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Knowing the difference between Business Organization or Entity types is critical when forming a new business venture. Business Polish has teamed up with Barbara Appenzeller, CPA to provide this informative overview of Entity Types. The document is not copyrighted, but should give credit to both Barbara Appenzeller and Business Polish when reproduced.
Barbara Appenzeller, CPA www.barbcpa.com
Starting a Business - What to Consider Before you start a new business, there are a number of preliminary decisions to be made. One of the first choices you will face is the legal form in which you will operate the business. Should it be an unincorporated sole proprietorship, a partnership, a limited liability company, a regular corporation, or an S corporation? Each of these forms has both tax and non-tax advantages and disadvantages that must be weighed in conjunction with your own plans and personal situation. Sole proprietorships, for example, are the easiest and cheapest business form to set up, and they can be operated with few formalities. However, they offer no personal liability protection and don't allow you to get many of the tax benefits that are available to corporate employees. Partnerships offer many of the same advantages and disadvantages as the sole proprietorship, but they allow the business to be owned and run by more than one person. Also, the liability problem can be overcome to a certain extent by forming a limited partnership, but partners whose liability is limited cannot be involved in actively managing the business. And losses from these partnerships may be restricted by the so-called passive activity rules. A newer form of entity, known as the limited liability company offers what many see as the best alternative for the typical small business. These entities can be set up to be taxed as partnerships, avoiding the corporate income tax, while the managing members' personal assets remain fully protected from business creditors. S corporations also offer liability protection, without a separate corporate tax. Like partners and sole proprietors, however, more-than 2% S corporation shareholders are ineligible for tax-favored fringe benefits. Another potential drawback of S corporations results from limitations on the number and kind of permissible shareholders. These restrictions can limit an S corporation's growth potential and access to capital in some businesses. In others, however, an S corporation can be a key ingredient toward success. What about regular corporations, known as C corporations? They do not have the shareholder restrictions that apply to S corporations, but they are subject to a double system of taxation. That is, their profits are subject to income tax at the corporate level, and are also taxed to the shareholders if distributed as dividends. But if profits are to be plowed back into the business to foster the company's growth, the tax price is usually lower than with an S corporation. And there are many situations in which the double tax can be substantially minimized. An advantage to this form of operation is that shareholder-employees are entitled to taxadvantaged corporate-type fringe benefits, such as medical coverage, disability insurance, and group-term life.
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As we discussed, because you are a professional corporation, your federal income tax rate will be 35% regardless of the amount of income subject to tax at year-end. Limited Liability Companies A few years ago, hardly anyone had heard of limited liability companies. Now businesses can operate as LLCs in all states, and the press and media have nothing but good things to say about them. Is all the hype justified? Much of it is. Limited liability companies offer an unprecedented combination of corporate-like liability protection and partnership pass-through taxation. Limited liability company "members" don't have to limit their participation in the firm's management to protect their personal assets from the firm's creditors, as they do in a limited partnership. Yet they can qualify for true partnership taxation. LLCs also have a number of distinct advantages over S corporations for many businesses. There are no limits on the number or kind of shareholders, giving LLCs greater access to capital. They're not restricted to a single class of stock as S corporations are, so LLC members have a greater ability to allocate gains, losses, deductions, and credits. LLCs have a lot more estate planning flexibility than S corporations, too. And there are other technical advantages that can make a bottom-line tax difference. With all that going for them, should your business become an LLC? The answer depends on your particular set of facts and circumstances. Established corporations with appreciated assets might find the tax cost of conversion to be prohibitive. But most start-up ventures should at least consider operating as LLCs. And existing proprietorships should definitely consider conversion; that way the owner's personal assets will be protected from any financial problems that arise in the business. Many existing partnerships and even some S corporations also should consider making the switch. Real estate partnerships are especially suitable candidates. It is not completely clear what kind of liability protection members of multi-state LLCs will have if they operate in states that don't authorize them. Nevertheless, there are great benefits from this new form of operation. C-Corporations A corporation is an artificial being, separate and distinct from it shareholders that is created under state law and is popular with small or large number of investors. The corporation allows such investors to contribute capital to a business entity that offers the attractive feature of limited liability. A C corporation is liable for regular tax, AMT, accumulated earnings tax, and penalty for underpayment of estimated income tax. In addition, there is an Arizona income tax that is required to be paid. Accumulated earnings tax is derived from leaving to much money in the corporation. Salaries are taxable to shareholderemployees and deductible by the corporation. FICA and FUTA taxes are applicable to compensation for services rendered. Distributions may be made by the corporation of accumulated earnings and profits; however, such monies are not a deduction for the corporation and are taxed at the individual tax rates. If a regular C corporation makes a dividend distribution, that amount distributed is subject to a double-tax, i.e., a tax on the income generated by the C corporation and another tax generated by the dividend distribution. Of course, it is possible to avoid the imposition of the double tax, if the amounts distributed are taken out of the corporation as compensation. However, if too much compensation is paid, it is always possible for the compensation to be subject to IRS scrutiny and for the determination to be made by the IRS that the
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compensation paid was unreasonable compensation, thereby subjecting the amount distributed to a doubletax. Medical benefits are fully deductible by the corporation for shareholders holding a greater then 2% interest in the company. In addition, the shareholders may have a medical insurance reimbursement plan; however, federal employment laws must be adhered to in establishing this type of policy. S Corporations Some of the advantages are: * * Your personal assets will not be at risk because of the activities or liabilities of the S corporation (unless, of course, you pledge assets or personally guarantee the corporation's debt). Your S corporation generally will not have to pay corporate level income tax. Instead, the corporation's gains, losses, deductions, and credits are passed through to you and any other shareholders, and are claimed on your individual returns. The fact that losses can be claimed on the shareholders' individual returns (subject to what are known as the passive loss limits) can be a big advantage over regular corporations. Liquidating distributions generally also are subject to only one level of tax. The S corporation also has no corporate alternative minimum tax (AMT) liability (however, corporate items passed through to you may affect your individual AMT liability). FICA tax is not owed on the regular business earnings of the corporation, only on salaries paid to employees. This is a potential advantage over sole proprietorships, partnerships, and limited liability companies. The S corporation is not subject to the so-called accumulated earnings tax that applies to regular corporations that do not distribute their earnings and have no plan for their use by the corporation.
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Some of the disadvantages are: * * * * * S corporations cannot have more than 75 shareholders (but with husband and wife being considered as only one shareholder). Further, no shareholder may be a nonresident alien. Corporations, nonresident aliens, and most estates and trusts cannot be S corporation shareholders. Electing small business trusts, however, can be shareholders, a distinct estate planning advantage. S corporations may not own subsidiaries, which can make expansion difficult, unless the subsidiary is a Qualified Subchapter S Subsidiary (a 100% owned S corporation). S corporations can have only one class of stock (although differences in voting rights are permitted). This severely limits how income and losses of the corporation can be allocated to shareholders. A shareholder's basis in the corporation does not include any of the corporation's debt, even if the shareholder has personally guaranteed it. This has the effect of limiting the amount of losses that can be passed through. It is a disadvantage compared to partnerships and limited liability companies, and is one of the main reasons that those forms are usually used for real estate ventures and other highly leveraged enterprises. S corporation shareholder-employees with more than a 2-percent ownership interest are not entitled to most tax-favored fringe benefits that are available to employees or regular corporations such as health insurance and medical reimbursement plans. S corporations generally must operate on a calendar year.
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DISCLAIMER The following form is provided by Business Polish for informational purposes only and is intended to be used as a guide prior to consultation with an attorney familiar with your specific legal situation. Business Polish is not engaged in rendering legal or other professional advice, and this form is not a substitute for the advice of an attorney. If you require legal advice, you should seek the services of an attorney.
Tailored for Small Businesses
Start-up & Planning Services Branding & Business Identity Packages Graphic Design & Web Services General Business Consulting Small Business & Minority Certifications (8(a), SDB, DBE, MBE, WBE)
See www.BusinessCertifications.com and www.MinorityCertifications.com