CHOOSING A FORM OF
I was posting a comment to a
business organization thread on the Internet Marketing Warriors forum
earlier tonight, and realized this is an area where people harbor a lot of
misconceptions that can cost them a lot of money. Since I don't want to see
any of you wasting money, I thought I would address the issue here.
I apologize in advance to those of you who reside and work outside the U.S.
This article addresses issues, primarily tax issues, related to U.S.
business organizations only.
Many people opt to incorporate their business without really giving much
thought to how they should be organized. This can create a considerable
number of problems down the road. It is an issue that not only deserves, but
requires a full understanding of how your choices will affect you in the
years to come.
YOUR INCORPORATION OPTIONS
There are basically three types of corporate form you can select from. The
first type is the regular corporation. The technical term for a regular
corporation is "C Corporation" because it is taxed under the provisions of
Subchapter C of the Internal Revenue Code. The corporation is organized
under the laws of the state you choose, normally the state in which you
live. The regular corporation is a separate legal entity that files a tax
return (Form 1120) and pays tax on its taxable income.
You may choose to have your new corporation taxed under the rules of
Subchapter S of the Internal Revenue Code. This is the second type of
corporation: the S Corporation. An S Corporation must also file a return
each year (Form 1120S). The taxable income of the S Corporation is computed
on the return, but the S Corporation is not subject to income tax. Instead,
the income of the corporation is allocated to its shareholders who report
their share of the income on their personal returns on Schedule E. Most
people almost automatically make the S Corporation election to avoid the
double taxation of earnings that can occur in the Regular Corporation
The third option is the Limited Liability Company (LLC). An LLC is actually
a fairly new "hybrid" organization that shares characteristics of both a
corporation and a partnership. It is included as an incorporation-type
option because it limits the liability of its shareholders in much the same
manner as a corporation does. Like an S Corporation, the LLC does not pay
tax on its taxable income. The income is passed through to the shareholders
who include the income on their personal returns.
WHICH FORM OF "INCORPORATION" IS BEST?
Regular corporations (C Corporations), S Corporations and LLCs all provide
you with protection against personal liability. S Corporations and LLCs
eliminate the concept of double taxation of earnings that you find in
regular corporations since the income of the S or LLC passes through to the
shareholders. In a regular corporation, the corporation pays tax on its
earnings and there is the potential of taxation again at the individual
level if you take out earnings in a non-deductible way, such as by paying
However, you have to remember that corporate tax rates are lower than
individual rates on taxable income up to $75,000, so if you plan to leave
profits in the business for awhile, it might be worthwhile to organize as a
There are also many ways to defeat double taxation in a regular corporation
environment as long as you have the ability to perform effective yearend tax
planning BEFORE yearend.
So, it is not a given that it is always better to go the S Corporation or
LLC route, but . . . it usually is. They are much simpler to manage for most
If you are the sole owner of the entity, an LLC will probably be the easiest
to manage since you report the income from the business on your Schedule C
just as you would if you did not incorporate. If you are not the sole owner,
the LLC will file a partnership return (Form 1065) and you will receive a
Schedule K-1 each year telling you what income to report on your personal
If you have other owners in addition to yourself, an LLC gives you more
flexibility in distributing cash flow and profits.
For example, assume you own 90 percent of the stock of the company and
another individual owns 10 percent. However, for valid reasons your
agreement is that the other shareholder will get 50 percent of the profits.
You can handle this type of situation easily with an LLC. A particular
shareholder's share of profits, cash flow and taxable income or loss do not
have to coincide with ownership interest.
With an S Corporation, however, all distributions and allocations of taxable
income must be made in accordance with stock ownership percentages, so there
is very little flexibility. In this example, you could have one terrific tax
mess to deal with if you were organized as an S Corporation but had to
distribute profits and cash flow based on something other than stock
Unless you fully understand the rules and the implications of your
decisions, you are going to need professional help. There are so many
variables involved in making this decision that it becomes quite easy to
make a devastating mistake. You must not only consider your business and
your plans for running it. You must also consider your personal tax
situation, the tax positions of other owners, the possibility you will be
bringing in additional owners in the future, and a wide variety of other
People tend to shy away from hiring attorneys and CPAs to help them with
organizational issues because it can become quite expensive. Don't cut
corners! Get the help you need and do it right from the beginning. Your
savings over time will greatly exceed the cost.
These are just a few of the issues you will encounter, but based on these
alone you should be able to see that this is a choice that requires a good
deal of thought and some professional assistance. If you've already chosen a
form of organization and believe you made the wrong choice, don't despair.
There are provisions that you can use to reorganize your business
organization tax-free and get it into a form that works better for you. Just
get the professional help now that you should have gotten in the beginning!
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