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Article added or updated:
04/29/2008 |
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Is an S Corp or LLC better for your Small Business.
S Corp Vs. LLC Comparison
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 Entities
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We continue to hear
attorneys and other allegedly knowledgeable authorities recommending the
use of Subchapter S corporations, when that ends up costing the clients
a lot more in tax dollars. I guess it's time for another refresher on
some of the big differences between normal C corporations and S. This is
not intended as a claim that one size fits all in regard to business
structure. There are times when an S corporation, or its newest
corollary, Limited Liability Companies (LLC s) and Limited Liability
Partnerships (LLPs), is a good idea. I just think it is wrong to so
quickly jump into such an arrangement without evaluating all of the
consequences of doing so.
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Tax Brackets
With our country's "progressive" tax rate structure, it is very
expensive to have too much income on any one tax return. For
individuals, the nominal rates go from 10% to 15%, 27%, 30%, 35% and
38.6% with actual effective rates much higher due to the phasing out of
so many tax breaks as income increases. With an S Corp , all of the
corporation's income flows right onto the 1040 returns of the
shareholders, pushing them up into higher tax brackets. A C corporation
has its own progressive tax rate structure, ranging from 15% on the
first $50,000 of net income, to as much as 39%. My philosophy is to look
at the overall tax picture for individuals and their companies by
smoothing income over the personal (1040) and corporate (1120) tax
returns. For 2000, a married couple's 15% tax bracket ends at $43,850 of
taxable income. It then jumps to 28%, almost double the rate. However,
if you consider that the couple's C corporation has its own $50,000 15%
bracket, their overall combined 15% bracket has more than doubled to
$93,850. That alone can save several thousands of dollars per year in
income taxes.
Income Taxed
With an S Corp , the shareholders are required to pay income tax on their
share of the corporation's income whether they take any money out of the
corporate account or leave it in there. A few years ago, I wrote about
the consulting client who had to include over $300,000 of S Corp income
on his 1040, when he had only taken out about $30,000. It wasn't bad
enough that he had to pay more income tax than he had received, but
things were much worse. He had a child support arrangement requiring him
to pay 29% of his adjusted gross income (AGI) each year. This meant he
had to pay 29% of the $300,000 to his ex-wife. It's not fair and I have
never understood why child support is based on the parents' income
rather than the actual cost to feed and clothe the kids; but that is how
things are. If he had shifted all or part of his income into a C
corporation, his child support would have been much less expensive.
More Deductions
As I have described elsewhere, the Section 179 expensing election is
much more lucrative for owners of C corporations because they can
literally multiply their total deduction by splitting their purchases of
business assets among their different business entities (1040 Sole
Proprietorships vs. 1120 Corporations). With an S Corp , the Section 179
deduction is limited to just the one amount. Likewise, the deduction for
net rental losses is magnified by using a C corp because it can use
rental losses to offset all operating income. An S corp's rental losses
are subject to the restrictive passive loss rules.
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Attack On the Rich
As I have described on many occasions, "Mean Testing" (penalizing the
evil rich) is a growing trend in this country, and is most often
measured by the AGI on your 1040. People over certain thresholds lose
tax breaks and have to pay in more taxes and penalties than others do.
Income from an S Corp will just make things worse. Income on a C corp
will not be counted in most mean testing.
Fiscal Year
One of the most useful tools in the tax game arsenal is the ability to
shift income between taxable years. Individuals report their taxable
income based on the January 1 to December 31 calendar year. S
corporations are required to also use the calendar fiscal year, allowing
no opportunity to shift income between years. C corporations, however,
can end their fiscal year at the end of any month. The first tax return
will almost always be less than a full 12 months, so don't worry about
coordinating it with the incorporation date. How this saves on taxes is
pretty straight forward. Toward the end of your personal fiscal year
(12/31), you bleed off some of your taxable income to your C corp by
paying it for something like rent or marketing services. In January,
your corporation can pay it back to you. Near the end of the corp's
fiscal year, bleed its net profits out by paying yourself This back and
forth income shifting can go on for a long time. Sometimes income is
never taxed; or if it is, we make sure that it is taxed at the lowest
rate possible (15%).
Employee Benefits
One of the benefits of a corporation is having it provide lucrative
employee benefits that are deductible by the corp and tax free to the
employees. Medical, life insurance, education, childcare, and retirement
plans are just a few of the types of benefits available. I don't have
space here to go over the rules for each type of plan. However, on a
side by side comparison, the tax free status of some of these plans is
much less generous for people owning more than 2% of S corporation
stock.
Double Taxation
The biggest fear of c-corporations has to do with double taxation, where
after-tax earnings are distributed to shareholders as non-deductible
dividends. This is rarely a problem with small corporations because
there are plenty of ways to pull money out of the corp in a manner that
is deductible, and thus only taxed once.
Compensation - wages or consulting income
Interest Payments
Lease Payments
Royalty Payments
Contributions to Retirement Accounts
Remedying A Bad Situation
If you have an S Corp that is hurting you more than it is helping you,
how should you fix it? While this is something you definitely need to
work on with your own tax advisor, I can give some general advice.
First, I have seen a lot of people confused as to whether they even have
an S Corp or not. When you charter a corporation with your state, it is
a normal C corporation. Until you file its first income tax return, the
fiscal year is still changeable, even if you said something else on the
SS-4 form you filed with IRS to obtain an identification number. You
have to take the formal step of filing Form 2553 with IRS, signed by all
of the shareholders, in order to become an S corporation.
Now, if you are an S-corporation, can you convert it to a C corporation?
You can by filing a formal request with IRS, that carries the
requirement that you cannot change back to an S corporation for at least
five years. You will however be stuck with the December 31 fiscal year,
nullifying any ability to use the income shifting tax saving strategy.
IRS will not allow you to change your fiscal year because they know that
will save you money and that is contrary to their purpose in life. What
I have found is that it is much easier to just set up a brand new virgin
corporation, especially in states like Arkansas and Missouri where it
only costs $50 in filing fees. In states like California, where the
filing fees are in the thousands, this strategy is a bit more expensive
and needs to be evaluated a little more closely .
Addendum
Lately, I have been receiving a lot of feedback from various people
around the country who have read this article, thanking me for pointing
out things that other advisors have been ignorant of. One area of
confusion still seems to be regarding exactly when a corporation becomes
an S. Many people believe that the decision to be an S or a C is made at
the time when the corporation is originally formed. That is not true.
All corporations, when originally chartered by the State, are C
corporations. Do nothing extra and it will remain a C corp.
However, to convert it to an S corporation, the shareholders must all
sign and submit Form 2553 with the IRS to request that status. This can
be done right away after the corp is originally chartered, or several
years down the road. You need to be sure to watch the effective dates of
the S election. Some States automatically accept the IRS's S election,
while others require a separate form to be submitted to the State tax
agency.
If a corp has been using a fiscal year that ends in a month other than
December, it will have to change to a 12/31 fiscal year end if it
changes to an S status. If the S status is later revoked, you will not
be allowed to change from the 12/31 year end.
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