Setting Up Your Business Entity

Do you remember getting started in your brand new business venture? Besides testing the market, deciding on a product or service, there was this decision regarding entity selection. Before the early 1990’s, there was the corporation (C or S), the partnership in its many forms, and the sole proprietorship. With the advent of the Limited Liability Company or LLC, choosing an entity form has become more interesting and thought provoking.

The C corporation is a taxable entity in and of it self. The C corporation is a tax designation that simply segregates a regular corporation fro the subchapter S corporation. Owners of a C corporation will ultimately decide whether the entity will pay income tax or the ownership group will pay income tax as individuals. In the closely held business world, owners in the C corporation are also the management team which is very different from most publicly held businesses. It is not uncommon for the owners in a closely held C corporation to strip the earnings out of the business to avoid paying corporate level income tax. The C corporation is an entity that can produce double taxation in the sense that it is possible to leave earnings in the entity, subjecting them to tax, and then later distributing them to the ownerhsip group, or shareholders, to be taxed again. Careful management of this issue can serve to avoid double taxation. The C corporation is a great source for providing fringe benefits to the shareholders of the entity unlike the other entity forms. Careful consideration should be given to this point when making an entity selection decision. In addition, there can be many advantages for first starting a business as a C corporation entity, including code section 1202 stock. This code section allows for the exclusion of 50% of the proceeds from the sale of the company’s stock. However, this exclusion is subject to the alternative income tax (a later discussin for my faithful readers). An important characteristic of 1202 stock is that one can sell C corporation stock and invest in another C corporation’s stock with the proceeds, and avoid paying income taxes currently on the transaction. As noted, careful planning is essential.

The S corporation, for income tax purposes, is typically a flow through entity. This means that earnings at the corporate level flow through to the shareholders to be taxed at their individual income tax rates. In a subchapter S corporation, these flow throughs are not subject to the employment taxes (SE tax) which could save significant tax dollars. Fringe benefits can not be paid and deducted for more than 2% shareholders of the S corporation and 1202 stock provisions will not apply. The S corporation does work very nicely where the business is extremely profitable and there is fear that there will be unreasonable compensation charges if the company were operating as a C corporation. There are instances when Internal Revenue will claim that wages paid to the shareholders in a C corporation consititute dividend payouts rather than deductible compensation. Dividends represent double taxation as they are taxed once at the C cororation level and again at the shareholder level.The S corporation eliminates this problem for the most part as the shareholders can set their compensation levels reasonably and allow the rest of the earnings to flow through. The S corporation can also be good for the sale of a business. Depending on one’s time horizon and structuring of the sale, the S corporation can provide for capital gain treatment if the business’ assets are sold rather than its stock (as compared to 1202 stock treatment of the C corporation).

The limited liability company (LLC) is an interesting entity choice. It works wonders for multiple businesses and can provide for significant tax savings when fully understood. The LLC can be taxed as a sole proprietorship, a C corporation, an S corporation, or a partnership. It is a versatile format for running one’s business. My personal preference is that new entities be formed as partnerships with our spouses. Imagine that I am a real estate broker. My earnings are subject to the self-employment tax. If my income is $60,000, my SE tax will be $9,180 ($60,000×15.3%). If my wife owns the business with me jointly in a partnership, she will not owe the SE tax on her half of the earnings (assuming she owns 50%) becasue she does not participate in the business on a full time basis. She is but a passive investor. By operating my business in this manner, my SE tax is cut in half to $4.590. This is a significant savings. I recently helped a client save $8,000 in taxes by forming this entity structure with his wife.

My favorite entity of all, when dealing with multiple entities, inldues a management company (C or S corporation) over seeing the LLC’s which own the different activites. This way, I can say that all earnings of the LLC,s are not subject to SE tax. I can demonstrate that the SE tax will be paid at the management corporation level. The LLC’s will pay management fees to the governing corporation where SE tax will be paid through W-2 compensation paid to the shareholder or shareholders. Whether the management company is a C corporation or S corporation depends on issues mentioned above. If I want fringe benefits, the C corporation is the proper choice. If wish to save even more money on SE tax, The S cororation will be my entity of choice (beware of getting too greedy as IRS is cracking down on S corporations with low salaries to owners). Because of this structure of LLC’s and the management company, I am not concerned about unreasonable compensation issues as I can control the amount of management fees that get back to the management company. All other earnings will flow through to the partners’ returns from the LLC’s and will not be subject to the SE tax.

Ron Piner, CPA Host of “Better Business” Saturday Mornings at 10ET On WBIS AM 1190 my my