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Choose Your Business Structure (Wisely!)

  Anyone starting a new business needs to choose a business structure. Do you incorporate your business? If so, do you form a C-corporation or an S-corporation? How about remaining a sole proprietorship or a partnership? And, what about the newer Limited Liability Company (LLC) structure?

  Issues of liability, taxation, ease of transfer of ownership, and access to capital will help determine your optimal business structure. The decision is important and depends upon your personal goals, so you probably want to consult your business and tax attorneys.

  Sole proprietors file Schedule C (or the easy version C-EZ) with their 1040 Individual Income Tax Return to report their earnings or loss from operating a business. Schedule C is just like any other attaching schedule to the 1040. You follow your nose. When the IRS says "subtract," you do. When the IRS says, "Enter the amount here and also on line 12 of Form 1040," you do. In the end all of your hard work is summarized by one line on your 1040 tax return showing your net profit or loss from running a business. Profits are taxed as ordinary income.

  If your business earnings are above $400, you also need to file Schedule SE (SE for Self Employment) with your personal tax return. This is the point at which new entrepreneurs get a queasy feeling and start thinking, "Hey, this sort of sucks. I'm going to be paying other taxes than just income tax on my earnings."

  As a business owner, you will learn about many, many taxes of which the average employee has little knowledge. Your self-employment tax is the equivalent of employee/employer Social Security and Medicare Benefits tax, better known to employees as FICA (Federal Insurance Contributions Act). On the positive side, these contributions give you future Medicare and Social Security benefits. On the negative side, these taxes reduce the amount of money you can take home today.

  Becoming aware of the taxes and tax rates you face under the different business structures is crucial to minimizing your overall taxation.

  The disadvantage of being a sole proprietor is that you and your business are considered the same legal entity. If someone falls in your retail store and wins a big judgment against your retail company, structured as a sole proprietorship, that judgment is also against you as an individual. All of your personal assets are at risk. For some businesses, that is acceptable. For other businesses, it is not. Unless you form some other business structure for your company, you are a sole proprietor if you are the sole owner of your company.

  If you enter into a partnership with others, unless you form a corporation or some other business structure, you will be deemed a partnership. Partnerships also offer little liability protection for entrepreneurs. Your personal assets are at risk.

  To get liability protection, many entrepreneurs incorporate their business. Corporations are considered separate legal and taxable entities from the owners of the corporation. Most corporations are C-corporations, taxable under Subchapter C of the IRS code (Don't confuse C-corporations with Schedule C to the 1040 above. They are entirely unrelated). Just as you file a Form 1040 personal income tax return and pay taxes on your earnings, so too, a C-corporation files Form 1120 and pays taxes on its earnings.

  C-corporations have employees, and they have shareholders. Shareholders own the corporation. Employees render services for the corporation. You will likely be both a shareholder and an employee of your corporation. If you are an angel investor in a company, you might be a shareholder without being an employee. But, you could be on the board of directors.

  There are two primary ways to withdraw money from your corporation. As an employee of the corporation, you are entitled to just compensation for any services you render the corporation. As the president of your corporation, you are entitled to a salary. So, you may have the corporation pay you a salary. This is the first way most entrepreneurs remove money from an incorporated business.

  The disadvantage to paying yourself a wage is that wages are subject to various employment taxes, for example, Social Security and Medicare taxes, in addition to income tax. While corporations don't pay self-employment taxes (you're an employee of the corporation and not self-employed), paying yourself a wage lops off about 16% of the wage in employment taxes.

  The second primary way that a corporation passes money to its shareholders is with dividend payments. Because you are a shareholder of your corporation, you can receive corporate dividends.

  A corporation is a separate taxable entity. So, if the corporation earns $1,000, it pays taxes on the $1,000. Suppose $850 remains after paying corporate income tax. Suppose that this $850 is paid to you as a corporate dividend. Then, you, as an individual taxpayer, must also pay income tax on the dividend received.

  After paying income tax at your personal marginal tax rate, you maybe have $600 of the original $1,000 in your pocket after all taxation. So, you effectively paid 40% of your earnings in income tax. And, this assumes relatively low tax brackets at both the individual and corporate level!

  This is what is meant by "double taxation." Double taxation usually means that a corporation has earnings which were taxed as income to the corporation. Then those earnings were paid as dividends to the shareholders. The shareholders need to pay personal income tax on the dividends received. Needless to say, you don't want to pay an effective 40% income tax rate or more on money withdrawn from your company!

  Because of the heavy tax hit, smaller C-corporations hesitate to pay dividends. The goal is often to retain the profits within the company to fund further growth and profitability. Sometimes, the long-term goal is to create a company of sufficient value so that it can be sold to another company or taken public. This provides a very profitable and tax-efficient exit strategy for entrepreneurs and angel investors alike.

  Incidentally, we should notice that in many situations double taxation of corporate dividends is much more punishing than paying added employment taxes. So, some entrepreneurs try to increase their wages to very high levels. The IRS frowns upon "excessive wages" paid from a C-corporation which it feels are dividends in disguise. The IRS can reclassify ultra-high salaries as dividends.

  To relieve small businesses from the burden of double taxation of dividends while at the same time offering small business owners the liability protection of incorporation, the IRS adopted the S-corporation status. By filing Form 2553, you can elect to have your corporation taxed as an S-corporation. This means it is taxed under Subchapter S of the IRS code. Unless you elect to become an S-corporation, a corporation is automatically a C-corporation.

  Because S-corporation status is intended for smaller businesses, you must meet certain requirements to be eligible. For example, your corporation can only have one class of stock, have at most 75 shareholders, and have no non-individual-non-people shareholders (remember, corporations as separate legal entities can own shares in other corporations).

  The difference between C-corporations and S-corporations is how they are taxed. While C-corporations are taxed as separate taxable entities, S-corporations are treated as a "pass-through entity." In other words, S-corporations typically pay no income tax. Rather, S-corporation income flows through to the individual shareholders.

  So, if an S-corporation pays dividends, those dividends will be taxed to the individual shareholder at his or her personal income tax rate. Such dividends are only taxed once. In this way, S-corporations are taxed like partnerships.

  While C-corporations file Form 1120, S-corporations file Form 1120-S (S for S-corp). Form 1120-S is usually only informational in nature. There usually isn't any tax due with the filing.

  To record the flow of income to the S-corporation shareholders, two other forms are filed. Schedule K and Schedule K-1, Shareholder's Share of Income, Credits, Deductions, etc. Schedule K-1 is shareholder specific taking into consideration the shareholder's percentage ownership of the S-corporation. Schedule K-1 is given to each shareholder and helps the shareholder prepare his or her individual income tax return.

  Because of the "pass through" nature, S-corporations are a good structure for profitable businesses from which you wish to remove most of the earnings.

  Many start-up companies aren't profitable right away. Just as income from an S-corporation flows through to the individual shareholders, so do any business losses. Such losses can offset other sources of income to reduce the shareholder's personal income taxes. This is one reason investors with other sources of income often favor the S-corporation structure for newer businesses which anticipate losing money until the business becomes established.

  Finally, while investors can divide their investment in your company into an equity portion and a debt portion and while you can create voting and non-voting shares in your corporation, the fullest variety of financial structuring can be achieved through the newest Limited Liability Company structure or the older Limited Partnership structure. (Old joke: "Why do they call them limited partnerships?" Answer: "Because you'll only get a limited part of your capital back!")

  For example, suppose you decide to produce a film. You raise $15 million. Amazingly, your film manages to breakeven and earns your company $15 million. Suppose, you and your investors each own 50% of the corporate shares. While you might like earning $7.5 million, your investors wouldn't be too happy about losing $7.5 million on their investment!

  Yet, you might not like giving up 95% of the return and ownership of the corporate shares as a just compensation for the large risk the investors are taking. That tremendously limits your financial potential from the endeavor in the event that it is a smashing success.

  So, you could imagine the investors asking for a deal like this: Until the investors receive their initial investment back, 100% of the profits of the endeavor go to the investors. Once the investors have recovered their initial investment, profits will be split 50-50 between the investors and the production company. For this deal and for more complex financing terms, a Limited Liability Company (LLC) might be your best structure.

  Entrepreneurs and angel investors should study and learn about basic business structure. As the old financial saying goes, "It's not how much you earn, but how much you keep that matters." The wrong business structure can cost you extra tax dollars, hinder financing availability, and subject you to unanticipated risk exposure.

For more information about business structure, see our Online Guide To Starting A Business.