Starting and maintaining a business today is a serious proposition involving many legal issues, including taxation and debt liability. One of the biggest decisions involves choosing the best business structure. A business may operate as a sole proprietorship, general or limited partnership, limited liability company, C corporation or S corporation. Each form has distinct advantages and disadvantages in terms of liability protection for the owners, the number, and types of equity owners allowed, which fiscal years, accounting methods and capital structures may be used, tax rates, and the number of levels on which income is taxed. If you are contemplating starting a business or changing the structure of a current one, please call or e-mail our office to discuss the matter in detail. Below is some general information on the business structures available in Indiana.
Corporations limit the personal liability of their owners. An S corporation can provide both legal liability protection and single-level taxation similar to a partnership. An S corporation, with certain exceptions, is not subject to tax. Its income and expenses flow through to the shareholders, who report them on their personal returns, subject to basis limitations and the passive activity rules.
Unlike a partnership, the shareholders do not receive basis for amounts borrowed by the entity, even if they provide personal guarantees. To obtain basis, the shareholders must borrow individually and advance the funds to the corporation.
An S corporation can have only one class of stock, but differences in voting rights are permitted. The corporation, with certain exceptions, must use the calendar year. It may use the case method of accounting unless it owns inventory.
Since the top individual tax rate (39.6%) is higher than the highest corporate tax rate (35% for income over $10 million) the income of an S corporation can be subject to a higher tax rate than that of a C corporation. However, S corporations provide many advantages, such as the avoidance of double taxation of earnings and no accumulated earnings tax.
Moreover, the IRS generally will not challenge compensation paid to the owners as unreasonable. Bear in mind that a C corporation that makes an S election is subject to a built-in gains tax for 10 years.
The 1996 Small Business Job Protection Act significantly improved the flexibility of S corporations, but not all states have adopted its provisions. Some of these provisions include the following:
- S Corporations may have up to 75 shareholders (husband and wife count as a single shareholder). Only US citizens, estates and certain types of trusts can be shareholders. For years beginning after Dec. 31, 1997, qualified pension plans and Section 501(c)(3) charities may also be S corporation shareholders. These tax-exempt entities will be subject to tax on their S corporation income.
- An employee stock ownership plan (ESOP) can own S corporation stock, although certain provisions which are beneficial to ESOP’s don’t apply to S corporations.
- S corporations may now own 80% or are of the stock of another corporation. A corporation 100% owned by an S corporation may elect S status.
A C Corporation is separate and distinct from its shareholders. It is taxed on its earnings; after-tax distributions to shareholders are taxed to them as dividends.
Corporations with taxable income of $1 million or more in any of the three preceding years must make estimated tax payments of at least 100 % of the current year’s tax. First quarter payments and all payments made by small corporations may still be based on 100% of the prior year’s liability.
A shareholder can be an employee of the corporation and receive reasonable compensation and employee benefits, which area deductible corporate expense. However, the IRS can reclassify compensation paid in excess of what is deems reasonable as a nondeductible dividend.
The taxpayer Relief Act of 1997 changed the treatment for net operating losses. Most corporate losses may now be carried back two years and/or carried forward 20 years as a deduction against income earned in those years. Losses arising in tax years beginning before Aug. 5, 1997, are still subject to the three year carry back and 15 year carry forward rules.
A C corporation with gross receipts of $5 million or more, other than a personal service corporation, must use the accrual method of accounting, but may use any fiscal year it chooses.
C Corporations that retain too much earnings without a valid business purpose could be subject to the accumulated earnings tax. Closely held investment corporations may be considered personal holding companies subject to a personal holding company tax if they do not distribute sufficient dividends.
Corporations are subject to an alternative minimum tax (AMT) of 20% based on the corporation’s regular taxable income, increased by tax preference items and increased or decreased by adjustments. The AMT does not apply to small business corporations for tax years beginning after 1997.
Operating as a sole proprietor is the simplest form of conducting a business. But, after operations have expanded, a sole proprietor may want to change to a different form of business.
A sole proprietorship’s net income is subject to both individual income and self-employment tax. If the owner actively participates in the business, its losses are fully deductible against other income. Losses exceeding the years taxable income may be carried back and/or forward.
In general, operating as a sole proprietor doesn’t offer you protection from liability. However, recently enacted”check the box” regulations permit the formation of a single member limited liability company (LLC) that is treated as sole proprietor for tax purposes and provides liability protection. Not all states permit single member LLCs.
The income and expenses of a partnership flow through to the partners; the partnership itself is not a taxable entity, avoiding the double taxation of partnership income and gain.
General partners are subject to unlimited liability, but limited partners are subject to liability only to the extent of their investments. A limited partner, unlike a general partner, is not subject to self-employment tax on partnership income unless he or she receives compensation for performing services for the partnership.
A partnership can deduct nonacquisition partnership losses against other income, up to their tax basis and the amount to which they are “at risk” in the business. The passive activity loss limitation provisions may also limit the amount of currently deductible losses. Partners, unlike S corporation shareholders, get basis for the partnership’s debt. Partners can also increase their basis when a change in ownership occurs.This is not available to S corporations.
With the passage of the Taxpayer Relief Act of 1997, the partnership taxable year ends for a partner on the death of that partner, effective for partnership years beginning after Dec. 31,1997.
Limited liability companies
Many people view LLCs as superior to S corporations and partnerships. The LLC offers liability protection similar to a corporation and, for LLCs treated as partnerships for tax purposes, the tax flexibility of a partnership.
In addition, the stringent S corporation rules don’t apply. The new “check the box” regulations have made qualifying an LLC for partnership taxation much simpler, and have made LLCs more flexible. (Not all states follow these regulations.)
In general, the members of an LLC, except those who would qualify as limited partners had the entity been formed as a limited partnership, are subject to self-employment tax.