Heroux & Compnay LLP

In looking back over our previous articles, we find that perhaps we've been a bit presumptious. We assumed that most of you operate in more of a corporate mode, rather than one of the numerous other types of business entities available.

You may think it doesn’t matter much what form you operate in, but it does. It matters a great deal – both from a tax and a business standpoint. For that reason, we thought we would discuss the options with you this month.

First of all, as always, let us first counsel you to look at business considerations first and tax implications second. As we have said before, your business’ main purpose is to make money. If it doesn’t make money, it won’t be in business long. If it makes money, your business will, at some point pay taxes, so in a sense, your aim should be to create taxable income at some point.

And even though, by this reasoning, paying taxes is a good sign, choosing the right business entity can help you minimize your tax liability and maximize your profits. That’s where this discussion comes into play. Each business structure has it’s own unique advantages and drawbacks as far as taxation goes, so let’s start talking.

Your first consideration is how much liability there will be in your business. If your business is going to offer accounting services, you will have risk, but nowhere near as much risk as a general contractor that builds high-rise buildings. Likewise, if you were a sole proprietor, you would have less general liability risk than if you had ten partners.

In either case, the more people you have in your business that you have no direct control over, the more risk. We submit to you that you can’t control any of your employees 100% of the time unless you have them chained to the desk (and even then, their minds may wander). While sometimes employees may feel shackled, we don’t know of too many shops that actually put this into practice nowadays.

If liability is your primary concern, you should consider doing business as a Corporation. Corporations are creatures of the state. Generally, you file Articles of Incorporation with the Secretary of State in the state of incorporation. You are then issued a certificate bearing your company name and incorporation date.

You begin your corporation’s life as soon as you issue stock. If the Certificate of Incorporation is the birth certificate of your company, then issuing stock counts as the first baby steps. Issuance of stock by a corporation is the first way of obtaining capital (operating funds) for the company. There are numerous other ways, including stockholder loans, but the traditional first step, legally and practically, is issuing stock.

Most state laws governing corporations, provide that all of the potential for loss to a corporation in a lawsuit lies with the corporation and the shareholders’ personal assets are not available to the corporation’s creditors. The major exceptions are that shareholders can lose whatever money they put into the company and officers and directors can be held liable for the actions of the corporation in some instances. Guarantors of corporate debt are also liable for any of the guaranteed debt a corporation can’t pay, up to their commitment.

If, for whatever reason, you’re not into corporations, Limited Liability Companies ("LLCs") and Limited Partners in a Limited Partnership ("LP") also have the same general protections as shareholders in a corporation, but the taxation aspects of these entities are quite different.

Sole proprietors and general partners in both general and limited partnerships normally have little or no protection and all of their assets are on the line. Limited Liability Partnerships("LLPs") offer a middle ground of protection. Most LLPs will protect you from losing your home due the negligence of someone else in your company, but won’t protect you from trade creditors.

If your main concern is taxation, then the partnership or sole proprietorship route is for you. Regular Corporations (we’ll explain later) earn money, pay you a salary and pay taxes on what’s left. The two most common ways to receive money from a C Corporation is to pay you a salary and/or dividend. If you pay a dividend, your corporation pays tax on its taxable income and so do you when you receive the dividend. Not very efficient is it?

You can minimize the effects of this double taxation by electing to be an S Corporation. A corporation passes through all of its income and expense to the shareholder to be taxed on their return. While this does alleviate some of the problem of double taxation, S Corporations can have their own traps.

Any of the other forms of business – partnerships, LLCs or sole proprietorships - offer the most flexibility in avoiding double taxation, without the headaches of an S Corporation. Partnerships even allow you the ability to make special allocations of income and expense to specific partners, assuming it makes good economic sense.

If one of your primary concerns is health insurance and other employee benefits, operating in the corporate form may be a better idea for you. C Corporations can pay for and deduct the cost of disability insurance premiums, health insurance premiums and retirement benefits for owners. None of the other forms of business allow this.

In the case of S Corporations, sole proprietorships, LLCs and partnerships, these benefits are deductible only at the individual return level, except for disability insurance, which isn’t deductible. Unfortunately, by then you've paid self-employment taxes on all the income which can be a significant amount if your business is successful.

One word about disability insurance – if you want to receive the benefits tax free, the corporation cannot pay the premiums. You must pay the premiums yourself with after-tax dollars to keep benefits tax-free.

If you think you might prefer to get money out of the business, and most people do, you’ll need to structure your capital injection carefully. In funding a corporation, it is usually best to put as little in capital stock as possible and then loan the rest of the needed capital in the form of a stockholder loan. This gives you the advantage of being able to take excess cash in the form of a loan repayment and also take money out of the corporation in the form of deductible interest expense. You will, of course pay personal tax on the interest, but you avoid the double taxation issue. The ability to take loan repayments and interest payments out of the corporation will minimize the need to take dividends out of the corporation.

Also, in order to be able to deduct S Corporation losses, you must have enough Basis to take the loss. Basis is simply your cash investment, less dividends or distributions, less any loss already deducted plus any income reported on your return. In the case of an S Corporation, you can also claim the amount of any loan made directly to the corporation by you. Loan guarantees will not count as Basis in an S Corporation, but they will in any of the other forms of business (with some exceptions in the case of LLCs and limited partnerships). The only Basis you have in a C Corporation is your cash investment.

One other very important consideration should be the type of assets to be placed in the business. If you are going to put appreciating assets into a business entity, put them in anything but the C Corporation. In all other entities, you will pay tax on any capital gain once. In a C Corporation, you will pay tax at ordinary rates when the property is sold and tax at ordinary rates when you receive the dividend. In the other entities, since you pay tax on everything to begin with, the tax code doesn’t treat you as taking anything additional when you pull the money or assets out.

Be careful if you choose anything other than a C Corporation, because the income received from the other entities will be subject to taxation. That means you will need to take enough out of the businesses to pay the taxes. This isn’t always as easy as it sounds. C Corporations pay taxes out of their own checking accounts, not yours.

Well, that’s our quick tour of choosing a business entity. Would you believe that people spend days trying to learn this stuff? The real truth is it takes experience, as well as technical ability, to determine what form of business entity is best.

We have that experience and technical ability. Give us a call and let us help you decide your wisest course of action.

Have a super April!