S M A L L - B U S I N E S S - P R O B L E M - N U M B E R - 4

 

Choosing the right legal format of ownership of your successful business venture, mainly for tax benefits and personal protection

(Please note that this material is primarily applicable to the USA but the points outlined have relevance in most countries of the world)

Because most owners believe they must choose one legal entity, many do not take advantage of the many features and benefits that other entities afford. By understanding the tax benefits of each categorization, business owners can save money and grow their company.


Inevitably, when meeting with a business owner, among the first issues to arise is that of the business structure. Most business owners profile their company as a certain type of entity such as a Limited Liability Company (LLC), S-Corporation, C-Corporation, or Limited Partnership. ( Note that in South Africa and Australia the LLC is equal to the (Pty) and the S-Corp is equal to the Close Corporation, CC) Typically they feel confident in the fit of their chosen entity. It's interesting, however that their reasoning is not always entirely correct, and, oftentimes it's apparent the owner is not familiar with all of the options available. For more information of how to "incorporate" your business, click here

For a business owner to fully admit that they don't understand why they use a certain entity over another is not unusual. Some offer weak reasoning for their choice. For example, "My CPA (accountant) says that this is the best entity available for such and such reason." Or, "My attorney compared and contrasted the best two entities and for me, this one is the best." The particular business categories may have made sense in the beginning, but business owners oftentimes realize they have outgrown the entity with which they started.

Because most owners believe they must choose one entity, many do not take advantage of the many features and benefits that other entities afford. By understanding the tax benefits of each categorization, business owners can save money and grow their company.

It takes a different mindset to fully understand multiple entity structuring. However, business owners that own more than one business may be utilizing the strategy without even recognizing it. For instance, a business owner may have two companies one that is a S-Corporation which allows him /her to utilize the self-employment tax savings, while the other business is structured as a C-Corporation which allows the owner to utilize medical benefits.

It is important to understand that each business situation differs and it's a good idea to consult a qualified tax advisor before utilizing multiple entity structuring. For more information on tax services available. click here

Although it has been in existence for 10 years in the USA, the LLC is the newest entity available.. One of the main advantages of the LLC is that it is taxed according to partnership law. LLC's do not pay taxes. LLC's file an information return (Form 1065) and all profits are reported on each member's own personal 1040 Form, according to ownership percentage. Another advantage of LLC's is they can be owned by other entities. Under most circumstances the members involved in the day-to-day running operations must recognize the income as earned income and pay the 15.3% self-employment tax.

The S-Corporation, like the LLC, is taxed like a partnership. S-Corporations file an information return (Form 1120S) and profits are reported on each shareholder's own 1040 Form, based on ownership. The main advantage of the S-Corporation is that a business owner can draw income from the company. Business owners may take a "reasonable " salary and distribute the rest of the profits as stock dividends. Usually, the dividend distribution is exempt from the 15.3% self-employment tax. One major disadvantage of the S-Corporations is that only individuals {not other entities} or certain types of grantor trusts may own stock in the company.

The C-Corporation is the only entity that actually pays taxes. This entity files Form 1120 and is taxed according to a different tax table than individual members. The primary advantage of C-Corporations is their ability to provide tax-deductible benefits. These benefits are usually not entirely deductible in the other entities, but dividends are from 2003.

Another main advantage of the C-Corporation is its lower tax bracket. The first $50,000 that a C-Corporation earns pays only 15 percent in federal income taxes. This can be extremely beneficial to a business owner that has expenses that are not deductible.

The primary disadvantage of the C-Corporation is how dividend distributions are taxed. Because dividends are paid after the corporation has paid taxes on its profits, double taxation occurs since the owner of the stock also pays taxes on the distribution. (This falls away during the 2003 tax year) Another disadvantage of the C-Corporation is that there are few ways to access retained earnings without incurring the double taxations discussed above.

The Limited Partnership, like the LLC and S-Corporation is also taxed like a partnership. It files an information return {Form1065) and all profits are reported by each owner on their individual 1040 Form.

The main advantage of the Limited Partnership is it has two types of owners. The general partners have voting rights and control, while the limited partners do not. This allows the general partners to control the distribution of profits, even though they may have been taxed at the limited partner's tax bracket

A business owner with children over the age of 14 can utilize his/her children's tax brackets as limited partners and not lose control over the entity, even though the children may own a majority.

One disadvantage of the Limited Partnership could be the business owner's ability to access money within the partnership for his or her own purposes.

Each entity has both pros and cons. However taking advantage of all of the pros while minimizing the cons should yield significant tax savings. By utilizing the self-employment tax savings of the S-Corporation and the lower tax brackets available in the C-Corporation and Limited Partnership, an owner can save up to 30% on their tax bill. If these entities are put together appropriately with an LLC, it {the structure} can be easy to manage.

Most business owners could find ways to spend the additional 30 percent savings such as reinvesting in the business, improving cash flow, and increasing employee benefits. While most businesses may only use one entity, modifying the structure may be more profitable.

(Reprinted with kind permission of the Utah Business Magazine)

 

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