Do You Need A Business Corporation?
A C-Corporation, LLC or S-Corporation
Can Protect You and Be Your Tax Shelter
A Sole Proprietorship, a Partnership and a Corporation
If you offer goods or services
for sale to the public, you are doing business. If you have not incorporated, you are doing business either as a sole proprietorship or as a partnership. If you own the entire business, you are operating the business as a sole-proprietorship and you are the proprietor. You are personally liable for all the debts of the business and legal claims made against the business. You will report the revenue, expenses and profit of the business each year on Schedule C, Profit or Loss From Business, with your federal income tax return.
If someone else owns the business
with you, you are partners. Your business is a partnership, even if you don’t put anything in writing. You are personally liable on 100% of the debts and lawsuits of the business, and your partner is also. You will file a partnership information tax return Form 1065 for the business each year. You’ll report your share of the partnership income, expenses and profit on Schedule K1 with your personal tax return.
If you and your spouse
own and operate the business, the business is considered a partnership in most, but not all, states. However, if you file Schedule C for the spousal business, the IRS treats the business as a sole proprietorship, with only one owner. The unnamed spouse could be at a significant financial disadvantage in this case.
What Is a Corporation?
Anyone can incorporate a business
. A corporation is a business entity entirely separate from its owners, and separate from the people who manage or operate it. The corporation is itself a legal person because it can own property, have legal standing to sue and be sued, conduct business, enter into contracts and borrow money. The corporation is subject to federal, state and local income taxes, as well as other taxes.
Why would you incorporate your business
? The chief advantage of incorporation is that the owners, shareholders, are not personally liable for business debts, claims or other liabilities. The people who invest in a corporation and own it normally stand to lose only the amount of money they have paid for its stock. This is called “limited liability.” People who do business with the corporation can sue the corporation for damages, but they cannot sue the owner personally. If you have personal assets like a home and savings, they are safe from business lawsuits. It is also easier to sell part ownership of the business, by selling shares of stock in a corporation. The benefits of incorporating are available to you as long as you operate the business at arms length, without intention to defraud.
There are disadvantages
to a corporate business, as well as the advantages. Fees are charged to file your papers of incorporation, usually a small percentage of the invested capital. If you do business as a corporation, you are expected to have separate bank accounts and financial statements. You cannot withdraw money from the corporation for your personal use. Instead, your corporation pays you a salary, pays you dividends or sometimes makes you a loan. Your corporation will file its own tax returns every year.
The C Corporation
A general corporation, called a C-Corporation
, is the most common type. A large business with many owners is usually organized as a general corporation. The owners are the stockholders. They can only take money out of the corporation in the form of salary, stock dividends, or a loan. A general corporation can have an unlimited number of stockholders.
The corporation pays federal income tax
on its profits every year. The chief disadvantage of a general corporation is “double taxation.” The dividends the company pays the owners are taxed twice, once when the corporation pays income tax on its profits, and again when the shareholder personally pays income tax on the dividends. Another disadvantage to the corporate structure is that, if the shareholders are paid a salary, the general corporation must pay payroll taxes on the money. Payroll taxes include federal social security tax, federal unemployment tax, state unemployment tax, workers compensation, and city tax. Rules vary state by state.
An LLC, Limited Liability Company
The LLC, or Limited Liability Company
, is a business structure created by states. The LLC gives the owners the legal protection of personal limited liability for business debts and legal claims, just like a corporation. However, the LLC does not pay income tax on its earnings. Instead, the profits and losses of the business are reported on the personal income tax returns of the owners. This “pass-through” feature solves the problem of double taxation that occurs with a general corporation.
The advantage of an LLC
is that it provides “limited liability,” the legal protection of a corporation, but avoids the double tax penalty on dividends of a general corporation. If your business operations have substantial risks, whether product liability, personal injury, employee, fiduciary or other, consider operating as a LLC, instead of a sole proprietorship or partnership. If your business could be sued, or might be unable to repay a large amount of debt, consider forming an LLC.
To create your LLC
, you must file articles or organization with your state business office. A fee is charged similar to the fee for incorporation. If the LLC has more than one owner, it should prepare an operating agreement to specify how profits and losses will be distributed, buyout arrangements and other contingencies.
Use Your LLC As An Income Tax Shelter
A corporation pays a federal income tax rate of 15%
on its first $50,000 of profits. In comparison, an individual may be in the top individual income tax bracket and pay 35% federal tax rate. An LLC can choose to be taxed like a corporation, and provide a legal “tax shelter” for a small business. The LLC usually passes through its income to the owners, and the earnings are taxed at each owner’s rate. If the corporate tax rate is less than the owner’s individual tax rate, you save money if your LLC is taxed on its profits as a corporation, at the lower corporate tax rate. This feature is useful and valuable if your LLC does not distribute its profits to the owners, but retains its profits for expansion of the business.
If you chose to operate as a LLC
, you can set up a simple LLC yourself using preprinted forms. Choose a name for your corporation, and apply to the IRS for a Federal Employer Identification Number, FEI, even if you won’t have employees. The FEI identifies your corporation in many situations, just as the Social Security Number identifies you.
An S Corporation
An S corporation is a general corporation
that chooses to be designated as an S corporation for income tax purposes.
A general corporation
can choose to be to a S-corporation to save income taxes. Each shareholder of the S-corporation is allocated a portion of corporate profits and losses and reports them on his/her personal tax return. The corporation does not pay taxes on its profits, but the shareholders do. By electing status as an S-corporation, the company can take advantage of the “income pass through” feature available to an LLC.
Why would a corporation
want to elect S-corporation tax status? If the corporation is unprofitable, it can distribute its losses to the shareholders. Shareholders can then report the loss on the personal tax return, and the loss will reduce their taxable income. The business loss has no tax value to the corporation, but it can save income tax for the shareholder.
Comparing An S-Corporation to a LLC
The “income pass-through” feature
for a LLC is more flexible than for an S-corporation. An LLC can distribute the profits to the owners in any ratio they choose. An S-corporation must distribute the profits to the owners in proportion to each ownership interest.
The S-corporation has a tax-advantage
over a LLC when it comes to the self-employment tax. The profits of an S-corporation are not subject to the self-employment tax. Only the salaries paid to the owners are subject to the self-employment tax. In an LLC, the owner pays the self-employment tax on the total profit of the business.
However, a LLC has the advantage
over an S-corporation when it comes to business losses. The LLC owner can deduct more of the business loss than the S-corporation owner can.
Other Taxes For Your Business
Whether you operate your business
as a sole proprietorship, a partnership, an LLC or a corporation, there are a number of taxes that apply to all businesses.
In some towns you may need a local license to do business.
Most business sales
are subject to state sales tax. You will collect the sales tax as an agent for the state and remit it to the state. Apply to your state for a Vendor Number or State Sales Tax Number.
If your business has employees
, the business pays federal social security tax on the wages paid, as well as federal unemployment tax, state unemployment tax and state workers compensation tax. As a sole proprietor, you will not pay yourself a salary, but can make withdrawals from the business at will. These withdrawals may be exempt from the state unemployment and workers compensation taxes.
I hope life brings you much success. I wish you a very happy day.
----- Surfer Sam