One of the most important decisions you’ll make for your company is what form of business organization – or business entity– your organization will be.
What are the advantages and disadvantages of your business being a C corporation? An S corporation? A limited liability company? A partnership?
Today’s business owners have many options to choose from when it comes to corporate organizational structure. There isn’t one right answer for every business.
What factors influence entity choice?
Two major considerations in choosing what form of business entity you should use and whether you should incorporate your business are:
- Protection from legal liability
- Income tax savings
Most business owners see liability protection and tax reduction as the most important factors affecting entity choice. Liability protection may be obtained even if the selected entity is not a corporation, but state laws vary so it is imperative you consult with legal counsel regarding your state’s liability laws. However, contract terms with lenders, suppliers and other parties may trump liability protection of the entity.
Choosing which business entity is best for your company can be one of the most confusing decisions you have to make. It is also one of the most important ones.
The selection of your company’s entity is a decision that should not be entered into without considerable analysis and professional advice.
Corporations are legal entities that are owned by stockholders, and ownership shares may be easily transferred. The life of corporations can extend beyond the participation of their founders. One of the chief advantages of corporations is that the owners are limited in their personal liability to creditors and lawsuits.
- C Corporation There are no restrictions on the type of shareholder that can own a C corporation. C corporations are taxed as separate entities subject to a separate tax rate schedule.
An advantage of C corporations, unlike S corporations, is that there is no shareholder tax on undistributed earnings.
Another advantage is the tax benefit available for some small businesses organized as C corporations. Small business stock purchased after Sept. 27, 2010, and before Jan. 1, 2012, and held for more than five years, the owner’s entire gain is tax free upon sale. The company that issues the stock must meet technical qualification rules. Qualified small business stock purchased before Sept. 28, 2010, may qualify for partial exclusion of gain. Although this provision is not available for purchases of small business stock in 2012 and subsequent years under current law, it may be extended. Be sure to check with your tax adviser on the status of this important tax benefit.
C corporations are commonly used by entities planning to go public.
One of the primary disadvantages of a C corporation is double taxation, in which income tax is paid at the corporate rate before any profits can be paid to shareholders. Then shareholders’ dividends are subject to income tax again at the individual rate.
Tax strategies to withdraw earnings in a deductible manner, such as through salaries, rents and interest, may alleviate this double tax burden. Double taxation may also be a major disadvantage upon eventual dissolution. In addition, C corporations may be subject to the accumulated earnings or personal holding company tax.
- S Corporation An S corporation is a domestic corporation that can’t have more than 100 shareholders, has only one class of stock, and has only U.S. citizens and residents as shareholders. In addition, shareholders generally must be individuals, estates or some trusts.
Named because it is taxed under Subchapter S of the Internal Revenue Code, an S corporation is a U.S. corporation and is taxed as a pass-through entity in which taxable income is taxed to shareholders on their personal tax returns in proportion to their ownership percentage of the S corporation. For state corporate law purposes, S corporations are treated the same as C corporations regarding limited liability. S corporation status must be elected.
The primary advantage of this form of organization is that shareholders have the organizational benefits of a corporation but escape the double taxation of a C corporation. The overall tax burden is lower for profitable businesses when the owners collectively are in a lower marginal income tax bracket than the corporation. Since any profits are taxed to the shareholders in the year they are earned by the S corporation, they generally are not taxed again when they are distributed (as with C corporations). And owners may be able to deduct losses on their income tax returns to offset other income on their returns.
Close attention must be paid to maintaining the necessary basis (and other criteria) to deduct these losses, including correct structuring of corporate debt. Unlike partnerships, debt of the entity does not give S corporation owners basis. The only basis S corporation owners get from debt is any loan directly from the owner to the S corporation. Read the rest of this entry »