If you are forming a small business, you face several choices: Sole Proprietorship, C-corporation, S-corporation, Limited Liability Partnership and Limited Liability Company.

Here are the basics.

When you start a business, you have many choices to make. One key decision is choosing the form of business entity you will operate under.

How can you narrow that list down? Small businesses typically decide against a C-Corporation, because C-Corps generate two levels of federal income tax. The C-Corporation pays one level of tax when it files its federal corporate tax return, Form 1120. A second layer of tax is imposed when the C-Corporation's profits are distributed to the shareholders as dividends. Those dividends are reported and taxed on the individual's federal tax return, Form 1040. Together, these two levels of taxes are referred to as “double taxation.” In addition, state taxes also typically apply to both C-Corporation profits and distributed dividends. Overall, the tax picture for C-Corps is far from ideal for small businesses. Even the current 15% tax rate on dividends does not completely do away with the disadvantages of double taxation.

Doing business as a sole-proprietor eliminates the double taxation curse. There are no corporate taxes to pay, and you only pay individual taxes on your net profits, typically reported on Form 1040, Schedule C. However, as a sole proprietor, you lack the legal protection that corporate status gives you. Owners of corporations enjoy limited liability, but sole proprietors do not. Simply stated, if you're a sole-proprietor, your personal assets are at risk if the business is sued—very risky indeed!

The choice then is an LLC or S-Corporation. Which is more appropriate for your business? Well, they are both “pass-through” entities that allow you to avoid double taxation, operating a business without paying corporate taxes. Net profits are reported by the owners in their individual tax returns, and both also offer protection from unlimited liability. Your liability will be limited to your investment in either entity.

When choosing between an S-Corporation and an LLC you need to consider many things. What may be appropriate for one set of circumstances may not be for another. Every business is different, and every owner has different needs and expectations. Let’s review the attributes of each type of entity to help you decide.

Created in 1958, the S Corporation was, for many years, the standard form of organization for conducting a small business. S Corporation status provides a way for you to avoid the double taxation imposed upon C Corporations and their shareholders. One advantage of the S Corporation is that income is taxed personally to the shareholders. However, your personal risk remains limited to your investment. In other words, double taxation is avoided and you get the protection of limited liability. 

Your corporation chooses “S-Status” by filing a special election, Form 2553. Bear in mind that the “S”  status of the Corporation only impacts taxes. Shareholders of S Corporations have all of the same  legal protections as those in C Corporations. But as once said by a famous Tax Court judge, “A  corporation is like a lobster pot. It's easy to get into…difficult to get out of.” In other words, once you have established an S Corporation, it would first have to be liquidated if you wanted to change to a  LLC, and liquidation of a corporation can result in taxable gains to the shareholders.

LLCs started in 1977 in Wyoming and have quickly become a popular form of business entity across the country. By default, LLCs with more than one owner (member) are taxed as Partnerships, while single-member LLCs are taxed as sole proprietorships (known as a  DISREGARDED ENTITY).  As with S corporations, with an LLC you only pay taxes with your  personal return. However, if you decide to do business as an LLC, you are not stuck with it. Simply by filing a Form 2553 at the appropriate time, an LLC can become an S Corporation without having to  liquidate. There is little risk of triggering a tax by changing from this form of doing business.

Establishing an S corporation is relatively simple and inexpensive. An attorney, or even you, can form a corporation by completing a series of “boilerplate” documents. We can assist you with this for a  small fee. These forms require you to complete the following information: who will own the business,  the business's activity, address, and other miscellaneous details. You will need an attorney to draft the shareholder agreement. Aside from being registered as an  “Inc., Co. or Corp.”, a corporation can also be registered as P.C. (Professional Corporation). This  designation is for professionals who choose to operate in corporate form and is popular with doctors,  lawyers, and accountants.

An LLC requires a bit more work to get started. Articles of Organization, to be filed with the state and an Operating Agreement (like a Partnership Agreement), should be drafted by a lawyer.

An S Corporation might be more restrictive than an LLC. There can't be more than 100 shareholders in an S Corporation. In addition, only individuals, estates, and qualifying trusts are permitted shareholders. An S Corporation may not have any non-resident alien shareholders. There can only be one class of stock ownership. Adding a second category or class of ownership  terminates the “S” Election, which could lead to unintended and unexpected tax consequences. The income and expenses from an S Corporation are allocated on a per-share/per-day basis. Your businesses' net income, after paying you a reasonable salary, would not be subject to self-employment taxes (also known as social security taxes) on your individual return.

The amount of your investment in the S Corporation--your cost basis--includes:

1) Your contributions of cash & property.

2) Your share of S corporation profits not distributed to you.

3) Loans made directly to the Corporation by you.

This “Basis” calculation is important because it is your tax cost. The more you have invested, the more “write-offs you can claim when there are losses.

LLCs offer more flexibility than S Corporations. They can have an unlimited number of owners and any person, business or trust can be a member, or owner. With an LLC you can choose to allocate particular types of income and expenses between the owners. Doing this can get pretty complicated, so be sure to speak with us about "special allocations." On the negative side, the status of the business's net income as subject to Self-Employment taxes is unclear. Current thinking is that reasonable compensation should be paid in the form of guaranteed payments, subject to SE tax, with the balance of income - - attributable to capital or the work of employees - - not subject to SE tax.

Your basis in an LLC (your tax cost) includes:

1) Your contributions of cash & property.

2) Your share of LLC profits not distributed to you.

3) Your share of the LLCs debts to others. In an LLC, loans to the company can increase your tax basis if you are personally liable for them. In an S corporation, only your direct loans to the company can increase your tax basis. For example if your S corporation borrows money from a bank and you, the major shareholder guarantee the loan (which is the usual case), that loan is NOT considered in your basis calculation. The better way to handle such a transaction is for YOU, the shareholder to borrow the money directly from the bank. Then YOU enter into an agreement with your S corporation and draw up a promissory note, outlining term of loan, interest rate and commencement date of payment. This will allow you to consider the loan when calculating your basis in the S corporation.

LLCs provide more ways to increase your tax basis. This illustrates a significant advantage of LLCs over S Corporations. Because of the way these calculations are done, your cost basis may be higher for an investment in an LLC than if you set up shop as an S Corporation.

Many businesses should probably start as an LLC. Advantages include flexibility of ownership, ability to gain tax basis from liabilities, and pass-through of profits and losses. If a corporate entity is determined to be required later, the change from LLC to corporation is quick and generally tax free. Of course the best approach would be to meet with professionals and discuss the pros and cons of each legal entity and make an informed decision the first time around.

For assistance in choosing the right entity call

Diane Offutt  - Accountant

Accounting Connections, LLC  (770) 846-7799  or  (770) 516-5987

Reasonable fees to fit your budget!

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