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Archive for the 'S Corporation Advice' Category

Keys for Using an S-Corporation

August 6th, 2008

By The XBanker

If you have been considering forming a corporation or other business entity to provide yourself with limited liability and financing options in your business venture, you have made an important first step. You may have compared the tax benefits of corporations and limited liability companies or limited partnerships. If you have done so, you likely realized that corporations are taxed twice, while limited liability companies and limited partnerships are taxed once.  While a corporation’s profits are taxed once as the corporation’s income and again when the profits are distributed as dividends, a limited liability company or limited partnership’s profits flow through the entity and are only taxed once as personal income to the individual member of the limited liability company or partner in the limited partnership. This is referred to as flow-through taxation. Based solely on the tax treatment of corporations, you may be prepared to use a limited liability company or limited partnership for your business.

While limited liability companies and limited partnerships feature outstanding charging order protection, Nevada has recently extended such protection to corporations with between two and seventy-five shareholders.

Before you decide which business entity to use, there is one more option for you to consider. If you choose to use a limited liability company or a limited partnership, your business may limit its financing options. Financing for a limited liability company or a limited partnership may not be as readily available as financing for a corporation, because interests in such entities are not as transferable as interests, or shares of stock, in a corporation. An S-corporation is the alternative that provides both financing options and flow-through taxation; however, to be treated as an S-corporation, your business must do the following:

• Incorporate the Business – As with a regular corporation, referred to as a C-corporation, an S-corporation must prepare and file Articles of Incorporation with the state, prepare and operate under Bylaws, operate under a Board of Directors and corporate officers, and engage in corporate formalities.
• File an S-Corporation Election Form - To be eligible for S-corporation tax treatment, the corporation must (1) be a corporation organized in any U.S. state, (2) not be an ineligible corporation (certain types of businesses are not eligible), and (3) have only one class of stock. If eligible, the corporation may file an S-corporation election form, Form 2553, with the Internal Revenue Service within forty-five days after incorporating. While this will allow flow-through federal taxation, it is important to note that five states do not recognize S-corporations and may tax the corporation as a C-corporation. It is also important to note that S-corporations are not eligible for certain tax deductions that C-corporations may enjoy.
• Notice and Obey S-Corporation Limitations – Once the corporation has made its S-corporation election, it must notice and obey the limitations on S-corporations to maintain its flow-through tax status. If the corporation violates any of the following limitations, it will lose S-corporation status and will not be eligible for flow-through taxation for five years: (1) it must have one hundred or fewer shareholders; (2) all of its shareholders must be individuals, descendants’ estates, estates of individuals in bankruptcy, or certain trusts, because business entities may not be shareholders; and, (3) all of its shareholders must either be United States citizens or resident aliens in the United States (nonresident aliens may not be shareholders). If the corporation loses its flow-through tax status, the Internal Revenue Service will treat it as a C-corporation.

Every business is unique. Your business’s form should be based on your specific circumstances. While the limitation on the number and types of shareholders allowed in S-corporations may affect financing options, such limitations may have less practical importance than the limitations on financing options created by using a limited liability company or a limited partnership. Accordingly, S-corporations’ tax benefits, management structure and transferability of shares may provide the benefits that your business needs in an entity that also provides you with limited liability. By considering your business’s options and choosing the best available business form, you will ensure that you take advantage of available opportunities.

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Choosing the Wrong Corporate Entity

June 11th, 2008

By The XBanker

Corporate entities come in three categories: the good, the bad, and the ugly. But even among the good, one size does not fit all. Choosing the wrong corporate entity can cost you time, money, and your personal assets.

The “bad” entity is the Sole Proprietorship, where the owner is personally liable for all claims against the business. If the business gets sued, as owner, you could lose more than just the company; you could lose your car, your house, everything. Though the paperwork required for a Sole Proprietorship is minimal and it is the cheapest entity to form, it is almost never worth the risk in today’s litigious society.

The “ugly” entity is the General Partnership, where each partner is responsible for the actions of the other. Any partner can obligate the partnership, even if one (or more) partner(s) protests a decision. And, as with a Sole Proprietorship, personal assets may be on the line. It is also important to understand that General Partnerships can be innocently formed. There is no filing requirement. A handshake or simple business arrangement – anytime you are sharing profits and splitting losses – could be seen by the courts as a General Partnership, regardless of the intent of the parties involved. Remember, with a General Partnership you have liabilities times two. You are responsible for your own mistakes as well as your partners’ mistakes. Not a good way to do business.

The “good” entities are the C Corporation, the S Corporation, the Limited Partnership (”LP”), and the Limited Liability Company (”LLC”). A corporation, LLC or LP is a separate legal entity with its own name, business purpose, and tax identity with the IRS. The corporation is responsible for the actions of the corporation, not individual owners or shareholders. As an owner or shareholder, your personal assets are protected. You are only liable for the money you put in to start the company, thus each corporation offers limited liability.

Simply filing as a corporation is not enough to protect personal assets, however. Certain corporate formalities must be followed (the same applies for LLCs and LPs) or a creditor will be able to claim that the business is a corporation in name only. In this case, the corporate veil may be pierced and personal assets claimed.

Choosing a corporate entity is a detailed, complicated process. Work with your XBanker account representative to properly set it all up. They will make sure you choose the right entity, thus avoiding a big mistake many business owners make.

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The Downside to the S Corporation

May 14th, 2008

By The XBanker

A downside to S Corps is the limitation on who can be a shareholder, and what kind of shares it can issue. There can be no more than 100 shareholders in total, and no one may take their shares in anything other than their personal names (or in their living trust’s name). So, forget transferring your S Corp shares into an irrevocable trust, limited partnership or children’s trust. And, you can’t have any non-U.S. resident shareholders, either. Everyone who holds shares in an S Corp must file a U.S. resident tax return. And, you can only have one class of shares, which can be confining, especially if your plans include taking your company public or looking for outside investors. If you breach any of these requirements the IRS will strip your company of its S Corp status, and automatically turn it into a C Corporation, which may have a negative tax consequence.

Another downside is asset treatment. Both C and S Corps are not great vehicles if your business will hold appreciating assets, such as land, buildings, stocks, bonds, etc. The tax on them upon sale or upon distribution will be much greater if held in a corporation than if held in a limited liability company or a limited partnership. This is further explained in the book How to Use Limited Liability Companies & Limited Partnerships, written by Garrett Sutton and available at www.successdna.com.

The steps to create a C or S corporation are the same. Articles of Incorporation are prepared and filed, Bylaws are prepared, directors are elected by the shareholders, officers are elected by the directors, and shares are issued to the shareholders. This may sound difficult but we will be there to guide you through it all.

The S Corp Declaration, the IRS Form 2553, should be filed within 75 days of the incorporation date, so don’t delay if this is how you see your company proceeding. If you don’t file within that 75 day period, the IRS can deny you S Corp status for a full year, meaning that your first year of operations will be conducted at C Corporation tax rates.

The shareholders, directors and officers of the company must remember to follow corporate formalities. They must treat the corporation as a separate and independent legal entity, which includes holding regularly scheduled meetings, conducting banking through a separate corporate bank account, filing a separate corporate tax return, signing all documents related to the business in their official capacity and filing corporate papers with the state on a timely basis. If these steps are not followed, a business creditor may be allowed to “pierce the corporate veil” and seek personal liability against the officers, directors and shareholders. Adhering to corporate formalities is not at all difficult or particularly time consuming. In fact, if you have our affiliate handle the corporate filings and preparation of annual minutes and direct your accountant to prepare the corporate tax return, you should spend no extra time at it with only a very slight increase in cost. The point is that if you spend the extra money to form a corporation in order to gain limited liability it makes sense to spend the extra, and minimal, time and money to insure that protection.

And remember, while there are some downsides to the S corporation there are some significant benefits as well. Work with your advisor to see if the S corporation is right for you.

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Appreciating the S Corporation

May 6th, 2008

By The XBanker

The Subchapter S Corporation (or S Corp) is structurally the same as a C corporation (i.e., it has officers, directors and shareholders), but with one key difference. An S Corp files an election with the IRS, called a Form 2553, that provides it with a flow-through tax structure as found in entities such as partnerships and limited liability companies. That means, the company’s income (and corresponding expenses, write-offs and deductions) will flow through to its shareholders, and be split among them according to each shareholder’s ownership percentage. The S Corp’s taxes will actually be paid by its shareholders, at their individual tax rates, and in proportion to their individual ownership percentages.

From a taxation standpoint, an S Corp is a great fit for a company that offers a service, because in many cases the revenues can be split and paid to the shareholders in two categories: salary and distribution (or profits) earnings. A flow-through tax structure means that the profits and corresponding losses, deductions and expenses are divided up among the shareholders, in proportion to their ownership percentages, and reported on each shareholder’s personal income tax return. Therefore, if your income from an S Corp is split into two streams, salary and profits, each stream will be taxed differently. Your salary stream will be subject to both income tax and payroll taxes which amount to a whopping 15.3% for Social Security and Medicare. However, the profit income stream will be subject only to income tax. So, by taking a reasonable salary from the S Corp and the rest in profits your taxes will be lower than if you were take your entire share of the earnings as salary. By allowing a percentage to flow through to you as profits you can save thousands of dollars a year in payroll taxes which, as we all know, we will never see the benefit from since Social Security is broken and bankrupt.An S Corp is also a great entity for businesses with low start-up costs that do not have to purchase a significant amount of assets to begin operations. For example, buying a working laundromat would be an excellent choice for an S Corp. You are purchasing a turnkey business – it’s already operating, and you aren’t going to be laying out significant cash to get it up and running. So, you will have a pretty good income stream immediately, and that income stream can best be disbursed to you and your partners, if any, through the S Corp structure. Two other great matches for an S Corp are network-marketing and Internet-only businesses. In each case, the business is likely to have no storefront, low operating costs, and probably doesn’t maintain a warehouse. Most network marketing and Internet-only businesses drop-ship from their suppliers directly to the end consumer when they are delivering products at all. Again, as these can be high-income, low cost operations, they work great in the S Corp structure.

Here’s another reason we suggest S Corps for many service-oriented businesses: To avoid being characterized as a Personal Service Corporation, or “PSC” by the IRS. PSCs are C corporations that are classified by the IRS as providing a service, such as consulting, to the general public. Now, as you may know, the United States government, in an effort to boost the economy and keep business working, assesses C corporations with a pretty low initial rate – 15% on earnings up to $50,000. That’s quite a bit lower than you would pay personally, if you were receiving that same $50,000 as salary. And that 15% rate is also lower than you would pay if your business was an S Corp. So, to head off the anticipated revenue drain, the IRS closed that loophole by designating C corporations that provide services to be PSCs. The additional tax rate for PSC earnings can be a flat 35% or the regular C Corporate rate plus 15% of the corporation’s undistributed personal holding company income. That may be higher than you would pay through your S Corp, if you took a reasonable salary and the rest as profit income. And, it’s enough, in many cases, to make the difference between choosing an S Corp and C Corp. Next week we’ll look at one significant downside to the S Corporation.

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