WHAT IS THE BEST ENTITY?

It's probably the most frequently-asked question that we hear from entrepreneurs, both experienced and those just getting their feet wet. So, we've put together this report to help you make that selection. Hopefully this information will allow you to make a more informed decision about the entity that is right for your business. But don't despair if you don't see your business fitting into any of the models set out below -- we also offer a service where your business structure is reviewed and you are provided with our opinion as to the best entity in your situation. And, because in many cases, the company structure you choose will be based on how it will pay taxes, our top-level review will have your business plan run past a CPA, to make sure all of your options are reviewed. We can also review your existing business structure and offer our suggestions for maximizing your strategy. A review of entities follows: Sub-Chapter "S" Corporations ("S Corp") An S Corp is a great entity for a beginning business that: • will provide a service; • does not have significant start-up costs; • will not need to make major equipment purchases before beginning operations; • will make a sizable amount of money without a great deal of effort and expense; and • expected growth of no more than 75 shareholders, who will all be people who living in the United States or who file a U.S. Resident tax return. An 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 passive 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 passive, each stream will be taxed differently. Your salary stream will be subject to both income tax and payroll taxes such as medicare and social security. However, the passive income stream will be subject only to income tax. So, by taking a reasonable salary from the S Corp your tax bracket would be lower than if you were take your entire share of the earnings as salary, and the remaining share would flow through to you as passive income, and would also be taxed at this lower rate. 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
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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 plus 15% of the corporation’s undistributed personal holding company income. That maybe higher than you would pay through your S Corp, if you took a reasonable salary and the rest as passive income. And, it's enough, in many cases, to make the difference between going S Corp and C Corp. 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 75 shareholders in total, and no-one may take their shares in anything other than their personal names (or in their living trust). 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 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, that Form 2553 we mentioned above, 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.
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