Fictitious Business Names
Sellers Permit / Resale License
Federal Tax Id
State Tax Id
Regular corporations (sometimes called C corporations) and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, LLC member-owners avoid this double taxation because the business's tax liabilities are passed through to them; the LLC itself does not pay a tax on its income.
You'd like to provide extensive fringe benefits to owner-employees. Often, when you form a corporation, you expect to be both a shareholder (owner) and an employee. The corporation can, for example, hire you to serve as its chief executive officer and pay you a tax-deductible salary, which, from a tax standpoint, is far better than paying you dividends, which can't be deducted by the corporation as a business expense and therefore wind up being taxed twice (once at the corporate level and once at the personal level).
LLCs that are taxed like corporations are able to split monies between business owners and the business itself, resulting in some situations in a significant overall tax saving. Also, Can save with splitting income between yourself and a C : give generous bonuses and fringe benefits which are not taxable personally to you but are deductible to the corporation. (if you elect to have your LLC taxed as a corporation. In that situation, as long as you meet the IRS guidelines, you can receive fringe benefits as an owner-employee of the LLC and not have to pay tax on the value of those benefits.) If. after reviewing all the financial implications and perhaps seeking the advice of a tax pro you decide to elect corporation-style taxation, you'll do this by filing IRS Form 8832, Entity Classification Election. Where the LLC has two or more members, they can all sign the form or authorize one member or manager to sign.
Flexible Management Structure
An LLC member may be an individual or a separate legal entity such as a partnership or corporation that has invested in the LLC. You and the other members jointly run the LLC unless you choose to have it run by a single member, an outside manager or a management group which may consist of some members, some nonmembers or both. If you decide to form an LLC, I recommend that all the members sign an operating agreement that spells out how the business will be managed. Again, the details of how to do this are well covered in Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo).
Flexible Distribution of Profits and Losses
The members of an LLC can decide to split up the LLC profits and losses each will receive any way they want. Although it's common to divide LLC profits according to the percentage of the business's assets each member contributed, this isn't legally required.
By contrast, rules governing corporate profits and losses are considerably more restrictive. A regular corporation can't allocate profits and losses to shareholders; instead, shareholders must receive dividends according to the number of shares they own if they receive dividends at all. (But it is possible, although more cumbersome, to establish two or more classes of stock, each with different dividend rights.) Similarly, in an S corporation, profits and losses are attributed to the shareholders based on their shares: a shareholder who owns 25% of the shares in an S corporation ordinarily must be allocated 25% of profits and losses no more and no less. Sometimes, however, corporations can get away from this strict formula by adjusting the salaries of shareholders who work in the business.
the rules on the self-employment tax are well-established: as an S corporation shareholder, you pay the self-employment tax on money you receive as compensation for services but not on profits that automatically pass through to you as a shareholder. For example, if your total share of S corporation income is $100,000 in 1999 and you perform services for the corporation reasonably worth $65,000, you will be taxed 15.3% on the $65,000 but not on the remaining $35,000.
By contrast, the rules for members of an LLC are murky. Proposed IRS regulations (which Congress has placed on hold) would impose the self-employment tax on your entire share of LLC profits in any of the following situations:
You participate in the business for more than 500 hours during the LLC's tax year.
You work in an LLC that provides professional services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting (no matter how many hours you work).
You're empowered to sign contracts on behalf of your LLC.
Until the IRS clarifies the rules on self-employment tax for members of an LLC, you should assume that 100% of an LLC member's earnings will be subject to the self-employment tax. Thus, using the figures in the above example, you should assume that the full $100,000 of your business's income will be subject to the self-employment tax (although the amount above the current year's Social Security tax cut-off figure$72,600 in 1999will be subject only to the Medicare tax).
The point is that for now and until the tax rules are clarified an S corporation shareholder may pay less self-employment tax than an LLC member with similar income. You'll need to decide if this potential tax saving is enough to offset such LLC advantages as flexibility in management structure and in distributing profits and losses
Here are some of the IRS ground rules for fringe benefit plans:
Medical Reimbursement Plans . Group Life Insurance .
at least 70% of employees must receive the benefits (could be less for others since benefits can be proportionate to compensation) But can exclude those under 25.
Clearly, this is technical stuff. Let's say you open a video store and hire a bunch of students to work part-time during peak periods, and contract out for bookkeeping servicesyou can set up a medical reimbursement plan without having to worry about covering a whole slew of employees. You could exclude the students because they're under 25 and work less than 35 hours a week. Your bookkeeper, being an independent contractor, wouldn't be an employee and wouldn't have to be covered. So perhaps your plan would cover only yourself and a few full-time employees, plus the families of all covered employees.
(3) Retirement Plans
It used to be that by incorporating you could set up a better tax-sheltered retirement plan than you could get as a sole proprietor, a partner or a shareholder-employee in an S corporation. The differences are no longer significant. Through a Keogh retirement plan that is available to sole proprietors and partners, the owners can shelter retirement funds to practically the same extent as they can with a corporate retirement plan.
The few differences that remain between corporate and individual plans run the gamut from the arcane to the inconsequential. Consider the most significant remaining difference: If you're a participant in the retirement plan of a regular corporation, you can borrow up to $50,000 from your account if you meet various tax requirements. Try to do the same thing with your Keogh plan funds or the funds you put into an S corporation retirement plan and you'll have to pay an excise tax on the money you borrow. Is that a compelling reason to incorporate? For most people, the answer is no.
Unlike a lender who, in return for providing money, receives a promise that you'll repay it with interest, an investor becomes a part-owner of the business. While it's possible to form a partnership and make an investor a partner or to form an LLC and make an investor a member, it's often more practical to form a corporation and make the investor a shareholder
Keep in mind that shareholders don't necessarily have to have equal rights to elect the board of directors or to receive dividends. To distinguish between various types of shareholders, you can issue different classes of stock with different rights, for example:
common, voting shares to the initial owners who will be working in the business
nonvoting shares for key employees to keep them loyal to the business
nonvoting preferred shares to outside investors, giving them a preference if dividends are declared or the corporation is sold.
To repeat this key point, the fact that the corporate structure makes it relatively easy to distinguish between different investors by issuing different classes of stock is a real advantage.
Stock options can motivate employees . Especially for a business that sells stock to the public or plans to do so before long, which allows the market to establish a price for the stock, issuing stock options to employees at a favorable price can be a great way to motivate them. That's because employees who hold options know that if the business is profitable and its stock price goes up, they'll be able to cash in their options at a substantial profit. This can motivate them to help make the business successful. Also, employees who get stock options are often willing to work for a bit less salary, making investment capital go farther in the early days of business life.
Structuring your business as a corporation is not only advantageous but actually essential if like many small business owners you dream of someday attracting investors through a public offering. And, fortunately, it's become far easier than it used to be for a small business to do just that without turning to a conventional stock underwriting company. Congress and state legislatures have liberalized laws that enable a small corporation to raise from $1 million to $10 million annually through a relatively easy-to-use procedure called a limited public offering.
Consider using the Internet to sell shares . You may decide to market your shares by placing your company's small offering prospectus on the Internet something now allowed by the Securities and Exchange Commission (SEC), the federal agency that watches over securities laws. If your company creates a website to inform the public about your products and services, you can also use that site to distribute your prospectus and market your shares. Of course, you'll first need to take care of the paperwork required by federal and state securities laws.
You don't need to incorporate to ensure that your business will continue after your death. A sole proprietor can use a living trust or will to transfer the business to her heirs, and partners frequently have insurance-funded buy-sell agreements that allow the remaining partners to continue the business.
for many new businesses especially those that won't run up significant debt or expose their owners to the threat of lawsuits a sole proprietorship or partnership may be a perfectly adequate way to go, keeping in mind that you can always incorporate the business or form an LLC later.
Paul is also concerned about taxes. He expects his company to lose money during its first few years; he'd like to claim those losses on his personal tax return to offset income he'll be receiving from consulting and teaching work. He registers with the IRS as an S corporation. Unless he changes that tax status later, his corporation won't pay any federal income tax. Paul will report the corporation's income loss on his own Form 1040 and will be able to use it as an offset against income from other sources.
For many years, if you wanted to limit the personal liability of all owners of your business and have the income and losses reported only on the owners' income tax returns, you would have no choice but to create an S corporation. Today, you can accomplish the same goal by creating a limited liability company (LLC), as explained in Section D, below. Because, in addition, an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, it's generally better to structure your business as an LLC than as an S corporation. (But see Section E for a discussion of when it might be better to create a corporation.)
Starting as an S corporation rather than a regular corporation may be wise for several reasons:
Because income from an S corporation is taxed at only one level rather than two, your total tax bill will likely be less. (But be aware that the two-tier tax structure for regular corporations can sometimes be an advantage. See the discussion below on how a regular corporation can achieve tax savings through income-splitting.)
Your business may have an operating loss the first year. With an S corporation, you generally can pass that loss through to your personal income tax return, using it to offset income that you (and your spouse, if you're married) may have from other sources. Of course, if you're expecting a profit rather than a lossbecause, for example, you're converting a profitable sole proprietorship or partnership to a corporationthis pass-through for losses won't be an advantage to you.
Interest you incur to buy S corporation stock is potentially deductible as an investment interest expense.
When you sell the assets of your S corporation, you may be taxed less on your gain than if you operated the business as a regular corporation (because of the dual taxation structure of corporations).
Your decision to elect to be an S corporation isn't permanent. If you later find there are tax advantages to being a regular corporation, you can easily drop your S corporation status, but timing is important.
In practice, however, a regular corporation may not have to pay any corporate income tax even though it is a separate taxable entity. Here's how: In most incorporated small businesses, the owners are also employees. They receive salaries and bonuses as compensation for the services they perform for the corporation. The corporation then deducts this "reasonable" compensation as a business expense. In many small corporations, compensation to owner-employees eats up all the potential corporate profits, so there's no taxable income left for the corporation to pay taxes on.
EXAMPLE : Jody forms a one-person catering corporation, Jody Enterprises Ltd. She owns all the stock and is the main person running the business. The corporation hires her as an employee, with the title of president. The corporation pays her a salary plus bonuses that consume all of the corporation's profits. Jody's salary and bonuses are tax-deductible to the corporation as a corporate business expense. There are no corporate profits to tax. Jody simply pays tax on the income that she receives from the corporation, the same as any other corporate employee.
(1) Tax Savings Through Income-Splitting
As an alternative to paying out all the corporate profits in the form of salaries and bonuses, you may want to leave some corporate income in the corporation to finance the growth of your business. You can often save tax dollars this way because, for the first $75,000 of taxable corporate income, the tax rate and actual taxes paid will generally be lower than what you'd pay as an individual. The federal government taxes the first $50,000 of taxable corporate income at 15% and the next $25,000 at 25%. Taxable income over $75,000 is taxed at 34% until taxable income reaches $10,000,000at which point the rate becomes 35%. Additionally, to make larger corporations pay back the benefits of these lower graduated tax rates, corporate taxable incomes between $100,000 and $335,000 are subject to an extra 5% tax. See the chart in Chapter 8, Section C1d.
Here's an example of how, with proper planning, a small incorporated business can split income between the corporation and its owners, retaining money in the corporation for expenses and lowering the corporation's tax liability to an amount that's actually less than what would have to be paid by the principals of the same business if it were not incorporated.
EXAMPLE 1 : Sally and Randolph run their own incorporated lumber supply company, S & R Wood Inc. One year their sales increase to $1.2 million. After the close of the third quarter, Sally and Randolph learn that S & R Wood is likely to make $110,000 net profit (net taxable corporate income) for the year. They decide to reward themselves and other key employees with moderate raises in pay, give a small year-end bonus to other workers and buy some needed equipment.
This reduces the company's net taxable income to $40,000an amount that Sally and Randolph feel is prudent to retain in the corporation for expansion or in case next year's operations are less profitable. Taxes on these retained earnings are paid at the lowest corporate rate, 15%. If Sally and Randy had wanted to take home more money instead of leaving it in the business, they could have increased their salaries and paid taxes at a rate of at least 15% and more probably 28% or 31% or higher, depending on their tax brackets.
Double taxation trap. Sally and Randy could have also declared a stock dividend. But because this would have subjected them to a double tax of 15% at the corporate level plus 15% or (more likely) 28% or 31% or higher at the personal level, it would have been a poor choice.
EXAMPLE 2 : Now assume S & R Wood is not incorporated but instead is operated as a partnership. Now the entire net profits of the business ($110,000 minus the bonuses to workers and deductible expenditures for equipment) are taxed to Sally and Randolph. The result is that the $40,000 (which was retained by the corporation in the above example) is taxed at their individual rate of 28% or 31% or higher rather than the 15% corporate rate.
Tax savings may be a largely theoretical advantage for the person just starting out. If your business is like many start-ups, your main concern will be generating enough income from the business to pay yourself a reasonable wage. Retaining profits in the business will come later. In this situation, the tax advantages of incorporating are illusory.
EXAMPLE : In its first year of operation, Maria's store, The Bookworm, has a profit of $25,000. As the sole proprietor, Maria withdraws the entire $25,000 as her personal salary, which places her in the 15% tax bracket after she subtracts her deductions and personal exemption. It doesn't make sense for Maria to incorporate to take advantage of income-splitting techniqueseven if she could get by on say, $20,000 a year, if she left the remaining $5,000 in the corporation, it would be taxed at the 15% corporate tax rate, so her total tax bill would be the same.
Lower Tax Rates Not Available for S Corporations
The lower tax rates for retained earnings don't apply to S corporations, because, as discussed in subsection a, above, an S corporation does not itself pay taxes on earnings. Individual shareholders in an S corporation pay taxes on their portion of corporate earnings at their personal income tax rates (as if they were partners in a partnership). This is true whether or not those earnings are distributed to them, meaning that even if the shareholders do leave some earnings in the corporation, the shareholders will be taxed on them at their regular tax rates.
(2) Fringe Benefits
The tax rules governing fringe benefits are complicated. Generally, however, if your business will be offering fringe benefits to employees, you can enjoy a tax advantage if you organize as a regular corporation. The business can pay for employee benefits and then take these amounts as business expense deductions. You and the other shareholders who work as employees of your corporation can have the corporation pay for such employee benefits as:
deferred compensation plans
group term life insurance
reimbursement of employee medical expenses that are not covered by insurance
health and disability insurance
death benefit payments up to $5,000.
But the real advantage is how these fringe benefits are treated on your personal tax return. As a shareholder, you won't be personally taxed for the value of this employment benefit. That's because none of the employees of a regular corporationeven if they're ownershave to pay income tax on the value of the fringe benefits they receive. So, for example, your corporation may decide to provide medical insurance for employees and to reimburse employees for uninsured medical payments. The corporation can deduct these payments as a business expenseincluding the portion paid for the owner-employees of the corporationand you and the other owner-employees are not taxed on these benefits.
Other types of business entities can also deduct the cost of many fringe benefits as a business expense, but owners who receive these benefits will ordinarily be taxed on their value. That's because the tax laws distinguish between an employee and a self-employed person. The tax laws say that you're a self-employed person and therefore are taxed on your fringe benefitsif you're a sole proprietor, a partner in a partnership, a member of an LLC that's taxed as a partnership or an owner of more than 2% of the shares of an S corporation. An owner-employee of a regular corporation, however, isn't classified as a self-employed person. So when it comes to fringe benefits, the tax treatment of owner-employees of a corporation is unique advantage.
This favorable tax treatment may seem like a powerful reason to organize your business as a regular corporation. Not so fast. Obviously, there's no benefit unless your business provides these benefits to employees in the first place. And that may be too expensive for some new businessesespecially because many types of employee benefits must be provided on a nondiscriminatory basis to a wide range of employees or to none, and must not be designed to primarily aid the business owner. If you put together a fringe benefit package that favors you and other owner-employees, the IRS will require owners to pay tax on their portion. Few new businesses can afford the cost of carrying expensive benefit programsa cost that typically more than offsets any tax advantage to you as owner of a regular corporation.
Here are some of the IRS ground rules for fringe benefit plans:
Medical Reimbursement Plans . If your business promises to pay employees' medical expenses that are not covered by health insurance, your plan can also include the spouse and dependents of each employee. Usually you'll set a limit on the total amount that can be reimbursed during the year; this limit must be the same for all eligible employees. In the typical small business, if you include owner-employees in the plan, your plan must benefit 70% of all employees or a "fair cross-section" of all employees. You can exclude employees who are under 25, work less than 35 hours per week or have been employed less than three years. As long as you meet these rules, employeesand even owner-employeeswon't be taxed on reimbursements they receive. If you violate these rules, however, an owner may have to pay tax on all or part of the reimbursements that he or she receives under the plan. (These technical rules apply only to reimbursement of medical expensesnot to employer payment of medical insur
Group Life Insurance . Your business can provide up to $50,000 of group term life insurance tax-free to employees if you meet certain conditions. To deduct the cost of the insurance, your plan must benefit at least 70% of all employees, cover a "fair cross-section" of all employees or limit the number of key employee participants to 15% of all group participants. (A key employee is an officer, one of the top ten owners or an owner of least 5% of the company.) All benefits available to participating key employees must be available to all other participating employees as well. You can provide different dollar amounts of life insurance to different employees without being "discriminatory" if the amount of coverage is uniformly related to compensation.
Clearly, this is technical stuff. Let's say you open a video store and hire a bunch of students to work part-time during peak periods, and contract out for bookkeeping services you can set up a medical reimbursement plan without having to worry about covering a whole slew of employees. You could exclude the students because they're under 25 and work less than 35 hours a week. Your bookkeeper, being an independent contractor, wouldn't be an employee and wouldn't have to be covered. So perhaps your plan would cover only yourself and a few full-time employees, plus the families of all covered employees.