Choosing the Best Legal Structure (Part 3)

Your Startup — What Legal Structure Is Best?
Part 3 of a Four-Part Tutorial


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What sets corporations apart from other business structures is that they issue stock and have shareholders. Technically it's the shareholders en masse, not the founders, who are the owners of a corporation. For the purposes of this discussion, however, we will use the term "owner" to refer to founders who retain enough shares to have controlling interest in the company.

There are two types of corporations, C-Corps and S-CorpsThere are two types of corporations in the U.S., and they take their name from the section of the IRS Code which governs them. The most common corporate form is the C-Corp. But smaller businesses often prefer being an S-Corp.

These designations — C-Corp and S-Corp — are merely tax classifications. They have no other legal meaning. When a new corporation files documents of formation with a state, the state neither cares nor asks whether the corporation will function as an C-Corp or an S-Corp. In the eyes of state the matter is inconsequential. Under the state's corporate code, all corporations are treated alike.

With the IRS, however, it's a different matter. The moment a corporation comes into existence it is answerable to the IRS as a C-Corp. The company can then notify the IRS that it wants to be taxed as an S-Corp. But until the company declares itself an S-Corp, it is treated as a C-Corp by default.

Reporting Federal Taxes as a Corporation

This declaration is significant in terms of how the corporation pays its taxes. C-Corps pay corporate income tax. S-Corps do not.

Corporations are taxed differently dependent on whether they are classified as a C-Corp or S-CorpS-Corps are "pass-through" entities, much like sole proprietorships, LLCs, and partnerships. An S-Corp's net profit passes directly to the shareholders, who shoulder the tax burden for the company's earnings. They report their tax liability by using Schedule E when filing their personal tax return.

A C-Corp, by contrast, is a standalone taxable entity, separate from its owner and any other investors. Its earnings are subject to a corporate tax rate that is different from the rate paid by individuals.

In any given year the owner of a C-Corp may or may not have a tax liability based on the company's operations. The determination of the owner's tax liability depends on two factors. First, is the owner salaried as an employee of the company? And second, did the company distribute dividends after paying its corporate taxes?

Any wages paid to the owner as an employee are tax-deductible expenses for the company. The owner receives a W-2 for these wages, reports them when filing his or her 1040, and pays taxes on them as ordinary income.

The owner may also have non-ordinary income from the company in the form of dividends. There is no mandate for C-Corps to issue dividends. They may instead choose to retain their after-tax earnings to fund growth, expansion, new capital equipment, or acquisitions.

If a C-Corp decides to forego dividends in a given year, its owners and investors incur no tax liability for these retained earnings. This distinguishes C-Corps from S-Corps, whose owners and investors do pay taxes on retained earnings.

In the years when a C-Corp does distribute dividends, owners report their portion of the dividends in the same way as any other shareholder. On the owner's 1040 tax return the dividends are declared on Schedule B and taxed at a rate which is normally lower than the rate for regular income.

By contrast, the operations of an S-Corp create tax liabilities for its owners every year, even when the owner is not a salaried employee. By law the S-Corp's profits must be apportioned each year to every shareholder and the shareholders must pay tax on that apportionment. Even if the S-Corp did not actually distribute its profits, opting instead to retain them, the shareholder still must pay tax on his or her share of the profits.

Which Should You Choose? A C-Corp? Or an S-Corp?

Your business does not have to be huge in order to be a corporation. A small home-based business can be organized as a corporation. Even if you are your company’s only employee, your business can structure itself as a corporation.

Choosing whether your corporation should be an S-Corp or a C-Corp has important tax implications for the business ownerIn general, startups which choose a corporate structure opt to be treated as an S-Corp. This gives them all of the advantages of a corporation without the level of record-keeping and administrative complexity of a C-Corp. S-Corps do not pay dividends, since all of the company’s profits are passed through to the shareholders as taxable income. And as we have noted, the corporation does not have the responsibility for filing an income tax report.

There are some unique limitations on S-Corps, however. As we shall see below, tax-free benefits that can be paid to owner-employees in a C-Corp are treated as taxable income to an owner-employee who holds more than 2% of the stock in an S-Corp. Also, unlike any of the other legal structures that are available to you, all shareholders in an S-Corp must be natural persons. That is, you cannot sell shares in an S-Corp to an LLC or to another corporation.

Pros and Cons of Incorporating

So, what considerations might lead you to form a corporation instead of an LLC? One reason is to have shares in the company which you can sell to raise capital. In general, corporations find it easier to raise capital than do sole proprietorships, LLCs, and partnerships, in part because the corporation can offer stock to investors.

Corporations can generally raise capital more easily than small businesses with some other type of legal structure.

Both S-Corps and C-Corps can sell shares. But the tax consequences for the purchaser are significantly different. With an S-Corp, as we noted earlier, the shareholder must pay taxes on company profits, whether those profits are actually distributed or not.

This can prove costly during the early years of a small startup when the company is retaining its profits to build up operating capital or in tough economic times when the company may choose to build up a cash cushion. (When S-Corps opt not to distribute their profits completely, they will commonly distribute enough profit to allow the shareholders to pay the tax liability that their shares have incurred.)

Shares in a C-Corp, by comparison, give the investor the promise of on-going dividend distributions, taxed at low dividend rates, along with participation economically in the growth and profitability of the company. But the shareholder has no tax liability unless a dividend is actually paid. For the business itself, selling shares may be preferable to taking out investment loans, because interest on investment loans must be paid whether the business is making money or not. Dividends, on the other hand, are paid only when the company is profitable.

A second reason to choose a corporate structure — particularly a C-Corp — is to amass working capital at a lower tax rate. If your household income is significantly higher than your company’s income, your C-Corp income tax rate may actually be lower than your household income tax rate. Therefore, within a C-Corp you can build up your working reserves with a smaller tax bite than would be the case with an LLC, a partnership, or an S-Corp.

A third reason to select the corporate structure is enhanced employee benefits. There are a variety of benefits which you can pay yourself tax free inside a C-corp that are are taxed as additional income for sole proprietors, members of LLCs, or shareholders with more than 2% of the stock in an S-Corp. In a C-Corp, for instance, you can have a medical reimbursement plan that is a tax-deduction for the business and is tax-free to the employee, in this case, you.

Because the rules on fringe benefits for owners differ so markedly from one legal structure to another, you need to consult a CPA or a tax attorney to identify the potential employee benefits within your own business and how to institute these benefits to maximum tax advantage. But you can also learn about many of these benefits by doing a little research on the web. You will quickly discover that you must follow precise formalities in setting up fringe benefits within your corporation.

This is one arena, therefore, in which you do not want to try a "do-it-yourself" approach. Get the detailed counsel of a tax professional.

The rules on fringe benefits for business owners who own corporations differ widely from one legal structure to anotherFor small business owners, the major disadvantage of a corporation, whether a C-Corp or an S-Corp, is the compliance burden with corporate regulations. While there are compliance burdens with any business, they are notably more complex with a corporation, especially a C-Corp.

You must have annual meetings of the shareholders. Directors, too, must hold annual meetings, along with intervening meetings whenever the company is undertaking an initiative that in a large corporation would require board approval. And minutes and records of all of these meetings must be maintained.

For small business owners, the major disadvantage of a corporation is the compliance burden with corporate regulations.

Now, in point of fact, these requirements may appear more onerous on the surface than they are in reality. In most states a C-Corp can have a single director and a single shareholder. State law will also require the corporation to have certain officers, namely a president, a secretary, and perhaps a treasurer. One person can usually fill all of these positions.

Therefore, you could theoretically be the only shareholder, the only director, the president, secretary, and treasurer. So "meetings" are hardly a laborious affair. Still, you do have to make a record of what transpired at these "meetings" and date and sign them properly.

One convenient way to do this is to use a written document called a Unanimous Consent in Lieu of a Meeting. The document simply lays out a decision that the company is making and is signed by the directors. This document of record then substitutes for the formal minutes of a meeting.

For small businesses operated as a corporation, it is vital to keep written records of decisions and keep these records up to dateThe important thing is to create such records of decisions and keep them up to date. Otherwise in a legal action the courts could conclude that the company was not indeed functioning as a corporation, but was merely an extension of your persona and therefore not entitled to the liability protection that a corporation normally provides.

For a handful of professions there is another pitfall with a C-Corp. It’s commonly referred to as the "personal services corporation trap." The IRS treats certain types of C-Corps as Personal Services Corporations (PSCs) and taxes them at a flat 35% tax rate. That’s a particularly punitive rate, especially when you consider that a corporation must otherwise show $75,000 in profits before it would be taxed at nearly that percentage.

Professions which are susceptible to being treated as PSCs are those in health, law, engineering, accounting, actuarial science, consulting, and performing arts.

The IRS applies two tests to determine if a C-Corp is indeed a Personal Services Corporation. First, does at least 95% of the corporation’s activity fall within one of the categories just listed. (Note that the test is not 95% of the company’s profits, but 95% of its activity.)

The second test is whether substantially all of the corporation’s outstanding stock is directly or indirectly held by the individual who delivers the corporation’s services. "Indirect" ownership refers to shares held by a spouse, lineal ancestors or descendents, or legal entities (such as an LLC) that are controlled by any of the people above.

There are common workarounds to escape the PSC classification. The simplest is to add enough diversification to your income stream that you fail the 95% activity rule. The other is to pay out all of the company’s earnings in salaries, bonuses, and fringe benefits to the owner-employees, so that there are no profits to be taxed.