There are many forms of business entities from which you can choose to organize your venture:
- Sole Proprietorship
- Partnership
- Limited Liability Company (LLC)
- Limited Liability Partnership (LLP)
- Corporation (for profit and not for profit)
This section will provide the most frequently asked questions about business entities in the U.S.A.
When should we organize as an S-Corp versus as a LLC?
A limited liability company (LLC) is like an S corporation. Generally, business owners form a LLC rather than an S corporation if one or more of the following situations apply:
- ANY owner of the company is another business entity or a nonresident alien (a person is a nonresident alien if he or she is neither a resident nor a citizen of the United States).
- The company will be owned by more than 75 persons.
- The company plans to issue more than one CLASS of stock (for example, special allocations of profits and losses will be made that are not proportionate to the equity percentage of each owner).
- The owners desire to use business debt (money borrowed by the company) to increase their tax basis.
- The state where your business is located imposes an entity level income tax on the profits of an S corporation and does not impose such a tax on the profits of a LLC.
If these situations do not apply to you, then an S corporation should do the job. Generally, the LLC is treated like a partnership for tax purposes and there is no entity level tax. Under the recently approved IRS check-the-box regulations, a LLC will be taxed like a partnership unless the members elect to have the LLC taxed like a C corporation (association). Prior to the check-the-box system, to be taxed like a partnership, a LLC could have no more than two of the following four characteristics of a corporation:
- Limited Liability;
- Centralized Management;
- Continuity of Life;
- Free Transferability of Ownership Interests.
Most LLCs have only the first two characteristics.
Formation of an S corporation or a LLC can offer many benefits including limited liability and tax savings. a LLC also provides liability protection like a corporation.
What is a “C” Corporation?
The term C corporation refers to the way in which the corporation is taxed. There is a corporate level income tax on the profits of a C corporation. In addition, if a dividend is paid to shareholders from retained earnings, the dividend is included on the personal tax return of each shareholder. Thus, the profits of a C corporation are subject to potential double taxation. Your corporation will be taxed as a C corporation this year unless you timely file IRS Form 2553 to elect tax treatment as an S corporation.
What is a “S” Corporation?
The term S corporation refers to the way in which the corporation is taxed. A S corporation is a pass through entity. There is no corporate level income tax. Instead, a pro rata portion of the annual profit or loss of the S corporation is included on the personal tax return of each shareholder. Many startup businesses benefit by making the election to be taxed as an S corporation.
What is a LLC?
A LLC or a Limited Liability Company is a separate legal entity (business structure) utilized for the purposes of forming a business. An owner of a LLC is frequently referred to as member. In “corporate” lingo, this is the equivalent of a shareholder.
A LLC is not a corporation! A LLC is frequently referred to as a hybrid of a corporation and a partnership. The members of a limited liability company are shielded from personal liability and profits and losses may pass directly to the members without taxation of the LLC itself. That’s another way of saying that a LLC is not double taxed. In other words, income is taxed at the member level.
As mentioned above, a LLC offers two primary benefits. First and foremost, a LLC provides the members protection from personal liability. Additionally, a LLC provides certain tax benefits. That is, a LLC allows for pass through taxation.
A LLC is similar to a corporation because it has a) limited liability; b) free transferability c) continuity; d) centralized management.
What is the difference between a corporation and a LLC?
Corporations are formed pursuant to state law and have shareholders, are managed by a board of directors, and the daily affairs are administered by officers. Similarly, a limited liability company (LLC) has members and may be managed by one or more managers. Most often, both entities must pay franchise taxes, but may have different federal tax liabilities.
Generally, most people form corporations or limited liability companies in order to shield the shareholders or members and officers or managers from personal liability for the debts and obligations of the entity. There may also be various tax advantages to forming these entities which may not be available for sole proprietorships and general partnerships.
How do “C” Corporations differ from “S” Corporations?
Some startup companies benefit by starting out as an S corporation, while others remain as C corporations because the owners desire to deduct 100% of medical expenses, the corporation fails to qualify for S corporation status, or the shareholders desire to have the opportunity to exclude from gross income 50% of the gain from the sale of “qualified small business stock” (explained below). Generally, a corporation fails to qualify for S corporation status if one or more of the following situations apply:
1) ANY owner of the company is another business entity or a nonresident alien (a person is a nonresident alien if he or she is neither a resident nor a citizen of the United States).
2) The company will be owned by more than 75 persons.
3) The company plans to issue more than one CLASS of stock (for example, special allocations of profits and losses will be made that are not proportionate to the equity percentage of each owner).
If the above situations do not apply to you, then the corporation may apply for S corporation status by timely filing IRS Form 2553. The law requires submission of Form 2553 for the S election within 75 days after the corporation first has assets, shareholders or starts doing business. If you miss the deadline, you may file Form 2553 within 75 days after January 1, but there may be tax consequences. If a corporation fails to qualify for S corporation status, then the corporation must be a C corporation. With a C corporation, 100% of the medical expenses incurred by you (as a shareholder and employee), your spouse and your children are tax deductible. In a sole proprietorship, only 60% of such medical expenses are tax deductible for the 2001 tax year.
In 1993, Section 1202 of the Internal Revenue Code was enacted to provide a 50% exclusion of any capital gain from the sale of “qualified small business stock.” For shares to qualify for the exclusion, several tests must be met. For instance:
1) Shares must be purchased directly from a C corporation and the shares must be held for at least five years (shares do not qualify if purchased in any later trading market).
2) A “qualified small business” must have not more than $50 million in assets at all times before and immediately after the issuance of stock.
3) At least 80% of the corporation’s assets must be used in the “active conduct of one or more qualified trades or businesses” throughout the holding period.
4) There are also limitations on the persons who may use the exclusion. You should consult your own tax advisor as to the availability of the capital gains tax exclusion.
