Want to open a business? If so, what structure makes the most sense for you from a tax perspective? Bruce Bell, an attorney at the Chicago office of Schoenberg, Finkel, Newman and Rosenberg, gives us some pointers:
Larry Light: Give us a run-down on the different business structures.
Bruce Bell: The myriad of factors that must be considered in choosing the proper business structure requires a careful evaluation of the available alternatives. In today’s business environment, most closely held businesses operate as conventional C corporations, S corporations or limited liability companies, known as LLCs.
Light: What’s the difference? The C corp is the one most people have heard of.
Bell: From a tax perspective, C corporations are treated as entities separate and apart from their owners. Income earned by a C corporation is taxed to the corporation while dividends paid by a C corporation are taxable to the shareholders. This can result in a dual layer of taxation, a tax at the corporate level on income and a tax at the shareholder level on dividends.
Light: Who should want to do a C corp?
Bell: The considerable flexibility in permitting multiple classes of stock and foreign ownership makes C corporations the optimal business structure for publicly traded and other large corporations. The C corporation structure can nevertheless be advantageous for a smaller corporation with owners seeking to reinvest earnings in the business. The 21% flat federal corporate income tax rate imposed on C corporations generally permits the accumulation of funds at a lesser tax cost than would result if earnings are taxed at the individual level and then reinvested in the business.
Light: What’s the C corp’s downside?
Bell: C corporations can, however, be particularly burdensome when businesses are sold to third parties, as most buyers prefer to buy the assets of a corporation rather than the corporation’s stock, thereby triggering a potential double tax on the sale proceeds.
Light: So tell us about the S corp.
Bell: S corporations are generally not subject to income taxation as business income, gain and loss flow through and are reported by the corporation’s shareholders on their personal income tax returns.
Light: And the disadvantage of an S set-up?
Bell: Although the absence of a tax at the corporate level is attractive, it comes with a cost. Only individuals, other than non-resident aliens, estates and certain trusts ,are permissible S corporation shareholders. S corporations can have only one class of stock, which restricts some of the financial flexibility other entities enjoy by offering preferential rights to distributions to some owners but not others. An S corporation cannot have more than 100 shareholders, which limits it.
Light: But the S corp has a leg up when it comes to payroll, right?
Bell: S corporations do offer payroll tax savings in that only the salaries paid to S corporation owners are subject to payroll taxes. Any dividends or distributions S corporation shareholders receive are not subject to payroll taxes. While an S corporation can readily revoke its S corporation status and become a C corporation, a five-year period must lapse before a C corporation can reelect S corporation status.
Light: And LLCs?
Bell: A limited liability company or LLC, like a corporation, can be treated as a partnership for federal income tax purposes. In many cases, LLCs offer the best of both worlds, the opportunity to avoid federal income tax imposed on C corporations and freedom from the statutory restrictions on S corporations.
Because LLCs permit owners or members to share in company distributions without regard for each member’s ownership interest in the company, differing distributions to members are commonplace in governing LLC documents, which permit the holding of preferred and common interests. LLCs are permitted to have to a variety of owners as corporations, partnerships and non-resident aliens are permitted owners as are individuals, estates and trusts.
Light: How does an LLC handle losses when it comes to shareholders?
Bell: In cases where a business entity is borrowing funds from a third party, an LLC may be the entity of choice if losses are anticipated as LLC members can deduct their share of company losses not only to the extent of their capital contributions but also to the extent of their share of loans taken out by the company.
In contrast, S corporation shareholders can only deduct losses to the extent of their capital contributions and any loans they have personally made to the corporation. One disadvantage of the LLC structure is that income reportable from operations by the members will be subject to payroll taxes.
Light: So what’s the best bet for small business owners?
Bell: The vast majority of closely held businesses are formed as S corporations or LLCs. Unless you are in an expansionary phase where you intend to accumulate earnings for future use of the business or need to maintain a structure that’s more widely recognized for institutional investors, the S corporation or LLC structure would appear to be best suited for your needs.