Isaac Yedid, Esq. and Raymond Zeitoune, Esq.
Forming a legal entity for your new business will establish much-needed separation between you and your business. Protecting your personal assets is the first and foremost reason to think about incorporating, but let’s face it, small business owners are typically concerned about one thing: taxes.
There are a whole host of reasons to incorporate as a C-Corporation. For example, the C-Corporation is the preferred structure if you intend on seeking venture capital or taking your company public, but forming a C-Corporation involves more paperwork, legal fine print and potential double taxation.
Understanding the Pitfall of Double Taxation
From a legal standpoint, a C-Corporation is a separate entity that may sue and may be sued. When it comes to taxes, a C-Corporation is a separate taxpayer that files its own federal and state (where applicable) tax returns, meaning that profits are first taxed to the corporation. Then, if the corporation decides to take that profit and distribute dividends to its shareholders, the dividends are taxed again (this time, on each shareholder’s personal tax return).
To better understand the potential of double taxation, let’s look at an example: Isaac is the sole owner of a mobile phone business and formed a C-Corporation. His business took in $90,000 in profits in 2012. The business must pay income taxes on its $90,000 in profits. After paying those taxes, Isaac wants to take that money home, and decides to distribute the remaining profits to himself as a dividend. He will personally owe taxes on the dividend payment at the current dividend rate.
Avoiding Double Taxation: Pass-Through Tax Treatment
To avoid the double taxation burden under the C-Corporation business structure, many small business owners choose to elect “S-Corporation status” (by filing form 2553 with the IRS in a timely manner) or to form a limited liability company (LLC). With these two types of business structures, company profits are “passed through” and reported on the personal income tax returns of the business owners.
As “pass-through” entities, individual business owners of an S-Corporation or LLC are liable for any taxes owed on profits, whether or not that money is retained in the company or put in the business owners’ wallets. This is known as “phantom income,” and can obviously cause a problem for some business owners who may not want to take the profits out of the S-Corporation or LLC but would still be required to pay taxes on the earned profit.
Here’s what it would mean for Isaac and his mobile phone business: As an S-Corporation, the business itself pays no income tax on the $90,000 in profits. Since Isaac is the sole shareholder and also works in the business, he must pay himself a reasonable wage for his activities, which will be subject to his personal income tax rate. Even though Isaac may decide to only take a $50,000 salary, the remaining $40,000 that the S-Corporation earned in profits will also be taxed as “phantom income” on Isaac’s personal income tax return. A similar result would be produced if Isaac organized his business as an LLC.
THE LLC AND S-CORPORATION
Both the LLC structure and the S-Corporation structure offer “pass-through” tax treatment and both business structures will protect your personal assets from any potential liabilities of the company (whether from an unhappy customer, unpaid supplier, or anyone else who might pursue legal action). Yet, LLCs and S-Corporations feature some key differences as well.
Business Formality
With its roots as a C-Corporation, the S-Corporation involves structure, formalities and compliance obligations, which may be burdensome for the solo entrepreneur. If you incorporate as an S-Corporation, you need to set up a board of directors, file annual reports and other business filings, hold shareholder’s meetings, keep records of your meeting minutes, and generally operate at a higher level of regulatory compliance than your business might need or want to deal with. LLCs, on the other hand, merely use an informal operating agreement.
What to know: If you want less red tape and formality, the LLC can provide greater simplicity.
Who Can Be a Shareholder?
The S-Corporation has more restrictions in terms of who can be a shareholder. For example, an S-Corporation cannot have more than 100 shareholders. In addition, all individual shareholders must be either US citizens or permanent residents.
What to know: If you have foreign owners or would like a non-individual to be a shareholder, you cannot form an S-Corporation and should opt for the LLC.
Allocation of Profits and Losses
Profits and losses of an LLC may be allocated disproportionately among the owners. By contrast, profits and losses of an S-Corporation are assigned to each shareholder strictly based on their pro-rata shares of ownership. This is an important distinction to understand.
For example: Sophia and Claire open a gift basket business, each owning 50%. As the year progresses, Sophia needs to focus her time elsewhere, while Claire does all the work. Their business becomes more profitable than they ever imagined, and they want to divide up the profits. Because Claire has put in the bulk of the work, they decide that she should keep 75% of the profits and Sophia should get 25%. This type of arrangement works with an LLC but not with an S-Corporation.
What to know: If you need flexibility when it comes to divvying up profits and losses among owners, the LLC is the preferred structure.
Pass-Through Losses
With LLCs and S-Corporations, members and shareholders are able to “pass through” company losses to their personal income tax reporting. In some circumstances, the LLC lets you pass more loss than an S-Corporation, most notably when it comes to real estate.
What to know: If you’re setting up a business structure for real estate investments, the LLC structure allows you to write off more losses on your personal tax reporting.
Choosing the right business structure is a multi-faceted decision, and will ultimately depend on all the unique aspects of your particular business needs, vision and circumstances. Discussing your particular situation with a trusted tax advisor or accountant can go a long way in helping you determine which business structure and tax treatment is optimal for you.
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The Corporate Practice Group and the Tax Practice Group at Yedid & Zeitoune, PLLC work together with each client to put together the best business model for each client’s needs, taking into account all favorable tax treatments allowable for the structure, as well as draft operating agreements, buy/sell agreements, and any other agreements that may be necessary with respect to the business model chosen.
