Business Forms

As part of our educational series, we answer the question of why it is so useful to set up your firm as an LLC. When setting up a new business or expanding an existing one...one of the most important decisions to make is the choice of legal entity.

Today, few firms are formed as regular C corporations, and even S corporations are becoming less popular. LLC’s are becoming the entity of choice. Some of the key tax issues when selecting a form of business are....

How its operating income will be taxed, and
How its owners will be taxed in the future when they exit the firm

In addition, a business founder will want to have flexibility in managing it, arranging its ownership structure, and allocating income among themselves. On all of these points,
C-corporations now generally are inferior compared with the pass-through entity alternatives available today.

A C-corporation is a separate taxpayer subject to corporate level taxes. But a pass-through entity has its income taxed directly on the personal tax returns of its owners..avoiding the corporate level tax. The pass-through entity alternatives are....

S-corporations are corporations organized in the normal manner under state law, which provide their owners with corporate protection against personal liability for the business obligations. The IRS imposes important restrictions on S-corporations. For instance: they can only have one class of stock; profits must be distributed to owners pro rate with stock ownership; and, there can be no more than 100 shareholders.

Partnerships are unincorporated business entities. They are not subject to the restrictions that the IRS applies to S corporations and so are much more flexible to use. A catch is at least one partner who is active in the firm must be personally liable for its obligations as a general partner. Others who are passive investors may attain limited liability as limited partners.

Limited liability companies (LLCs) have only recently become available in all 50 states as a cross between a corporation and a partnership, offering the best of both. Like a corporation, an LLC provides protection to all its owners against personal liability for a business obligation. But an LLC owner is usually taxed by the IRS as a partner.

The advantages of pass through entities to consider...Operating income. Because
C-corporations are subject to their own corporate level tax, profits paid to shareholders as dividends are subject to double taxation. First, as income to the corporation, then to the dividend recipient.

Capital gains realized by the corporation do not receive the new low 15% tax rate paid by individuals. They are taxed at ordinary corporate rates. Losses incurred by a business are locked in the business and can’t be used by its owners to offset other income.

The income of pass-through entity is taxed directly on its owners’ personal tax returns. Thus, double taxation of profits is avoided, capital gains receive the lower personal tax rate, and business losses can be deducted by the firm’s owners personally.

Corporate level taxes also create problems when the owner of a private C-corporation wants to sell the firm. The owner probably will want to sell the stock of the business to obtain tax-favored capital gains. But the buyer probably will want to buy the business’s assets so the purchase price will be attributed to them and they can be depreciated from a higher basis. If the seller insists on a stock sale, the buyer will want to pay less because they obtain smaller depreciation deductions. But if the seller accepts a sale of assets, gain will be taxed to the corporation at normal rates, and profits distributed from the sale will be subject to double tax. Pass-through entities are able to avoid these problems because of the lack of entity level tax. A sale of either the business or its assets will have the same basic result on its owners tax return.

Here are the differences among pass-through business forms. For many years the choice of pass-through entity was only between an S-corporation and a partnership. The trade-off was that an S-corporation provides protection against personally liability for business debts. The details of the law that apply to LLCs vary by state and LLC status may not be available for all kinds of businesses or in all circumstances. If you own a business that is already operating as a C corporation, consider expanding it through subsidiary or sibling firms organized as a pass-through entity. But there are problems...

Profits are taxed to owners even when not distributed to them. So if profits are retained in the business to fund growth, the owners may not have cash with which to pay the tax. You can, however, have the business always distribute enough funds to cove the tax on its total profits.

Owners of pass-through entities are subject to restrictions on tax-favored benefits and perks that do not apply to owners-employees of C corporations.

Owners of partnerships and LLCs are not salaries employees who receive W-2s and IRS rules governing their compensation are complex.

This intellectual capital is provided to our clients and friends. For this and other strategies write us at isueirs@aol.com or phone our office at (702)642-8953. So if you know someone that is looking to save taxes, avoid audits and remain invisible to the IRS, think of us. We guarantee our work product. No exceptions, No conditions. No time limits. No IRS.