Business Entity Selection, Incorporation & Document Preparation

Your business entity selection has a large impact on your taxes and other creditor liabilities. From your company’s inception through its growth and development, we can advise you on choosing an entity type and later, make changes to another entity time when it is most advantageous. We will incorporate you and prepare all the documents and license forms that you require.

Starting your own business can be a lucrative and rewarding venture.  The type of business entity you choose will affect your taxes, personal liability, the size of your company, and how you transfer ownership. 

There are five principal business ownership structures for income tax purposes:

1. Sole Proprietorship
2. Partnership
3. C Corporation
4. S Corporation
5. Limited Liability Company.  Publication 583
   

1. Sole Proprietorship

• A sole proprietorship can be appropriate when you, or you and your spouse are the sole owners
  
  
• It has the least complicated form of ownership
  
  
• t avoids the double taxation of a C corporation
  
  
• A sole proprietorship can be appropriate when you are not overly concerned with personal liability
  
  
• A proprietorship may be appropriate if your business product or service does not expose you to much risk, and if you have protection provided by malpractice and/or liability insurance.
  
  
• Business losses are deductible from your other sources of income.
  
  
• Long-term capital gains are subject to a maximum federal tax of   15 %.
  
  
• Capital losses are deductible to the extent of capital gains, plus $3,000.
  
  
• Expenses of starting up the business are deductible.
  
  
• In addition to federal and state income taxes, for 2009 the net income from the business is subject to the Self-Employment Tax at the rate of 15.30% on the first
  $ 106.800 and 2.9% on amounts above that.

2. Partnership - IRS  Publication 541

• A partnership is appropriate when you are in business with an individual other than your spouse.
  
  
• It avoids the double taxation of a C Corporation.
  
  
• It enables you to divide profits and losses in a ratio that does not correlate with the amounts each partner has invested.
  
  
• It provides a business structure that is easy to get started.
  
  
• It enables you to split income between family members.
  
  
• Business losses are deductible from your personal sources of income depending upon your level of participation in the business.
  
  
• Consider a Limited Partnership when:
  
  
• The business venture is risky.
  
  
• You want to limit your losses to the amount you have invested in the business.
  
  
• Your involvement is limited to providing financial backing.
  
  
• The organization of the business and the ongoing management is left to others who have the necessary expertise.  See Tax Planning: Strategies For Investing In Tax Shelters
  
  
• In 2009 a general partner's net earnings from a trade or business are generally is subject to the Self-Employment Tax at the rate of 15.30% on the first  $ 106,800 and 2.9% on amounts above that.

3. C Corporation - IRS  Publication 542

• The use of a C corporation will provide you with limited personal liability
  
  
• It enables you to split income among family members through stock ownership
  
  
• Consider a C corporation over a sole proprietorship for maximum tax savings provided that:       
  (1) you are in the maximum tax bracket for individuals,
  (2) the corporation plans to save its earnings for future expansion, and
  (3) the taxable income of the business is less than $75,000.

C Corporate Tax Rates

Carl is the sole owner of ABC Company, a sole proprietorship.  Carl is personally in the 31% marginal Federal tax bracket.  The net income of ABC Company is $75,000.  ABC Company plans on using its net income to expand it operations.  Carl will save $9,500 in personal income taxes by setting up the business as a C Corporation as opposed to a sole proprietorship.

•  If your C Corporation is considered to be a Qualified Personal Service Corporation, all income is taxed at a flat rate of 35 percent.  In addition, the tax year-end of the corporation must correspond to the tax year of the owners which is usually December 31.  An exception is granted if the corporation can show that there is a valid business purpose for having a different year-end.
  

A qualified personal service corporation is any corporation:  (a) where substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and (b) at least 95 percent of the stock of which is owned by employees performing the services, retired employees who had performed the services listed above, any estate of an employee or retiree described above, or any person who acquired the stock of the corporation as a result of the death of an employee or retiree described above, if the acquisition occurred within 2 years of death.  See Temporary Regulations section 1.448-1T(e) for details.   

• You may want to pay the flat 35% tax if you are in the maximum personal tax bracket and if you plan on plowing earnings back into the company.
  
  
• Consider a C corporation for the following tax advantages:
  
  
• Ability to select a tax year-end other than December 31.
  
  
• Tax-free fringe benefits for shareholder-employees, including health care and life insurance.
  
  
• Retirement plans that can own the corporation's stock.
  
  
• Only 30 percent of dividends received from other corporations are taxable. (Twenty percent if the corporation owns 20 percent or more of the other company.)
  
  
• Greater deductibility of losses from tax sheltered investments against the corporations earned income.
  
  
• The ability to control when taxable dividends are distributed to shareholders.
  
  
• The ability to accumulate at least $250,000 ($150,000 for Personal Service Corporations) without being subject to the unreasonable accumulations tax.  Greater amounts can be accumulated if there is a valid business purpose.  To the extent income is accumulated within the corporation, double taxation is avoided.
  
  
• You can borrow from a C corporation retirement plan.  However, if you ever convert to an S corporation be sure the loan is paid off first.
  
  
• The major disadvantage of a C corporation from a tax standpoint is  the potential for double taxation in the event of a sale of the business.  A buyer will likely insist on buying the assets of the business to avoid potential business liabilities and to be able to depreciate or amortize the purchase price.  A sale of corporate assets locks the sale proceeds in the C corporation.  The proceeds can only be conveyed to the shareholders with a second layer of tax such as in liquidating distribution or a dividend.  A sale of C corporation stock will avoid the double taxation problem, but even assuming that the buyer will agree to do this, a knowledgeable buyer will factor in the loss of tax advantages from the asset purchase in setting a lower purchase price for your business.  Therefore, when choosing your form of business, you should also consider how you will likely dispose of the business in the future.
  
  

Another tax disadvantage is that the tax rate on certain ranges of taxable income is greater than the tax rate for individuals with the same amount of taxable income.  Your filing status (married, single, head of household) will have a major impact on what that range of income is.  In addition, previously taxed corporate income which is then distributed as a dividend is taxed again.  To a certain extent, this problem can be controlled by paying shareholder-employees larger salaries and bonuses.  Salaries and bonuses reduce the corporation's taxable income and increase the shareholder-employee taxable income.  However, the shareholder-employee's compensation must be reasonable in light of the services rendered.

4. S Corporation  IRS Publication 334, IRC 1361

• An S corporation enables you to split income among family members who own stock
  
  
• It provides you with limited liability
  
  
• It avoids double taxation of income.  The net income of the corporation is reportable by the shareholders in the year it is earned.
  
  
• Capital gains and losses, and charitable contributions made by the corporation are also passed through to the shareholders.
  
  
•  Income that is not taken in the form of a salary is not subject to employment taxes.  However, the salary must be a reasonable amount in exchange for the services performed.  This benefit is particularly valuable in light of the fact that there is no limit on the amount salary that is subject to Medicare taxes.
  
  
• Bill earns $400,000 through his S Corporation.  By limiting his salary to $100,000, which both Bill and his CPA believe to be reasonable compensation for his services, and reporting $300,000 as a dividend, Bill and the company save $8,700 in Medicare taxes ($300,000 x 2.9%.)
  
  
• Losses incurred in non-profitable years are deductible by the shareholders, subject to certain limitations.
  
  
• Nontaxable fringe benefits are not available for shareholder-employees owning more than two percent of the stock.  Premiums paid for health and accident insurance is taxable income to the owner/employee and also deductible by the corporation.  The owner-employee may deduct 60% of the cost in 2001 on page 1 of  form 1040.  In addition, loans to shareholders from retirement plans are prohibited.  Revenue Ruling 91-26, IRC 1372
  
  
• Only 75 shareholders are permitted.  However, multiple S corporations that operate through a partnership can effectively exceed the 75 shareholder limitation.  IRC1361(b)(1)(A),  Revenue Ruling 94-43 and Revenue Ruling 77-220
  
  
• An unlimited amount of earnings can be accumulated within the S corporation without the imposition of the accumulated earnings tax.  The accumulated earnings tax is aimed at C corporations that try to avoid double taxation of earnings (once at the corporate level on net income and again at the shareholder level on the distribution of that income as dividends).  You receive an increase in the tax basis of your stock for the amount accumulated which will reduce your taxes should you wish to liquidate the business in the future.
  
  
• If you as a shareholder are in the maximum federal tax bracket of 39.6% and your S Corporation is accumulating income for various business needs, you may be better off revoking your S election and paying taxes on the income at the lower C corporation rates.  The maximum C corporation rates on taxable income that is less than $15,000,000 is 35%.
  
  
• If you plan on selling your business, particularly the assets of the business, an S corporation will only be subject to income tax at the shareholder level.  A "C corporation" is subject to income tax at both the corporation level and individual shareholder level.
  
  
• S corporations can generate passive income for shareholders that can be used to absorb passive losses from limited partnerships or other passive activities that otherwise would not be deductible due to Section 469 passive activity rules.
  
  
• S corporations generally do not pay a corporate level tax on the sale or distribution of appreciated assets. (However, see BIG below.) Sales or distributions do create gains that flow through to the shareholder for taxation.   If an S corporation was formerly a C corporation, and the S election was made after 1986, then the S corporation is subject to a corporate level tax on the "build-in gain" (BIG) at the time of the S election.  BIG is generally defined as the taxable gain inherent in appreciated property if the asset were sold for its fair market value.  BIG also includes certain accrued income items that were not required to be reported as taxable income while a C corporation.  Appreciation that occurs after the effective date of the election is not subject to the BIG tax.  The S corporation is generally subject to the corporate BIG tax for the 10-year period beginning with the tax year of the S election.  The BIG is subject to a flat 35% corporate tax.  In addition, the shareholders also pay tax on the BIG.  The shareholders are allowed a deduction for the corporation's BIG tax which reduces the impact of the double taxation somewhat.
  
  
• An S corporation that has earnings and profits generated when it was formerly a C corporation may also be subject to income tax (flat 35%) on excess net passive income.  If excess net passive income occurs for three consecutive years, the S election is terminated.  Excess passive income occurs when passive income exceeds 25% of gross receipts.  For this purpose, passive income is defined as gross receipts derived from royalties, rents, dividends, interest, annuities, and net capital gain.
• S corporations are not subject to the complex corporate minimum tax rules.
  
  
• An S corporation may have an ESOP.
  
  
• You can't increase your stock tax basis for commercial loans made to the company.  Consequently, losses generated by the corporation in excess of the tax cost of your stock may not be deducted and are suspended until your tax basis is increased.  This is generally not the case with a partnership.  However, your tax basis will be increased for personal loans you make to your company.  IRC 1366 (d)(1)
  
  
• Nonresident aliens, corporations, and certain trusts cannot own S corporation stock.   S corporations can be held by charitable organizations, retirement plans, and small business trusts.
  
  
• Only one class of common stock is allowed.  However, common stock can be issued with voting and nonvoting rights. 
  
  
• Estate planning techniques which employ two classes of stock in an attempt to freeze the value of the company while providing income to the owners is not possible for the S corporation.
  
  
• Income and losses must be allocated to shareholders in direct relationship to their stock ownership.  Special disproportionate distributions are not permitted.
  
  
• For C corporations wishing to elect S corporation status, LIFO inventory reserves must be claimed as income.  Any resulting tax is payable by the S corporation over a four-year period.  IRC 1363(d)
  
  
• The S corporation status can easily be unintentionally revoked which may cause major tax problems.  The S status can be revoked for the following reasons:  (1) more than 75 shareholders exist, (2) ineligible shareholders, and (3) disproportionate distributions to shareholders (second class of stock).  For this reason, it is often advisable to have a stockholders' agreement that restricts transferability to only eligible shareholders and where such additional shareholders will not cause the total to exceed 75.  There are also provisions to apply to the IRS for a waiver of inadvertent terminations.

5. Limited Liability Companies

• Limited Liability Companies (LLC) have attributes of both a partnership and a C corporation.  All tax consequences pass through to the owners who enjoy the corporate benefit of limited liability.  Many states require an LLC to have at least two owners called members.  Such an LLC is taxed like a partnership and is not as complex as an S corporation. However, some states will subject an LLC to income tax.  Some states permit a single member LLC for which the entity is disregarded for income tax purposes.  In this case, the LLC is treated as a sole proprietorship or division of another entity for income tax purposes. Regulation 301.7701-3, Private Letter Ruling 9010027