Business Structure
Choosing the Right Business Structure
You shouldn’t select a business structure solely to cut taxes; however, you shouldn’t disregard taxes when you decide how to do business.
Your simplest choice is to operate as a sole proprietor. There’s little paperwork and no corporate income tax. However, sole proprietors are personally liable for all debts incurred by the business. Moreover, it’s not easy for a sole proprietor to raise money if more capital is needed.
Partnerships, too, are exempt from the corporate income tax. However, partners (with the exception of limited partners) do not enjoy any protection from liability, and it may be difficult to accommodate outside investors.
That’s why most sizable businesses operate as corporations—which subjects them to the corporate income tax. But how can you get the limited liability and investment appeal of a corporation without being liable for corporate income tax?
One Tax Is Better Than Two
One approach is to elect S corporation status because S corporations are exempt from the corporate income tax. To qualify, you must meet certain criteria:
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A company may have no more than 100 shareholders. A husband and wife are counted as a single shareholder.
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A company may have only one class of stock. All shares must have the same rights to profits and assets, although differences in voting rights are permitted.
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No corporations or partnerships (and only certain types of trusts and tax-exempt entities) may be among the shareholders.
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All individual shareholders must be residents of the United States.
If your business can clear these hurdles and you have the unanimous consent of all shareholders, you may elect S corporation status. As long as the election is made by the 15th day of the third month of the tax year, the election will be effective for that year. Later elections will become effective the following year.
‘S’ Still Stands for Savings
Business owners often face personal federal income tax rates (35 percent and 38.6 percent) that may exceed the top corporate tax rate (generally 34 percent). (Companies with annual taxable income up to $10 million will pay no more than an average of 34 percent.) If you’re in this category, do S corporations still make sense?
In most cases, yes. Keep in mind that money you receive from your company as compensation (salary or bonus) will be taxed at your personal tax rate, no matter what. Any corporate income tax you pay as a C corporation will be more than the zero tax you pay as an S corporation.
The situation is even worse if your company pays you dividends from profits. You’re fully taxed on those dividends, and your C corporation is also taxed. Electing S corporation status helps you avoid this double taxation.
Example: Let's say your C corporation makes $1 million. The after-tax results are as follows:
Corporate taxable income $1,000,000
Corporate tax @ 34% 340,000
After-tax income to shareholders 660,000
Personal tax @ 38.6% 254,760
Net to shareholders 405,240
By contrast, here’s what happens with an S corporation:
Corporate taxable income $1,000,000
Corporate tax 0
Distribution to shareholders 1,000,000
Personal tax @ 38.6% 386,000
Net to shareholders 614,000
The end result: You wind up with 52 percent more net income by using an S election.
An S election works against you only when you have undistributed profits. Business needs or creditors’ limitations may force your company to retain earnings. When you retain earnings, you’ll pay personal income tax on all profits at rates that may go as high as 38.6 percent. With a C corporation, some undistributed profits may be taxed as low as 15 percent or 25 percent, depending on the amount.
A Better Tomorrow
Even that tax saving may be illusory. With an S corporation, the extra tax you pay today will lead to a much greater tax break if you sell the company, if your company redeems your shares from you or if you receive liquidating distributions.
If you own an S corporation, undistributed earnings increase your basis in corporate shares. When you sell, that increased basis reduces the amount you owe in tax, often much more than the “tax penalty” you’ve paid throughout the years.
Example: You own a company that generates $1 million a year in undistributed earnings. Operating as a C corp, you’d pay $340,000 a year in tax on the retained earnings. Operating as an S corporation, the earnings would be passed through to you, so you might owe $386,000 a year in a 38.6 percent tax bracket. So you’d pay an extra $46,000 a year, or $460,000 over 10 years. Most likely, your S corporation would distribute $386,000 to you, so you could pay the tax. The extra $614,000 that’s retained goes into your basis in the S corp’s shares. Over 10 years, you’d increase your basis by $6.14 million.
Suppose you sell the company then, and the top tax rate on long-term capital gains is still 20 percent. Because your basis is $6.14 million greater, your gain is $6.14 million smaller. You’d owe about $1.23 million less in tax—a nice return on $460,000 in extra tax payments.
In a C corporation, you would pay a double tax on the $1 million a year—once when it’s earned and again when the profits are distributed.
Similarly, if you give away S corporation shares as part of an estate plan, the recipients assume your basis in those shares. Each year that you pay tax on S corporation undistributed earnings, your basis in your shares increases. Thus, your family members will receive gift shares with a higher basis, reducing their tax obligation on future sales.
Shelter From the Storms
Electing S corporation status allows you to enjoy other tax benefits, such as:
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No accumulated earnings tax. If you pile up excess undistributed earnings inside a C corporation to avoid paying tax on dividends, the IRS may tax that excess at 38.6 percent. With an S corporation election, you’re not exposed to the accumulated earnings tax.
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No unreasonable compensation tax. Similarly, S corporations are not subject to this tax, which is essentially a double tax on C corporation compensation that the IRS recasts as dividends.
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No corporate alternative minimum tax. S corporations aren’t subject to this tax either.
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No personal holding company tax. C corporations are subject to a 38.6 percent tax on personal holding company income.
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S corporations can be on a cash basis. A C corporation can use the cash method of accounting only if average gross receipts over the three prior years are $5 million or less.
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S corporations offer favorable tax rates on long-term capital gains. C corporations will pay full tax, up to 35 percent, but S corporation gains are passed through to individuals and generally capped at 20 percent. Capital losses are also treated more severely inside a C corporation.
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Losses pass through. Just as all S corporation income is passed through to owners, so are losses. If you have a loss from a start-up or because of a poor year, you may be able to deduct your share of the loss on your personal return. As long as you materially and actively participate in a business (generally, by working there at least 500 hours a year), you can deduct your share of the loss, up to the amount of your adjusted basis in the company. Unfortunately, you can’t increase your basis by guaranteeing a loan from a third party. Instead, you can borrow directly, using an S corporation note to secure the loan. Then, lend the money to your own S corporation, which increases your basis. With a C corporation, no losses can be passed through.
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S corporations offer payroll tax relief. Although salary you receive is subject to Social Security, Medicare and other payroll taxes, distributions of profits are not subject to payroll tax. The 2.9 percent Medicare tax (employer and employee share) applies to all compensation, with no cap. Therefore, you should keep your salary from an S corporation as low as you can justify. If you need more income, you can pay yourself a dividend from earnings—subject to income tax but not payroll tax. Watch out if you set your salary too low: The IRS may recast dividends as salary. So be prepared to support your salary level.
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S corporations offer income-shifting opportunities. You can give away S corporation shares to family members. It is especially advantageous to give them to children age 14 or older, who are probably in the 10 or 15 percent bracket. As long as you keep a majority of the shares, you remain in control. But the undistributed earnings on your kids’ shares will be taxed at a low rate, perhaps lower than if they had been retained in a C corp.
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S corporations now can have subsidiaries. Before 1997, S corps were prohibited from owning 80 percent or more of a subsidiary corporation. But now S corporations can own one or more such subsidiaries. A special election is available for most 100-percent-owned subsidiaries. They can be qualified subchapter S subsidiaries (QSSS). For federal income tax purposes, a QSSS is treated as an unincorporated branch or division of the parent corporation. Therefore, no separate federal tax return is required. The QSSS still has all the advantages of limited liability of a regular corporation without any extra tax-filing hassles or complexities. If a subsidiary is not wholly owned by the parent S corporation, it is treated as a C corporation and a separate tax return must be filed. However, as explained later, C corporation status can be advantageous for some businesses.
‘C’ Can Stand for Cuts (Tax Cuts, That Is)
The list of C corporation tax advantages is shorter, but it is still significant:
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Fringe benefits are tax exempt for C corporation owner-employees. In an S corporation, fringe benefits such as medical insurance premiums, medical reimbursement payments and group term life insurance up to $50,000 are taxable income to shareholders with an interest of 2 percent or more.
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C corporations have more flexibility than S corporations in choosing a fiscal year.
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C corporations can use employee stock option plans and various estate-planning strategies. Only certain types of trusts can qualify as S shareholders, so these strategies may not be viable.
Decisions, Decisions
So what’s the bottom line? If you think you might be selling your company within the next few years or distributing appreciated assets, an S corporation may be the better choice. However, C corporation status may make sense for companies if they are not making distributions of profits, if they do not expect to make such distributions and if they have no near-term plans to dispose of assets.
Also, you might choose C status if you can reduce profits so low that you’ll never owe corporate income tax or if you expect to have a substantial amount of undistributed profits each year. A C corporation may also be a good choice if your company has a legitimate reason for reinvesting a sizable amount of its profits and if there’s no plan to sell the company or give away shares as part of an estate plan.
If you choose to operate as a C corporation, remember that capital gains may be subject to double taxation and capital losses may expire without any tax benefit. This is why you should not hold capital assets (such as real estate) in your C corporation.
Instead, the property should be owned by a pass-through entity (an S corporation, partnership or limited liability company), which, in turn, is owned by the same individuals who own the C corporation. Then, simply have the pass-through entity lease the property to your C corporation. This arrangement allows the C corporation to reduce its taxable income by making deductible rental payments that benefit its shareholders (through their ownership of the pass-through entity). Expenses associated with the assets (such as depreciation and interest) are passed through to the owners, who can deduct them on their personal tax returns. Any gains upon the eventual sale of appreciated assets will not be subject to double taxation, and the favorable individual capital gains tax rate may apply. Any losses will be treated under the less restrictive rules for individual capital losses.
Don’t overlook the possibility of holding valuable intangible business assets (such as patents, copyrights, customer lists and so forth) through a pass-through entity. Again, these assets can then be leased to the C corporation. These days, intangible assets are among the most likely to appreciate rapidly, with the resulting double taxation problems if these assets are owned by a C corporation.
If you currently operate as an S corporation and are considering making a switch, be cautious before terminating your S election. Unless the IRS consents, you can’t generally go back to S status for five years.
S corporation status will be revoked automatically if your company ceases to comply with all the rules. In addition, an S corporation election can be revoked with the consent of shareholders holding more than 50 percent of the stock. For the termination to be effective for the current tax year, it must be made by the 15th day of the third month.
Limited Liability Companies: Best of Both Worlds
Before 1990 limited liability companies (LLCs) were recognized only in Florida and Wyoming. Now they are permitted in all states. What’s the big attraction of an LLC? Consider these points:
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As the name suggests, you have limited liability. Your personal assets won’t be depleted to meet a business obligation. Such protection has become increasingly important today.
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You aren’t subject to the corporate income tax. LLCs are taxed as partnerships, meaning that income flows through to the owners’ personal tax returns, without a corporate tax bite. Tax losses and credits can also be passed through.
