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Article added or updated:
04/29/2008 |
S Corp,
LLC
or C Corp. The various advantages
compared.
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Article first appeared
07.07.03. Please make sure
the info cited is still correct
See Also:
S Corp, LLC, C Corp
LLC vs. Corp
S Corp-LLC Compared
Corporation vs.LLC
S Corp vs. LLC
S Corp vs LLC 2
Business EntitiesC corp? S corp? LLC? The new tax law creates some
new wrinkles.
If you own your own business or
are starting one, pay attention: The recent federal tax cuts could
affect the kind of corporation you use and how you handle salaries,
dividends and reinvested profits.
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Passthroughs still rule.
In recent years
S corporations and other "passthrough"
entities, such as limited liability companies, have become more popular
than traditional C corporations. Rightly so. Passthroughs aren't taxed
at the corporate level. Instead their earnings, losses and credits flow
onto the owners' tax returns. C corps, by contrast, pay corporate income
tax. If owners receive those profits as dividends, they're taxed again.
The new law seems to provide a big boost
for C corps, since the maximum tax on dividends is chopped from 38.6% to
15%. Look closer. Pass-through entities did well, too. How so? Your
earnings from a passthrough don't qualify for the 15% dividend rate;
they're taxed at ordinary income rates. But the top individual
rate dropped from 38.6% to 35%, the same as the top corporate rate. And
a double tax is still a double tax--the top combined corporate and
individual tax on a dollar of distributed C corp earnings is now 44.75%,
compared with a 35% single rate for a passthrough.
Can't C corp owners limit the double hit by
taking large salaries and leaving less corporate profit to be taxed?
Yes, but salary is subject to payroll taxes--at a combined
employer/employee rate of 15.3% on the first $87,000 in 2003 and 2.9%
above that. With an
S corp
you can take less salary and more profits,
cutting payroll taxes. (Warning: Be reasonable. If you draw way too much
or way too little salary, the IRS can challenge it.)
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Consider a C corp cash-out.
In the past many owners of C corps have
retained earnings, rather than pay them out as dividends taxed at a
38.6% rate. That way, when they retired, they would be able to sell
their generously capitalized business for more, thus effectively
converting high-taxed dividends into low-taxed long-term capital gains.
Even better, if they held the business until death, their heirs would
get a "step up" in its basis, thus avoiding the gains tax, too.
But the new 15% rate for dividends provides a
tempting opening to distribute some earnings. Why not just leave all the
cash in the company and defer taxes? Two reasons. First, under the new
law the 15% rate, which applies to both dividends and capital gains,
lasts only through 2008; in 2009 the top dividend rate returns to 35%
and the gains rate to 20%. Second, if you accumulate too much in
earnings in a C corp, you could be hit with the accumulated earnings tax
or the personal holding company tax. The new law drops the rates for
these two penalty taxes from 38.6% to 15%, but again, only through 2008.
Don't act too fast, however. "Companies must be
careful not to become overly emotional about this and overdistribute
dividends," warns Michael Grace, a tax lawyer at Jackson & Campbell in
Washington, D.C. Keep enough cash on hand to fund future operations. And
before you distribute a penny, ask your tax accountant to calculate the
impact on your state tax bill and your federal alternative minimum tax
liability. You could be in for a nasty shock.
John Ziegelbauer, a partner with Grant Thornton
in Washington, D.C., suggests that retiring C corp owners may want to
rethink their business sale plans. Instead of selling all the stock in
their company to get a low capital gains rate, they may want to retain
some stock, deferring gains taxes and drawing dividends over time. (This
strategy won't look as good if Congress doesn't extend the 15% dividend
rate beyond 2008.)
LLCs are great, but …
If you're starting a new business, the entity
of choice is usually an LLC, says Peter Faber, a tax lawyer with
McDermott, Will & Emery in New York. It's more flexible than an S corp
and has certain tax advantages. For example, you can create different
shares of stock with different profit draws in an LLC, but not in an S
corp. And when an LLC borrows money, it adds to your basis in the
company; when an S corp borrows, it doesn't. If, however, you are
converting from a C corp to a passthrough, an
S corp is preferable--you
can convert to an
S corp, but not an LLC, without triggering extra tax.
You'll need a C corp to go public. A C corp
might also work well if you are starting a sideline business and want to
build up some capital. The first $50,000 of income in a C corp is taxed
at only 15%, notes Phoenix CPA Edward Zollars. Even if you do take those
profits out, you'll still be better off--paying a 15% corporate tax plus
a 15% dividend rate--which works out to a combined 27.75%. Anything
above the $50,000 you can take as salary, so long as it's reasonable and
not too obviously keyed to the level of profits. Warning: The lower rate
isn't available for professional service corporations, like law firms.
And you must consider state corporate taxes, too.
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