In our first article, we discussed different forms of partnerships. Now let’s focus on corporations.
A corporation, unlike the other structures, results in the formation of a completely independent legal entity and is created under the authority granted by state law. Most people have heard that forming a corporation provides “limited liability” — that is, it limits your personal liability for business debts. A corporation is considered separate from the persons who own, control and manage it. It has its own legal rights as well as liabilities. A corporation must file and adopt articles of incorporation and by-laws which govern the rights and obligations of its shareholders, directors and officers and issue stock.
One of the main advantages of incorporating is that the owners’ personal assets are protected from creditors of the corporation. If the technical requirements of the corporate form are observed, only corporate assets need be used to pay business debts, and you stand to lose only the money that you’ve invested in the corporation. Therefore, if a court judgment is entered against your corporation saying that it owes a creditor, you will not be forced to use personal assets, such as your home, to pay the debt.
Please note that this protection can be lost if corporate records are not properly maintained and shareholder and director obligations are not undertaken (i.e., meetings, voting, etc.). Another advantage of incorporating is that it can facilitate bringing in additional equity capital as well as allow efficient ownership transfer among shareholders of the business. This in turn allows for business continuity when shareholders retire or sell their ownership interest. There is no limit on the number of shareholders that may own shares in a C corporation.
Sometimes, in the case of a small corporation, creditors may still require the personal guarantees of the principal shareholders before extending credit. Depending on the type of business, the additional up front expense of incorporating and the ongoing cost to administer the corporation will be countered by the benefit gained from the limited liability protection to the shareholders.
In a regular C corporation, the company itself reports and is taxed on its net income on Form 1120 at graduated rates. You and the other stockholders pay individual income tax only on money paid out of the corporation to you as a salary, bonus or dividends. An S-Corporation, which I’ll get to shortly, works differently.
If an owner of a corporation works for the corporation, he is paid a salary, and possibly bonuses, like any other employee. Tax is withheld on this income as with non-owner employees; and the income is reported on the shareholder’s personal tax return.
A personal service corporation (PSCs) is a type of Corporation that is engaged in the performance of personal services. These services are conducted by employee-owners. Qualified personal service corporations perform services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting. As a C corporation, the personal service corporation files Form 1120 and pays tax on net earnings at the entity level. However, unlike a C corporation, it is taxed at a flat rate of 35 percent of taxable income, unless it makes an election to become an S corporation.
An S corporation is a regularly created corporation under state law that elects S status with the IRS (and often an equivalent status with the state of incorporation). By electing to become an S corporation, the corporation and its shareholders are treated in many ways like a partnership and its partners for Federal income tax purposes. The result is that the S corporation has limited liability like a regular corporation AND in general does not pay an income tax. Instead, the S corporation’s income and loss items are passed through to the shareholders similar to the way that a partnership’s income or loss passes through to its partners. S corporation shareholders must share these items in proportion to their share of ownership. And only a limited number of shareholders may own stock in an S corporation. S corporations are more restrictive in terms of the number and type of eligible shareholders and the fact that there can only be one class of stock. Before deciding on this type of structure, you should contact your CPA to be sure of the specific requirements in your state.
In a C corporation, the company itself is taxed on business profits. With an S corporation, the net income or loss flow through to the shareholders and are included by them with other separate components of income and expenses on their individual income tax return, in addition to any salaries paid to the shareholders. Note: Some states impose a corporate level income on S corporations.
Let’s turn the discussion to limited liability companies. A limited liability company (LLC) can be taxed as a sole proprietorship, a partnership or a corporation for federal tax purposes, but provides the liability protection of a corporation to its members. Similar to shareholders in a corporation, LLC members enjoy limited personal liability for the entity’s debts and liabilities. Protection from personal liability means that if an LLC cannot pay a creditor such as a vendor or landlord, the creditor cannot legally pursue claims against the assets of any member of the LLC, such as the member’s house or car or any other personal possessions. Only the LLC’s assets are at risk for these claims. That is the “limited” nature of an LLC. However, LLC members don’t have limited liability for their own personal misconduct.
For tax purposes, a single member LLC is treated as a sole proprietorship. A multi-member LLC is treated as a “pass-through entity,” like a partnership, although the members may elect to treat and tax an LLC as an S or C corporation if they wish. This means that business income or loss can be passed through the business to the LLC members, who report their share of profits – or losses – on their individual income tax returns or taxed at the corporate level.
An operating agreement determines how income or loss is allocated among the members, as well as other operating matters. From this perspective, the ability to allocate components of income and expenses according to an agreement gives the LLC more flexibility than an S corporation. Also, unlike the S corporation, the LLC can have an unlimited number of owners and any person, business or trust can have an ownership interest. LLC’s are often preferable to S-corporations when setting up highly leveraged ventures such as real estate. This is because unlike an S-corporation, your share of the LLC debt owed to others counts as “basis,” meaning you have a larger investment against which to deduct any LLC losses.
While an LLC itself doesn’t pay taxes, LLCs file Form 1065, an informational return, with the IRS each year. This form, the same one that a partnership files, sets out each LLC member’s share of the LLC’s profits (or losses), to report on the member’s individual income tax return.