The current economic climate has really been a challenge for many people are facing either a career change, delays in retiring as planned, or simply having to go back to work.  Not surprisingly, starting a new business may be the one true viable option given the current job market and employment rate.

This article will be one in a three-part series dealing with business entity choice, change in the limited partnership law effective January 1, 2010 and dividing up a business tax-free for asset protection purposes. The current article below is from RIA dealing with business entity selection dealing with some very basic points.

 

C corporation vs. Partnership, Do you plan to do business through a corporation or partnership? If so, you need to determine which entity will work best for you—a C corporation or a pass-through entity like a partnership, Limited Liability Company (LLC) or S corporation. Both corporate and individual tax rates are graduated beginning at 10% for individuals and 15% for corporations and going as high as 35% for individuals, and 38% for corporations (after considering the corporate surtax). (Personal service corporations are not eligible for graduated rates and pay a flat 35% rate. 

 

By organizing the business as a C corporation and splitting the business income between the owner(s) and the corporation (e.g., by having the corporation pay reasonable compensation to the owners and/or paying interest on loans from the owners of the corporation part of the business) the income will be taxed at the lowest rates applicable to each. Total federal income taxes payable will usually be lower than if the business was a sole proprietorship. 

 

But other factors need to be considered. For instance, if the organization will distribute all the profits of the business to the owners, it is usually better that it not be a C corporation, since corporate shareholders are subject to an additional tax on dividend distributions from the corporation. If the organization is expected to incur tax losses, it is important to structure the organization in a manner which would allow the maximum benefit from the tax losses. For instance, if the owners of the business have other income, it is often better to structure the organization as a pass-through entity in order to allow the owners to offset their other income with the losses of the business  On the other hand, if the owners of the business will not be able to use the losses to offset other income, e.g., because they have no other income or because of rules preventing the use of the losses, such as the rules which limit the deduction of capital losses from ordinary income or the passive loss rules it may be preferable for the organization to be taxed as a corporation, since it will be able to offset its future income with the losses. 

 

There are some other advantages of C Corporation status: C corporations may deduct nontaxable fringe benefits paid to shareholder-employees, while pass-through entities are sometimes not eligible for this type of deduction.  Similarly, corporations are allowed a dividends-received deduction while pass-through entities are not. Finally, pass-through entities are limited in the taxable years they are permitted to, while C corporations (other than personal service corporations) are generally allowed to adopt any taxable year. 

 

Partnership vs. S corporation.  Have you decided to do business through a partnership or S corporation? If it is important that the owners of the business be protected from unlimited liability, you are likely to be better off structuring the entity as either an LLC that is taxed as a partnership or an S corporation, rather than a partnership. However, in various situations, an LLC that is taxed as a partnership has advantages unavailable to S corporations. 

 

The rules on which corporations are eligible to make the S corporation election may preclude many organizations from becoming S corporations. For instance, any organization which has a foreign owner, an owner who is not an individual (other than certain trusts), or more than 100 owners, will not be eligible to make the S corporation election. 

 

An S corporation is generally not allowed to have more than one class of stock. Therefore, an S corporation does not have flexibility in giving different shareholders different interests. In contrast, a partnership may give different partners different percentages of different types of income, subject to certain anti-abuse rules.  A partner may deduct his share of partnership losses up to his basis in his partnership interest which generally includes the partner's share of indebtedness incurred by the partnership. In contrast, a shareholder in an S corporation may deduct his share of the S corporation's losses up to his basis in his stock and his basis in debt the S corporation owes him (but not including his share of debt the S corporation owes to others). 

 

A general partner is subject to self-employment tax on his share of partnership income (other than non-trade or business income items such as dividends and interest), while a limited partner is subject to that tax on guaranteed payments from the partnership that are for services he performs. Proposed regs would generally treat individual members of an LLC who are not managers as limited partners. A shareholder of an S corporation isn't subject to self employment tax. 

 

No income tax is imposed at the partnership level. No tax is generally imposed at the S corporation level, except for California’s 2.5% tax . However, the S corporation itself may be taxable on certain items such as built-in gains and excess passive income.