Creating a legal entity for your startup will establish much-needed separation between you and your business. Shielding your personal assets is the first and foremost reason to think about incorporating.
But let’s face it. When it comes down to choosing a business structure, small business owners are typically concerned about one thing: taxes.
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There are a whole host of reasons to incorporate as a C Corporation. For example, the C Corp is the preferred structure if you intend on seeking VC funding or taking the company public. But forming a C Corp involves more paperwork, legal fine print and potential double taxation.
Understanding the Pitfall of Double Taxation
From a legal stance, a C Corp is a separate entity that can sue and be sued. When it comes to taxes, a C Corp is a separate tax payer that files its own federal and state (where applicable) tax returns. This means that profits are first taxed with the corporation. Then, if the corporation decides to take that profit and distribute dividends to shareholders, the dividends are taxed again (this time, on each shareholder’s personal tax statement).
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To better understand the potential of double taxation, let’s look at an example: Carl owns a graphic design business and formed a C Corporation (he’s the only shareholder at the moment). His business took in $90,000 in profit in 2011. As a C Corporation, the business would first be taxed on the profits, paying $19,000 (assuming $13,750 plus 34% of the amount over $75,000).
Carl wants to take that money home, and decides to distribute it to himself as a dividend. He will also owe taxes (at the 15% qualifying dividend rate) on the dividend payment.
Carl's total tax payments amount to $19,000 (corp) plus $13,500 (personal), totaling $32,500.
Avoiding Double Taxation: Pass-Through Tax Treatment
Two business structures are often preferred for small businesses, since they avoid this double taxation burden: the LLC (limited liability company) and S Corporation. With these business structures, the company is taxed more like a sole proprietor or a partnership than as a separate entity, like the C Corporation.
Company profits are “passed through” and reported on the personal income tax return of the shareholders.
Here’s what it would mean for Carl and his graphic design business: Carl incorporates his graphic design business as a C Corporation, then chooses to elect "S Corporation Status" by filing form 2553 with the IRS in a timely manner (note: the S Corporation deadline is 75 days from the day your company is formed, or March 15 for existing companies).
His company earned $90,000 in profit in 2011. As an S Corporation, the business itself pays no income tax. Since Carl is a shareholder and also works in the business, he must pay himself a reasonable wage for his activities. This will be subject to his personal income tax rate.
Then, he can distribute the rest of the profits to himself as a dividend, which are taxed at a 15% qualifying dividend rate.
Please bear in mind that these examples are over-simplified to introduce the concept of double taxation at the highest level. As expected, nothing is ever so simple when it comes to the world of business taxes. Discussing your particular situation with a trusted tax advisor or accountant can go a long way to helping you determine which business structure and tax treatment is optimal for you.
The LLC and S Corporation
Both the LLC and S corporations offer the pass-through tax treatment explained above. And both will protect your personal assets from any potential liabilities of the company (whether from an unhappy customer, unpaid supplier or anyone else who might pursue legal action).
Yet, the LLC and S Corp feature some key differences as well. Stay tuned for my next post, when I explore these differences and how they impact your business.
Image courtesy of iStockphoto, bluestocking
This story originally published on Mashable here.
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