The BizFilings blog covering business tips and trends.
What is the Best Entity for your Business?
Published on Apr 4, 2012
Read our article, 'What is the Best Entity for your Business?' at 'Time to Start Up,' the small business blog by BizFilings.
By Eva Rosenberg, EA
There is no perfect entity that is right for everyone. No ‘one size fits all’ solution. Each business structure has advantages and disadvantages. Your decision is based on what you want to get out of your business – and your ultimate exit strategy.
Hitting the basics
Single owner businesses without a business plan or vision start as sole proprietorships, sometimes called a DBA.
With two or more owners, a partnership is the natural structure. Often two friends start something together, without written agreements, business plans, or outline of what the business will and won’t pay to them, or for them. And limited protection from lawsuits and creditors.
Owners of sole proprietorships and general partnerships pay income taxes and self-employment (SE) taxes (13.3% in 2011 and 2012) on all their profits – even without drawing the money from the business. Even when the partnership doesn’t give you a check for your share of the profits. When funding a retirement account, which reduces your income taxes, you’ll still pay SE taxes on those profits. That’s why smart people look at corporate structures.
We described how LLCs let you select your business structure. For some liability protection, that’s a good starting point for all states, except California.
Getting Something Out of Your Business
Suppose your goal is to structure a business giving you lots of benefits. You want the business to pay for your health insurance, medical expenses, a generous pension and deductible childcare. You will sweat blood to grow the business exponentially. Your plan includes venture capital or going IPO. You want to pay the least amount of tax possible when you do go public. The best entity to accomplish this is a C Corporation.
In a C corporation, there are no restrictions on the deductibility of an officer’s benefits. While an S-Corp prohibits or complicates benefits paid to an employee who owns 2% or more of the company. You can ‘sort of’ take certain deductions in the S Corp – but you must jump through hoops to do it.
On the other hand, with the right planning and documentation, you can hire your spouse and/or children in your sole proprietorship or partnership and get certain similar benefits, like deductible health care, medical expenses, and other benefits using a special Section 105 plan. Sometimes, not having a corporate structure may be less restrictive.
When you sell the Qualified Small Business Stock of a C Corporation, you can exclude a substantial portion of the gains. Should the C Corporation happen to fail, despite all your best efforts, you can deduct $50,000 ($100,000 if filing jointly) of the loss as ordinary losses each year – without being limited to $3,000 per year of capital losses.
S Corps are Easy
When you don’t need all those benefits, or anticipate going public, an S Corporation is adequate. That’s what I did. My husband’s job covers us for health care in full. When we anticipate high medical expenses in any year, we can use his flexible spending account. I am plowing by profits back into the business to grow it, for now.
When it gets big enough, I can always switch to a C Corporation to take advantage of deductible retirement plans and other goodies.
Meanwhile, S Corp record-keeping demands are less formal than the requirements for a C Corporation. C Corps must maintain detailed Minute Books, while S Corps can be more casual about the Minutes and corporate meetings. Though smart officer/shareholders take the time to enter all policy, compensation and benefit decisions into the minutes each year.
Drawbacks to the Corporation structure
C Corps face double taxation, the Personal Service Corporation (PSC) tax rates and payrolls.
Double taxation means the corporation pays taxes on its profits. When it pays you dividends out of those same profits, you pay taxes on the dividends. You could avoid taxes on the profit, by spending the profits on retirement contributions and other employee benefits for the officer. But if you have other employees, you’ll have to spread the benefits around.
But why bother? With today’s top tax rate of 0% and 15% on qualified dividends, that’s a lower tax than if you paid the taxes on the profits personally, as you would with S Corporation profits. In fact, the smart tax pro uses this as planning tool to reduce taxes for high-income individuals.
Then there’s the personal service corporation (PSC). Those are corporations formed by people providing specific services, like consulting, accounting, etc. PSCs are taxed at a flat rate of 35%. This comes as a shock to someone who elected to be a C Corporation without understanding they fall into this category – like Internet consultants. Folks providing services can avoid this problem by electing to be an S corporation or other business structures, like LLPs, etc. S corporations don’t pay federal taxes at all. Though some states, like California, do tax S Corporations.
Another problem area is payroll. Working shareholders of profitable small corporations (S or C) just draw money out whenever needed. They don’t set themselves up payroll – and don’t draw paychecks. Folks preparing their own tax returns aren’t alerted to the big, red bulls-eye they have just put on their corporate tax returns.
The U.S. Internal Revenue Code insists that working corporate officers must be on payroll. The payroll must be reasonable. This is wide open to interpretation, with lots of court cases trying to define ‘reasonable.’ Seasoned tax professionals understand the best way to establish a payroll structure that will avoid IRS scrutiny. They warn their clients about this. After all, corporate tax returns showing a profit, without showing officer wages are practically guaranteed to be audited. When IRS does audit, the audit will go back for three years. That’s a very unpleasant experience.
Are you utterly confused? See, as hard as I try to simplify the decision, there is no way to do that. You must do your business plan first – than consult your tax and legal team for the final guidance.
Eva Rosenberg, EA is the publisher of TaxMama.com , where your tax questions are answered for free. Eva is the author of several books and ebooks, including Small Business Taxes Made Easy. Eva teaches tax courses at IRSExams.com and CPELINK. IPO – Initial Public Offering – what Google did, and what Facebook is just about to do – to generate billions of dollars in stock purchases on the Stock Exchange – NASDAQ or NYSE.
 Note: This 0% and 15% rate for capital gains and qualified dividends is scheduled to end on 12/31/12. In today’s economic climate, it’s almost certain Congress will raise these tax rates for 2013.