible from income.

Congress responded many years ago to the double taxation issue by authorizing a "subchapter s" corporation. Subchapter s is a subchapter
of the Internal Revenue Code which basically eliminates tax at the corporate level. A corporation figures up its income and expenses and
passes both of those items through to its shareholders in proportion to their stock ownership. For example, a shareholder who owns 40% of the
outstanding shares of stock would report, on his or her personal income tax return, 40% of the income and expenses of the corporation. The tax
is levied only on the shareholders.

However, Congress also put some rather severe limitations on Subchapter S corporations. It is very difficult to use a fiscal year other than a
calendar year. It can only have 35 total shareholders (husband and wife count as one shareholder). It can only have one class of stock. The
shareholders can only be individuals or a qualified trust.

In response to these restrictions, in 1977 Wyoming became the first state to enact legislation recognizing the LLC business entity. The LLC
is a hybrid of sorts. It has most of the same pros and cons as a regular corporation, except that it is taxed as the Subchapter S
corporation, but adds an additional level of complexity in operation because it is very tax-sensitive. I cannot briefly explain why it is so
tax sensitive, but suffice it to say that the tax treatment of an LLC is not guaranteed. It has to be properly designed and operated.

However, the IRS has now ruled that members active in management are subject to self-employment tax. And there is an open issue of whether
there can even be, for tax purposes, a single-member LLC. Most commentators argue that a single member LLC should be taxed just like a
sole proprietor. (A corporation can have just one shareholder without affecting its tax status.) This shows that the corporation's advantage
of knowing the issues and answers does not apply to an LLC yet.

One can get around the self-employment tax issue by creating another entity to be the member and having the individual actively manage the
entity. This works very well if the entity that is a member is a family limited partnership.

I most commonly advise small businesses to use the Subchapter S form so long as they can live with the restrictions. However in second place is
the LLC.

Another issue you should consider is how many entities do you need. As a matter of basic asset protection in this litigous society, I generally
advise my clients to set up a separate entity for each income stream. If there is a lawsuit, only one income stream is generally put in
jeopardy.

Self-Employment & Payroll Taxes for S-Corporation Shareholders

2008-03-05T06:34:00.001-08:00

If structured and implemented properly, an S corporation could save you thousands of tax dollars per year.

The number one audit risk for S-Corporations is salary and wages paid to officers of the corporation.

Shareholders of S-Corporations do not pay Self-Employment Tax if they are actively engaged as a shareholder-employee of the S-Corporation. Why? Shareholder-employees are paid a salary, with their wages reported on a W-2 and with Social Security and Medicare taxes already withheld.

Shareholder-employees will therefore receive two tax documents from the S-Corporation: a W-2 wage statement and a Schedule K-1 statement.

Shareholder-employees are taxed on their wage income and on any profits distributed by the S-Corporation. These profits are taxed as ordinary income instead of the more favorable qualified dividends tax rate. Dividends are a distribution of corporate profits to shareholders, but a qualified dividend has already been taxed at the corporate level, so a qualified dividend is taxed at a preferential tax rate on the individual tax return.

Vice presidential candidate John Edwards saved $600,000 in taxes by forming an S corporation (also known as a subchapter S corporation). How can an S corporation help you?

Edwards made $26.9 million as a trial lawyer in 1995, and he minimized paying Medicare taxes by forming his own S corporation. Edwards paid himself a salary of $360,000 each year for four years and had the S corporation pay him the rest in dividends.

Salary is subject to Medicare taxation at a rate of 2.9%, but dividends escape Medicare taxation. There is no wage base for Medicare, all wages or salaries are subject to the full 2.9% tax. Social Security does have a wage base, which means wages above some limit (currently $87,900) are exempt from the Social Security tax.

So, Edwards saved 2.9% of $25,460,000 or $738,000 in Medicare taxation. However, sole proprietorships are allowed to deduct one half of what they pay in Social Security taxes from their income tax (sole proprietors file Schedule C along with their personal 1040 tax returns). Thus, had Edwards operated as a sole proprietor, he'd get a deduction for $369,000 from his income tax. Figuring income tax at the then-current 39.6% rate, he'd reduce his income tax by about $146,124 if he had filed as a sole proprietor.

Thus, Edwards net savings for forming the S corporation were about $591,000.

Reasonable Compensation
The fastest way to get audited as an S-Corporation is to file an 1120S with no amount showing on Form 1120S Line 7 "Compensation of Officers." It is assumed by the IRS that no one works for free, and so the IRS has said over and over again that officers of the corporation must receive wages (reported on line 7). As an owner-employee of the S-Corporation, you must pay yourself a salary, and pay payroll taxes on your salary, even if the business is losing money. You don't have to pay yourself a high salary, but it must be a "reasonable amount" according to the IRS.

S-Corporation profits, however, have not already been taxed, and so they will be taxed as ordinary income on the shareholder's tax return.

Because shareholder-employees receive both wages and profits from the S-Corporation, there is a strong temptation to pay a lower salary and a higher profit distribution. Wages are subject to FICA payroll taxes. The S-Corporation will pay the employer's share of FICA taxes (7.65%), and the employee will pay the other share of FICA taxes (also 7.65%). Between the S-Corporation and the shareholder, wages are subject to a combined 15.3% payroll tax, plus the shareholder's income tax rate. Profit distributions, however, are not subject to FICA payroll taxes; they are subject only to the shareholder's income tax rate. So all things considered, the shareholder-employee will have a strong preference to pay herself a minimal salary and thereby increase the profit distribution.

The IRS is fully aware of this situation, and they are actively seeking out S-Corporations paying out below-average wages. The IRS has said over and over again that S-Corporations must pay their shareholder-employees a "reasonable compensation" for services rendered to the company.

IRS Warns Businesses, Individuals to Watch for Questionable Employment Tax Practices
Failure to pay employment taxes is stealing from the employees of the business