Do you remember how you got started in your new business venture? In addition to testing the market, deciding on a product or service, there was this decision on entity selection. Before the early 1990s, there was the corporation (C or S), the partnership in its many forms, and the sole proprietorship. With the advent of the Limited Liability Company or LLC, the choice of an entity form has become more interesting and challenging.

The C corporation is a taxable entity in its own right. The C corporation is a tax designation that simply separates a regular corporation from the subchapter S corporation. The owners of a C corporation will ultimately decide whether the entity will pay income tax or whether the ownership group will pay income tax as individuals. In the world of closely held businesses, the owners of the C corporation are also the management team, which is very different from most public companies. It is not uncommon for the owners of a closely held C corporation to eliminate profits from the business to avoid paying income tax at the corporate level. The C corporation is a potentially double taxable entity in the sense that profits can be left with the entity, taxed, and then distributed to the group of owners, or shareholders, to be taxed again. Careful management of this issue can serve to avoid double taxation. The C corporation is a great source to provide additional benefits to the shareholders of the entity unlike the other forms of entity. This point should be carefully considered when making an entity selection decision. In addition, there can be many advantages to starting a business for the first time as a C corporation entity, including code section 1202 stock. This code section allows for the exclusion of 50% of the proceeds from the sale of stock of the business. However, this exclusion is subject to alternative personal income tax (discussed later for my loyal readers). An important feature of 1202 shares is that one can sell shares of one C corporation and invest in shares of another C corporation with the proceeds, and avoid paying actual income taxes on the transaction. As noted, careful planning is essential.

The S corporation, for income tax purposes, is typically a flow-through entity. This means that profits at the corporate level flow to shareholders to be taxed at their individual income tax rates. In a subchapter S corporation, these flows are not subject to employment taxes (SE tax), which could save significant tax dollars. Fringe benefits cannot be paid or deducted for more than 2% of the shareholders of the S corporation and the 1202 stock provisions will not apply. The S corporation works very well when the business is extremely profitable and there is a fear that there may be unreasonable compensation charges if the company were to operate as a C corporation. There are cases where Internal Revenue will assert that salaries paid to shareholders in a C corporation constitute dividend payments rather than deductible compensation. Dividends are double taxed as they are taxed once at the C cap level and again at the shareholder level. The S corporation eliminates this problem for the most part, as shareholders can set their compensation levels reasonably and allow the rest of the profits to flow. . The S corporation can also be good for the sale of a business. Depending on the time horizon and structuring of the sale, the S corporation may provide capital gain treatment if the company’s assets are sold in lieu of its stock (versus the C corporation’s 1202 stock treatment).

The Limited Liability Company (LLC) is an interesting entity option. It works wonders for multiple businesses and can provide significant tax savings when fully understood. The LLC can be taxed as a sole proprietorship, a C corporation, an S corporation, or a partnership. It is a versatile format to manage the business. My personal preference is that new entities be formed as partnerships with our spouses. Imagine that I am a real estate broker. My earnings are subject to self-employment tax. If my income is $60,000, my SE tax will be $9,180 ($60,000 x 15.3%). If my wife owns the business with me jointly in a partnership, she will not owe SE tax on half of her earnings (assuming she owns 50%) because she is not in the business full time. She is nothing more than a passive investor. By operating my business this way, my SE tax is cut in half to $4,590. This is a significant savings. I recently helped a client save $8,000 in taxes by forming this entity structure with his wife.

My favorite entity of all, when it comes to multiple entities, includes a management company (C or S corporation) that oversees the LLCs that own the different businesses. In this way, I can say that all LLC profits are not subject to SE tax. I can show that the SE tax will be paid at the level of the management company. LLCs will pay management fees to the governing corporation where the SE tax will be paid through W-2 compensation paid to the shareholder or shareholders. Whether the managing company is a C corporation or an S corporation depends on the issues mentioned above. If I want fringe benefits, the C corporation is the right choice. If I want to save even more money on SE tax, The S cororation will be my entity of choice (beware of being too greedy as the IRS is cracking down on S corporations with low wages for owners). Because of this LLC structure and management company, I am not concerned with unreasonable compensation issues, as I can control the amount of management fees that go back to the management company. All other earnings will flow through the LLC partners’ returns and will not be subject to SE tax.