www.HisCPA.com   Taxes by the Book: A Biblical Guide to Tax & Business Management… Choosing a Business Entity Type, LLC’s, S Corporation, LLP, C Corporation, Partnership, Proprietorship and Tax Effects of Entity Choice

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Business Entity Types

Incorporating as a Subchapter S Corporation, C Corporation, Limited Liability Company or Partnership

When Incorporating in Georgia, evaluating what type of entity your business should be, we strive to balance the legal protection issues vs. the tax savings. Over the years, we have developed the mindset that there is no perfect election but there are ones that are better than others.

My clients tell me that they want to pay as few tax dollars as legally possible. Below are some very specific rules, as well as some generalities. If you are considering incorporating in Georgia, we suggest that you sit down with a tax professional to see how these guidelines relate to you.

S Corporations

S Corporations can have no more than one hundred shareholders and they all need to be U.S. citizens or resident aliens. This corporation type almost always has to have a calendar year as the fiscal year. S Corporation rules have been around since the 1950s and were set up to simplify the rules and regulations of being a business owner.

Liability Protection and Subchapter S Corporations

S Corporation, like a C Corporation, affords the business owner personal liability protection from business risks. Some of the keys to maximizing that protection are to treat the corporation like one by doing all your business in the corporate name, signing all of your documents listing your corporate title, not co-mingling any personal issues/bills in the corporation, and by having your annual Board of Directors and Annual Shareholder Minutes Meeting.

Tax Advantages of S Corporations

An S Corporation pays no income taxes are paid with the corporate return. The profits of the business are reported on the personal tax return of the S corporation’s shareholders. As long as you pay yourself a reasonable salary, you may also take shareholder distributions out of the business that are devoid of FICA/Medicaid taxes.

If you have corporate losses, and you fund (you put the money in the business) those losses personally, then you can deduct those losses on your personal return. Any losses that are funded by the bank (a direct loan from the bank to the corporation) or by trade creditors are not deductible.

Setting up a loan so that the bank lends to you personally and then you could do a personal loan to the company, which will result in you having contributed basis/the dollars to the business, thus making any losses that you fund deductible.

S Corporation Taxation

There is no income tax paid by as S Corporation when the annual tax return is filed to the IRS. However, as a part of the corporate return which is prepared, a Form 1120S, there is an attached schedule which shows each owners respective ownership percentage and via a Form K-1 for which each shareholder should reflect on their personal return. K-1 profits, losses, and shareholder distributions are all required by tax law to be issued based upon the each shareholders ownership percentage. In order for losses to be deductible a shareholder has to have a positive tax basis, which is a component of past profits, losses, and loans to and from the business. If a shareholder has no basis to cover losses reported on a K-1, they are by tax law considered to be “suspended losses” and can be rolled forward to future years when the shareholder has positive basis, which can be created by future years profits or the shareholder loaning money to the business.

The K-1 profit, which is based upon their share of the business and not the amount of their shareholder distributions. This is a common misnomer about S Corporations and often leads to confusion for the new business owner. To that end it is best to remember that you pay taxes on the profits when you make them and not when you take them. For example generally speaking if your business nets $100,000 and you are the sole owner, you will pay taxes on $100,0000 whether you take zero dollar of shareholder distributions, a $100,000 or any number in between. Thus if you were to have a $100,000 profit in any given year and take no distributions then you would be able, absent any other issues, to take shareholder distributions in subsequent years with no additional tax responsibility as these monies would have already been taxed.

S Corporation has only four and many businesses will qualify. To be an S Corporation you must have:

• Have a December 31st year-end.
• Have less than 100 shareholders.
• Shareholders have to be U.S. citizens or resident aliens.
• Only one class of stock.

Many states recognize and reflect the same tax treatment for S Corporations as the IRS and charge a relatively insignificant net worth tax such as Georgia, there are many states which charge a franchise tax as well.

C Corporations

This type of corporation is perfectly set up for those who do not qualify to be an S Corporation, such as a public held company that has thousands of shareholders, lots of classes to stocks, and sells its stock to anyone (corporations, individuals, retirement plans, etc).

C Corporation Taxation

C Corporation’s pay taxes on all its profits first at the corporate level and then when the dollars are paid out to the owners in subsequent years, the owners pay tax again at the individual level. C Corporations, therefore, are exposed to a “double taxation” that none of the other entity types are exposed to. If you think taxes are bad enough paying them once, try paying them twice. OUCH!

Changing from a C to an S Corporation

C Corporation’s can make a timely tax election to become an S Corporation and start taking advantage of tax advantages of being an S Corporation. Care should be taken to ensure that all shareholders understand and agree to become an S Corporation and that there are no or relatively insignificant net operating losses that might still be utilizable if you were to stay a C Corporation.

Then after these are utilized/considered, we would affect the change.

LLC’s, LLP’s and Forming a Partnership

Limited Liability Companies (LLCs), Limited Liability Partnerships (LLPs) and General Partnerships are all taxed in the same manner. Choosing one of these types as a business entity would be a poor selection for a business such as a print shop, as they will all result in higher taxes with no additional advantages for the printer.

We have developed a mindset that if you do not need to be another entity type then you need to be an S Corporation. For example, generally speaking a printer that was an LLC, LLP, or Partnership will pay higher taxes with no additional advantages as opposed to being an S Corporation. A Limited Partnership is also an option that could be explored when certain partners want to limit their liability and exposure.

Below are some of the reasons you might want select an LLC or LLP as your entity choice:

• If you were a lawyer or physician’s practice then all of the partners’ personal assets are at risk if one partner does something wrong, while if an LLC or an LLP, only the offending partners personal assets would be at risk. This is because of the professional service statutes for these types of professionals, but these rules do not relate to our printer.
• If you were a real estate developer and you had a piece of land that had dramatically increased in value, you can transfer that property to an LLC, LLP, or Partnership without having to pay any capital gains tax. Also with these entity types, you can take shareholder distributions that are not based upon ownership, whereas in an S or a C Corporation they have to be. Again, this does not relate to our printer client.

Changing  LLC to an S Corporation for Tax Purposes

An LLC is legally allowed to convert over to an S Corporation for tax purposes which can legally allows the savings of thousands annually. Although being an LLC offers some flexibility (no Board of Directors/ease of formation), being an LLC will typically result in many businesses paying an higher tax bill on its earned income.

If an LLC converts to an S Corporation for tax purposes, it remains an LLC for all other issues thus maintaining the advantages initially desired. When a business converts over to an S Corporation all active employee/owners are required to take a fair and reasonable salary. The best test of a reasonable salary is what an owner would have to pay someone else to perform their position and it is a function of their position, responsibilities, and the business’s profit. If an LLC converts over to an S Corporation for tax purposes its federal and state income taxes will remain essentially the same. However, an LLC pays FICA & Medicaid taxes on all of its net earnings/earned income whereas an S Corporation will be obligated solely on its salary/W-2 wages.

The IRS has long had an established system for converting an LLC legally over to an S Corporation for tax purposes for which we are intimately familiar. Each and every tax situation is unique and I would welcome meeting with you to discuss.

All Scripture is God-breathed and is useful for teaching, rebuking, correcting and training in righteousness, so that the man of God may be thoroughly equipped for every good work.

2 Timothy 3:16

Entity Selection Tax Effects

Among the different ways of incorporating your new Georgia business — C corporations, S corporations, and Limited Liability Companies — there are practical reasons for choosing a given method, such as the number of shareholders or liability considerations. For many small businesses that are going to consider incorporating in Georgia, the tax advantage of the Georgia S corporation should not be overlooked.

S Corporations Advantages

As a Georgia LLC, LLP, partnership or sole proprietorship, you are subject to the 15.3% Self Employment/FICA tax on all of your net earnings. The S corporation, on the other hand, pays you a deductible salary (which is subject to FICA), and then the profits flow through your personal return via a Schedule K-1. This K-1 income allows for permanent deferral of the FICA tax. The Georgia S corporation allows small business owners to legally save taxes as long as they pay a fair and reasonable salary to themselves.

Please take a look at the following comparison. It shows the tax effects on a single year’s income for a Georgia LLC, LLP, partnership, or sole proprietor vs. a C corporation, and compares it to a subchapter S corporation. Due to the way Georgia C corporations are exposed to double taxation, the payments are spread out over two years, which is not the case for partnerships or S corporations.

Difference between LLC, LLP, Proprietorship and S Corporation
$36,270 – $30,150 = $6,120

* 1st year is tax on W-2, 2nd year is tax on $34,000
($40,000 prior year taxable, less $6,000 paid during the first year)

Please note this representation is only an example. It is being used for demonstration purposes; it does not take into consideration exemptions, deductions, fling status or any other significant tax matters. Your situation may not yield the same results. Please contact a tax professional before making any financial decisions.

We have helped hundreds of business owners select the proper entity choice for their business. When Incorporating in Georgia, His CPA PC can help you chose the correct type of legal structure for your business we help you make/evaluate this most critical business decision.

Related posts:

1. www.HisCPA.com Taxes by the Book: A Biblical Guide to Tax & Business Management…Corporate Income Taxes & Depreciation Expense
2. www.HisCPA.com Taxes by the Book: A Biblical Guide to Tax & Business Management…Incorporating in Georgia: The Basics, The Details and The Set-up
3. www.HisCPA.com Taxes by the Book: A Biblical Guide to Tax & Business Management…Business Checklist For New Corporations & Avoiding Incorporation Pitfalls
4. Atlanta CPA Presents…www.HisCPA.com Taxes by the Book: A Biblical Guide to Tax & Business Management…Tax Preparation Checklist & Profit Maximization & Management
5. Atlanta CPA Presents…www.HisCPA.com Taxes by the Book: A Biblical Guide to Tax & Business Management…Payroll Reporting & Tax Planning

This entry was posted on Tuesday, February 1st, 2011 at 7:26 am and is filed under Business Loans & Money Management, Business/Tax Consulting, Financial Statements & Bookkeeping, Incorporating in Georgia/Entity Selection.
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