What is the Best Type of Business Entity for Our Sole Proprietorship?
There are various options available for choice of a corporate entity. The downside of incorporation is that the income of the corporation is taxed separately—and the owner gets his or her share only after the corporate tax has been deducted. The owner also then owes additional taxes on his or her earnings. Thus double taxation is involved. A husband and wife may elect to be treated as a qualified joint venture for tax purposes, however, the business does not have corporate status and the protection against indidual liability that corporate status offers.
An S corporation combines the limited liability of a corporation and the "pass-through" tax-treatment of a partnership. It is a business structure suited to small business owners who want the continuity and liability protection of a corporation but wish to be taxed as a sole proprietorship or partnership. S corporation status is appropriate for:
-Companies expecting start-up losses during the initial years of operation.
-Companies expecting start-up losses during the initial years of operation.
-Companies with no intent of going public in the future.
-Companies that do not expect to issue multiple classes of stock
-Companies that might be subject to the Alternative Minimum Tax.
-Owners who live in a state with no personal state income tax.
-Companies whose sales are less than $250,000 per year (as a rough guideline).
-Shareholders who earn less than maximum amount subject to Social Security tax --Shareholders who actively participate in the business.
-Companies that plan to distribute most of its annual profits to its shareholders.
Forming a S corporation begins with a C corporation. An S corporation is essentially a C corporation that has elected to become an S corporation for tax treatnment purposes. The S corporation election form 2553 is filed with the Internal Revenue Service. Instead of being taxed at the corporate level, the income “passes through” to the individual shareholders. This is the same basic "pass-through" treatment afforded partnerships and LLCs. Any income or loss generated by the S corporation is reported on the individual tax returns of the shareholders, rather than being taxed at the corporate level. Thus, the S corporation election is a popular choice for most small businesses. In this case the corporation cannot have more than 75 shareholders. There are restrictions regarding who may and may not own stock. Generally, non-resident aliens, trusts, other S corporations, C corporations (with few exceptions) may not own stock. An S corporation must have a maximum of 75 shareholders who are individuals (though certain types of trusts and estates may qualify). Once a corporation makes the Subchapter S election to be an S corporation, profits and losses are passed through the corporation and are reported on the individual tax returns of the respective shareholders of the S corporation. Thus, the key distinction of the S corporation is that profits and losses are not taxed at the corporate/business level like they would be if the corporation remained as a C corporation.
An S corporation follows the same state formalities as does a C corporation, such as filing articles of incorporation and paying state fees.
S corporations must make a special tax election under sub-chapter S of the Internal Revenue Code by filing IRS Form 2553. The election, which is made by filing form IRS 2553, must be made by March 15 in order for the election to take effect that year. If the election is made after March 15 but within 75 days of the incorporation date, the election will be effective for the next calendar year. If the S corporation is not a calendar-year taxpayer, the election must be made within 75 days of the beginning of the corporation’s tax year. Some states also require a filing of S corporation election.
The S corporation must complete and file IRS Form 1120s to report its annual income to the IRS each year.
If your corporation has a tax-year end date other than December 31, you must file for permission from the IRS.
ALL shareholders of the corporation must be U.S. Citizens or have U.S. Residency Status. If, for any reason, shares are somehow sold or transferred (even if by will, divorce, or other means) to a shareholder who is a foreign national, the corporation will lose its S corporation status and be treated as a C corporation. S corporations cannot be owned by C corporations, other S corporations, many trusts, LLCs, or partnerships. Estates or trusts may be allowed as stockholders, but corporate or foreign investors are not allowed. This includes other businesses that are not corporations, such as partnerships or sole proprietorships. This provision, therefore, excludes corporate subsidiaries from claiming S corporation status.
75 Shareholders Maximum.
S corporations may have only one class of stock. This means that with the purchase of stock must come the same economic rights, such as receiving dividends or compensation in the event of liquidation at the same time and in the same amount per share as all other shareholders. Voting rights may differ amongst the shareholders without being considered a sign of the possession of different classes of stock.
An S corporation that loses its status as such may no re-elect S corporation status for a minimum of five years.
An S corporation’s passive income level must not exceed the 25% of gross receipts over a consecutive three year period limit.
For certain individuals, the pass-through treatment of income will result in lower tax liability than taxation at the corporate level. Stock may be issued to the public as long as the 75 shareholders limit is not exceeded. S corporations enjoy the limited liability attached to corporations. The corporation can pay the owner a reasonably small salary (which is subject to Social Security and Medicare tax). Then, the corporation can pay a relatively large distribution of profits (on the Schedule K-1 form – which is not subject to Social Security and Medicare tax). This may save the Social Security/Medicare tax on a sizable chunk of income. It is relatively easy to transfer ownership and add new owners.
Individuals who benefit from the lower tax rate paid by corporations should not apply for S corporation status. S corporation status imposes limitations on ownership of company stock, such as foreign ownership. An S corporation may only offer one class of stock and an S corporation is limited to a maximum of 75 shareholders. If you plan to invest corporate profits back into the corporation and will only draw a nominal salary, you may still have tax liability on the balance of the dividends that you reinvested in the corporation. When a shareholder of an S corporation is sued in a personal (not a business) lawsuit, the shares of stock are assets that may be seized. Separate tax returns must be filed and there is a possibility of double taxation at the shareholder and corporate levels.
LLC vs. S-CORPORATIONS
An advantage of an LLC is that the formation and ownership requirements are less rigid. Usually, an S-Corporation can issue only one class of stock, while a LLC may offer a variety of classes. The LLC also doesn't limit the number of shareholders to seventy-five or less, and doesn't prohibit non-resident aliens from possessing ownership in the company. A LLC has no restrictions against shareholders being other corporations, LLCs, or partnerships, as exists for an S-Corporation.
The LLC also is more flexible regarding management of the company. The LLC can be “member-managed,” meaning that it would be managed directly by the shareholders. Alternatively, the owners of the LLC can agree to have the business “manager-managed,” meaning that the management can be structured and delegated from the owners to managers.
One of the main reasons an S-corp may be preferable is the ease with which the stock can be sold or otherwise transferred. A sale of an ownership interest in an LLC must meet certain requirements, but there are very few restrictions on selling S-Corporation stock. Another advantage to an S-Corp may be lower state filing fees. Also, the pass-through tax advantage may be less beneficial to businesses that are small enough to take advantage of the 15% and 25% tax rates.
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