Jonathan Bryant
Memo 2, Problem 3B
Advising Private Business Owners
Key facts with quick notes about issues raised:
Sam, Larry, and Joe are three equal co-owners in management consulting/computer training business.
All working full time for the business (Toilers)
Will always be the owners (Not worried about going public or other sales of their interests.
Because there are fewer than 100 owners, don’t need to worry about S Corp SH limitations if all
owners are U.S. citizens).
Generate fees from professional services (All income coming from their services, and not
generated by capital or equipment; thus, bailing out earnings will be reasonable as
compensation. C Corp okay, will avoid double taxation on profits [once profitable, will function
like a pass-thru. Still need to beware of trapped losses]. Don’t think this has to be a professional
service corporation because there is no special license required for providing management
consulting and computer training; thus, there will be favorable corporate brackets up to $75k if
choose to be a C Corp).
Intend to bailout income as compensation (Will avoid double taxation because the business is
not generating income from capital. If all income from services, then it will probably be deemed
reasonable).
Want to maximize their fringe benefits (C Corp definitely the choice. C Corps offer far and away
the best fringe benefits for SH employees).
Summary of entity recommendation based on information provided:
I would recommend forming a C Corp based on (1) the owners’ desire to maximize fringe benefits,
and (2) the fact that C Corp double-taxation should be a non-issue for a business generating all income
from services provided. However, the owners should be made aware of the self employment tax hit they
will take by bailing out all earnings to themselves.
Earnings Bailout for C Corps Distribution is NOT a dividend if it is compensation
o While SHs pay tax on dividends received from a corporation, SHs can avoid dividend tax.
The most common way to avoid corporate distributions being taxed as dividends is if a
SH employee receives earnings in the form of taxable compensation. The limitation is
that the compensation must be reasonable. Also, the cost of employee compensation is
deductible by the C Corp. Stripping out earnings in the form of compensation can easily
be justified if that compensation is for corporate earnings attributable to services. (If
Corp has substantial goodwill, capital, or other assets to which earnings are attributed,
then it is harder for SH/employee to justify all earnings as compensation. Not the case
here.
The Bracket Ride (Good low end brackets in C Corps)
o While the business is growing from two employees to more, the owners should consider
whether lower C Corp rates (up to $75k) can be used advantageously to service debt, or
otherwise finance the biz. While this does not apply to PSCs, this entity should not be
considered a PSC (no special licenses required).
Fringe Benefits (C Corp is the best)
Jonathan Bryant
Memo 2, Problem 3B
Advising Private Business Owners
o A number of fringe benefits available to SH/employees that are not available to owners
of pass-thru entities. (Toilers love ‘em. And here, we have a group of three Toilers)
Group-Term Life Insurance. §79.
Medical-Dental Reimbursement Plans. §106.
Cafeteria Plans. §125.
Dependent Care Assistance Programs. §129.
Self-Employment Taxes (Important negative aspect of C Corp self-employment tax)
o C Corps that bail out all earnings (such as with PSCs) will pay self-employment taxes on
everything. Have to be sure that the owners understand this.
o S Corps may present an opportunity to save on self-employment taxes SH can collect
a modest salary and distribute the rest as dividends (that escape double tax treatment
by virtue of the S election).
Tax Deferral by Using a Fiscal Year (Another positive thing about using a C Corp)
o C Corps that are not PSCs may select any fiscal year for tax reporting purposes. This
allows a pretty sophisticated tax deferral.
o Partnerships, LLCs, S Corps, and sole proprietorships required to use calendar year
unless prove business purpose (hard burden).