Company Formation law generally deals with incorporation, limited liability companies, partnerships and S Corporations. To properly protect your personal assets from business liabilities it is important to consider the type of entity that will be utilized for your business activities. Each business entity has a different tax consequence. These articles are for information only and should not be used as a substitute for competent legal advice or the advice of your tax accountant.
What are the Benefits of Incorporating?
Limited Liability Protection
When you incorporate your business, you erect a wall between your personal assets and any liabilities of the business. When you incorporate your business, you invest money in it. Only the money you have invested is at risk. A creditor cannot go after your personal assets to pay your business debts.
The management of a corporation is conducted by a board of directors. Essentially this means that there is a central organization that generates management decisions.
Transferability of Ownership
A corporation or limited liability company can continue in existence indefinitely. Ownership in a corporation or limited liability is considered personal property that can be transferred independent of the business. For example, you can sell your shares of stock in a corporation, or transfer your membership in a limited liability company to your heirs via your Last Will & Testament.
Limited liability companies and S-corporations enjoy pass-through taxation. Pass-through taxation means that the owners of the business report gains or losses on their personal income tax returns. The income of a C-corporation is taxed twice. First, the corporation pays taxes on its profits. Second, the individual shareholders pay taxes when distributions are made to shareholders.
Which Legal Entity is Right for my Business?
Incorporation or Limited Liability Company?
Your choice of business entity is very important. Your entity choice will depend on a number of factors, including whether or not you plan to issue securities, whether or not you plan to use investors to fund your business, the management structure of the business, your estate planning goals, how many employees you will need, how you will compensate your employees, and the potential for profit and losses.
Below are some basic types of business entities:
If you are self-employed, your business is called a sole proprietorship. You may have employees who work for you. You report gains and losses on your personal income tax return since a sole proprietorship is not legally considered to be a entity separate and apart from you. You may be found personally responsible for the debts and liabilities of the business.
A business that has more than one owner is considered to be a partnership. Under state laws, this type of business is a “default entity,” meaning a legal entity called a partnership exists even if the owners haven’t registered the partnership with the state. General partners report the gains and losses of the general partnership on their own personal income tax returns. The general partners may be found personally responsible for the debts and liabilities of the business.
A limited partnership is formed by the owners who want to be involved in the business as general partners, and the owners who just want to invest in the business as limited partners. The limited partners don’t want to have day-to-day duties related to the business and are only liable for business debts to the extent they have invested in the business. The general partners may be found personally responsible for the debts and liabilities of the business. Both general and limited partners report gains and losses of the business on their own personal income tax returns.
Limited Liability Partnership
Many states recognize a business entity known as the limited liability partnership. A limited liability partnership is a general partnership in which all of the partners enjoy limited liability. This means that each partner may only be liable to the extent they have invested in the business.
Limited Liability Company
A limited liability company is managed by either its “members” or its “general manager.” A limited liability company may use the titles “president”, “vice president”, “secretary” and “treasurer” to designate the persons who run the company. All members of a limited liability company enjoy limited liability. This form of business entity allows members to report gains and losses of the business on their personal income tax returns.
A corporation is created under state law. A corporation must indicate how the corporation will be taxed for federal income tax purposes. A corporation that chooses to be treated as a “C corporation” pays its own taxes on the profits the business makes. In addition, shareholders of the C Corporation pay taxes on distributions made to shareholders. This is sometimes referred to as “double taxation.”
A corporation may elect to be treated as a “S Corporation” for federal income tax purposes. An S-corporation pays no taxes on profits. Any gains or losses “pass through” directly to its shareholders who report them on their personal income tax returns.
There are three major points that you should consider when choosing a business entity.
The C Corporation. A C Corporation pays income taxes both at the federal and state level. However, a C Corporation can take deductions for fringe benefits, employee wages, and other expenses. Also, C Corporations can use the current low rates of capital gains taxation available to shareholders.
The S Corporation. S Corporations, partnerships, and certain LLCs offer “pass-through” tax treatment. This means that the profits of the business are not taxed at the business level. Any profits paid to the shareholders are taxed on the shareholder’s personal tax return. Therefore, shareholders or members of pass-through entities often pay much less tax than C Corporation shareholders.
2. Corporate Formalities
Small business owners often fail to observe corporate formalities by maintaining corporate minutes, resolutions, and other records. This lack of record keeping may expose business owners to liability. In the instance of litigation against the business, the plaintiff may try to “pierce the corporate veil” to reach shareholder assets. Do yourself a favor by choosing a legal entity that requires minimal corporate formalities.
For example, if you have an LLC, your operating agreement can be customized to your needs. The operating agreement can specify that certain records need not be kept. This approach has two advantages, it can save you time and money and it can prevent veil piercing by litigants.
Don’t forget to consider the money. Who will claim profits or losses? For example, let’s say you have an LLC. With an LLC, members can recognize both pass through gains and losses. The operating agreement can also be customized to allocate gain to one member, and loss to another.
What is an S Corp and is it right for your business?
An S Corporation is established under state law. To be an S Corporation, the entity must qualify under Subchapter S of the Internal Revenue Code. These Code sections provide that the S Corporation is not taxed as a corporation for federal income tax purposes. The tax laws regarding S Corporations are complex. It is important to discuss the advantages and disadvantages of an S Corporation with your accountant.
An S Corporation provides that stockholders have limited liability for corporate obligations. And, an S Corporation is taxed in the same manner as a partnership, rather than a corporation. There are rarely any federal income taxes at the corporate level for S Corporations. Profits or losses from S Corporations flow directly through the company to the shareholders. This avoids double taxation.
In addition, losses from S Corporations are applied as direct tax deductions against other income. There are limitations on deductions for those shareholders considered to be passive investors in the S Corporation. The sad news is that stockholders of S Corporations are taxed on the net profits and gains of the corporation even if they do not receive any dividends from the corporation. On the bright side, dividends paid by S Corporations generally are not taxable to the stockholders because profits have already been taxed. There are limitations. To qualify for an S Corporation election, the business must be a domestic corporation, have no more than 75 shareholders, and have only certain classes of eligible shareholders. This means that C corporations, partnerships, LLCs, and trusts cannot be shareholders of an S Corp. All stockholders must consent to an S corporation election. However, the S Corporation election can be revoked by shareholders. After an election is revoked, the S Corporation must wait five years before it can elect to be an S Corporation once again.
An S Corporation has only one class of stock. It is possible however, to have one class of stock with different voting rights, for example, voting and nonvoting common stock. An S Corporation has a continuing obligation to meet these conditions. Otherwise, the S election is terminated and the corporation is taxed as a C Corporation.
Fringe benefits (medical insurance, medical reimbursement plans, disability income plans, group term life insurance) paid to stockholders owning more than two percent of company stock cannot be deducted by the corporation. Health insurance premiums can be deducted by the owner-employee in the same way that self-employed individuals can deduct these expenses.
This article is for information only. Please discuss your particular situation with a qualified attorney and your tax advisor.
Dissolving a Corporation.
It is actually quite easy to dissolve a corporation once it is no longer needed.
1: Liquidate assets and pay off debts
You will want to sell the assets of the corporation. Please note that there are tax consequences to selling off the assets of the corporation. Make sure you review potential sales with your tax adviser before proceeding. For example, suppose you sell a laptop computer to an employee. In that instance, you will have to calculate the difference between the computer’s fair market value and its book value. Any difference between fair market value and book value is reported as a gain or loss on the corporation’s tax returns.
These tax laws can be tricky, so make sure you speak to your tax advisor.
The proceeds are then used to pay off company debts.
2: Distribute any remaining assets to shareholders
Any assets you have left over can be distributed to shareholders or donated to charity.
At this point, the corporation should have no assets and no debts.
3: File articles of dissolution
Prepare and file Articles of Dissolution with the state of incorporation to inform the state that the corporation has gone out of business.
4: File final tax returns
File the final corporation tax return with the IRS.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
This article is intended to provide general information about business entity selection and should not be relied upon as a substitute for legal advice from a qualified attorney or tax accountant.