What
is the Best Legal Structure to Cut Taxes
and Reduce Liability- S Corporation, C
Corporation or a Limited Liability Company?
Now,
Explore some real options!
This is not the fluff that you hear elsewhere!
For someone
to say that one structure will work best for all situations doesn’t
make any sense. The most favorable choice depends on many factors-the
number of owners, the type of business, whether or
not it will be profitable right away, what type of income
will it receive and how all this blends in with your current situation.
Let’s
examine the options:
The first
basic step is to realize that if you operate your business as a sole
proprietorship or partnership you will have many worries about losing
your personal assets to business-related liabilities and increasing
your chances of an audit!
The solution
is to create an entity that has limited liability. Your choices are
S and C corporations and LLCs. With the LLC we will need to address
both the single and multi-member LLC. NCP prefers LLCs taxed as partnerships,
which means, it would have two members. Most states allow a single member
LLC. This is being recommended by tax practitioners to replace the sole
proprietorship. In general it provides liability protection and an uncomplicated
tax picture.
Only the
member’s investments in the LLC and the assets in the LLC are generally
exposed to liabilities created by business operations. Personal assets
are protected (unless someone can pierce through the LLC veil, a key
reason to form your LLC in Nevada).
Many CPAs
will recommend a single member LLC to someone who is currently a sole
proprietorship. For federal income tax purposes, the IRS ignores a single-member
LLC. That means the single-member LLC will be treated as a sole proprietorship.
You would continue reporting business income and expense on Schedule
C and computing self-employment tax on Schedule SE (an LLC taxed as
a partnership will not file a Schedule C.). Schedule C is very highly
audited! NCP has a different opinion for sole proprietorships that is
also shared by many other CPAs.
The LLC taxed as a partnership (with two members) will file a minimally
audited Schedule E. If you take money or assets out of the LLC, there
are no Federal tax complications (taxed as a sole proprietorship). The
same is true if you move money or assets into the LLC.
Procedure:
Converting a sole proprietorship into a single-member LLC usually only
involves filing a registration form with the appropriate state agency
and paying a fee. Then the assets of the proprietorship are moved into
the LLC as a tax-free transaction.
Downside:
All profits generated from this LLC are hit with self-employment tax.
And you can generally only deduct 60 percent of your health insurance
premiums in 2002. You can’t deduct retirement plan contributions
in figuring SE tax. You can’t form an ERISA pension plan either.
If you are not an LLC taxed as a partnership there is no charging
order protection of the individual operating the sole proprietorship
if he or she gets sued personally.* In an LLC taxed as a partnership,
the manager, will be subject to SE taxes.**
Another
Option Over the Single Member LLC and
Possible Multiple Member LLC is to Save Payroll
Taxes and Reduce Liability with S Corporation Status
Like LLCs,
S corporations offer owners protection against liabilities generated
by their businesses. Specifically, S corps can take advantage of pass-through
taxation, meaning there generally is no corporate-level federal income
taxes to worry about. Instead, all the company’s income, deductions
and tax credit items are "passed through" to the shareholders,
which then report everything on their Form 1040 and pay the taxes.
In contrast,
running your business as a C corporation can result in double taxation,
meaning your business income gets taxed once at the corporate level
and again when liquidated or where there are retained earnings. Keep
in mind this is a simplistic answer. There are many advantages to a
C corporation also and the effects of double taxation can be minimized
or eliminated, as you will soon see.
S corporations
have strict qualification rules:
- The
corporation must have only US shareholders, estates or specific types
of trusts and can only have one class of stock.
- There
must not be more than 75 shareholders.
You must
also consider these major disadvantages to an S corporation:
- The
stock of an S corporation is very difficult to protect from a personal
lawsuit, whereas the stock of a C corporation can be held by a family
limited partnership or an LLC taxed as a partnership.
- In some
states, S corporations are taxed and must file a state level tax return.
- If the
S corporation owns appreciated assets, they cannot be distributed
to you without triggering an income tax bill. There is no such problem
with a single member LLC.
- If you
die, the company cannot step up the basis of its assets to reflect
the fair market value on the date of death. With a single member LLC
and LLC taxed as a partnership, your heirs benefit from a step-up
for most business assets.
Now, let’s
look at the tax benefits of an S corporation over the single person
and LLC taxed as a sole proprietorship.
As the
shareholder-employee of a solely owned S corporation, you receive a
salary, subject to a 15.3 percent federal payroll tax (for Social Security
and Medicare) on the first $84,900 and 2.9 percent on the excess (for
2002). The corporation, as your employer pays half, and the other half
gets withheld from your paychecks. The corporation deducts your salary
as a business expense on its tax return (Form 1120S).
Under current
law, that pass-through income is not subject to SE tax. In contrast,
all income from an LLC could be subject to SE tax.
Strategy:
Pay yourself a low salary to avoid federal payroll taxes. Just make
sure it’s not too low. Have industry comparisons on hand to show
you’re in the ballpark.
Example:
The taxable income generated by your S corporation business is estimated
to be $100,000 for 2002 before you pay yourself. You take a $50,000
salary. Only that amount is hit with the 15.3 percent federal social
security and Medicare tax, which amounts to $7,650. You can withdraw
the remaining corporate cash flow in the form of distributions to yourself
that will not be subject to SE taxes (this will be added to your personal
income on which you will pay tax at your current tax bracket).
If you
operate the same business as an LLC where each member is subject to
SE taxes, you owe SE tax on your entire $100,000 profit, for a total
of $13,427.60 (15.3 percent of the first $84,900 and 2.9 percent of
the remaining $15,100). So operating as an S corporation could save
you thousands ($13,427.60-$7,650= $5,777.60).
Remember:
You must be able to show that a $50,000 salary is reasonable. If the
IRS thinks it’s too low, it may try to reclassify all or part of
your purported cash distributions as disguised wages.
Select
C corporation status when profits are on the rise.
Like S
corporations, the main advantage of a C corporation is the personal
protection from business liabilities. The big disadvantage of C corporations
is that retained earnings are subject to double taxation, which in turn
can mean:
- Payments
to shareholders-in cash or property-may be treated as dividends (ordinary
income to shareholders with no deduction for the company).
- Two
layers of tax on retained corporate cash flow (once when the corporation
earns income and again on the resulting increase in stock value when
shares are sold).
- Both
corporate and shareholder-level taxes when the company holds appreciated
assets and liquidates so shareholders can go their separate ways.
- Ditto
if the corporation sells all its assets and gives the resulting cash
to its shareholders in liquidation.
Also, if
the business will have significant losses in the startup phase, they
can’t be passed through to the owner (they will carry forward and
offset profits from year two). With an LLC or S corporation, losses
can generally be passed through and deducted against other personal
income.
Here
is a way to Pay Less to the IRS with
Two C corporation Strategies
A C corporation
can actually be the best bet when you don’t anticipate startup
losses and you can avoid double taxation. Here are two techniques for
keeping taxes to a minimum.
Strategy
1: Try to "zero out" the company’s taxable income
every year with deductible payments that benefit you. These payments
can include salary, bonuses, and fringe benefits, rent for assets owned
by you and leased to the corporation and interest on loans from you
to the company. If the company’s income can be zeroed out, double
taxation is no threat.
Strategy
2: Use a C corporation for a growth business when you need to maximize
cash flow to finance equipment additions and growing levels of inventories
and receivables.
Example:
You have a great idea for a new business. Personally, you’re already
in the 39.6% tax bracket because of income from other sources. The new
business will make money, but you need to maximize cash to finance growth.
If you set up as a single-member LLC or S corporation, you’ll have
to withdraw 39.6 percent of the new venture’s income each year
just to pay your personal taxes.
But if
your set up as a Corporation, the company pays only 15 percent on its
first $50,000 of taxable income and 25 percent on the next $25,000.
In fact, you can have taxable income up to $10 million and pay a highest
rate of only 34 percent.
Comparison
of LLCs and S and C Corporations:
| |
LLC
|
S
Corporation |
C
Corporation |
| Tax
at personal level |
Distributions
may be subject to SE taxes. |
After
salary, remaining distributions are not subject to SE |
Not
a flow through entity; it files its own tax return. |
| Entity
Tax Rates |
No
tax at entity level |
No
tax at entity level (usually) |
15%
on first $50,000 in profits. |
| Asset
Protection at Personal Level |
May
be partial or complete at personal level (depends on how the
LLC is taxed). |
None
|
None
|
