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CHOOSING A FORM OF ORGANIZATION

by: Cary Christian

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 scenario.

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 dividends.

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 regular corporation.

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 people.

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 return.

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 ownership percentages.


BOTTOM LINE?

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 factors.

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!


Copyright (c) 2002
 

 


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