Along with personal liability protection, record-keeping requirements, and how you plan to finance your operation, one of the main factors to consider when choosing an entity structure for your business is deciding how you want your company to pay taxes. Your choice of entity will not only determine the rate at which your business is taxed, as well as how and when you are required to file your taxes, but it can also impact a variety of other factors affecting both you and your company.
Last week, in part one of this series, we covered the tax obligations associated with three entity structures: Sole Proprietorships, Partnerships, and Limited Liability Companies (LLCs). Here in part two, we'll cover the tax treatment of the remaining two entity structures—C Corporations and S Corporations—along with discussing the benefits and drawbacks related to each one.
A C Corporation is a separate tax-paying entity that files its own tax return, Form 1120, to report its income, as well as claim deductions and credits. Corporations taxed as C Corporations currently pay taxes at the corporate tax rate of 21% on all net income.
Post-tax profits are then distributed to the company's shareholders as dividends. Dividends are then taxed on the shareholder's personal income tax return at their individual tax rates. This means that the corporation itself gets taxed first, and then you get taxed again on your income from the corporation.
To avoid this system of “double taxation,” the owner of a C Corporation may elect to have the C Corporation taxed as an S Corporation, which we will cover next.
Due to the expense and complexity of creating and maintaining a traditional corporation and dealing with double taxation, very few small businesses will choose to be taxed as a C Corporation. However, once your business begins to have annual profits over $200,000 or so annually (beyond your salary and retirement account contributions), it could be worth considering a C Corporation for your entity structure.
Once you get there, or if you are there now, talk with us to discuss whether a C Corporation entity structure might be an effective tax-saving strategy for your business.
An S Corporation is not a business entity in and of itself. Rather, the S Corporation is a special tax election made by the owner of a C Corporation or an LLC to notify the government that the Corporation should be taxed as a pass-through entity. As we wrote last week, unless you elect for your LLC to be taxed as an S Corporation, a single-member LLC is automatically taxed as a sole proprietorship, while multiple-member LLCs are taxed as a partnership.
A C Corporations can also elect to be taxed as an S Corporation, thereby avoiding the double taxation issue discussed in the prior section. Instead, when your business entity elects S Corporation status, all profits of your business entity are passed through to the shareholders via a K-1, and each shareholder reports their share of the profits as income on their personal tax return.
However, not all LLCs or C Corporations can elect S Corporation status. In order to file the S Corporation election, your business must meet the following requirements:
- Must be filed as a U.S. corporation
- Can maintain only one class of stock
- Limited to 100 shareholders or less
- Shareholders must be individuals, estates, or certain qualified trusts
- Each shareholder must be a U.S. citizen or permanent resident alien, with a valid Social Security Number
- All shareholders must consent in writing to the S Corporation election
As we mentioned previously, in addition to these requirements, for an S Corporation election to save taxes versus reporting all profits on a Schedule C, you'll want to have at least $60,000 of net income per year. Furthermore, to prevent business owners from avoiding payroll taxes by taking disproportionately large profit distributions, the IRS requires S Corporation owners to pay themselves “reasonable compensation” in exchange for their services.
What constitutes reasonable compensation is a highly subjective matter, and one that you should discuss with us along with your CPA. This issue is particularly crucial for you to get right, because if the IRS determines that your compensation was not reasonable by its standards, your business could face serious consequences.
For instance, the IRS could reclassify all of your S Corporation distributions as wage payments subject to employment taxes, which could leave you on the hook for a massive back tax bill. On top of that, you could face tax penalties of up to 100%, plus negligence penalties. Given such grave repercussions, consult with us to ensure your compensation satisfies the IRS requirements.
Choose the tax treatment best suited for your business
Choosing the entity structure that's right for your business is something you shouldn't try to handle on your own—there's simply too much at stake should you get something wrong. We will offer you trusted advice on selecting the entity that's best suited for your particular company—not only for how it's taxed, but for all of the other factors that affect your chosen entity as well.
From personal liability protection and required administrative formalities to your ability to finance your company, we will offer you the support and guidance you need to choose the entity that's most advantageous for every circumstance your company might face. Contact us today to learn more.
This article is a service of R&R Legal Advisors LLC and Family Business Lawyer®. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death or incapacity. We also offer services specifically for startups and ongoing businesses, which review all of the legal, financial, and tax systems you need to LIFT your business. Call us today to schedule your consultation.
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