Starting and maintaining a business today is a seriousproposition involving many legal issues, including taxation anddebt liability. One of the biggest decisions involves choosing thebest business structure. A business may operate as a soleproprietorship, general or limited partnership, LLC, Ccorporation or S corporation. Each form has distinct advantagesand disadvantages in terms of liability protection for theowners, the number and types of equity owners allowed, whichfiscal years, accounting methods and capital structures may beused, tax rates, and the number of levels on which income istaxed. If you are contemplating starting a business, or changingthe structure of a current one, please call or e-mail our officeto discuss the matter in detail. Below is some generalinformation on the business structures available in Indiana.
Corporations limit the personal liability of their owners. AnS corporation can provide both legal liability protection andsingle-level taxation similar to a partnership. An S corporation,with certain exceptions, is not subject to tax. Its income andexpenses flow through to the shareholders, who report them ontheir personal returns, subject to basis limitations and thepassive activity rules.
Unlike a partnership, the shareholders do not receive basisfor amounts borrowed by the entity, even if they provide personalguarantees. To obtain basis, the shareholders must borrowindividually and advance the funds to the corporation.
An S corporation can have only one class of stock, butdifferences in voting rights are permitted. The corporation, withcertain exceptions, must use the calendar year. It may use thecase method of accounting unless it owns inventory.
Since the top individual tax rate (39.6%) is higher than thehighest corporate tax rate (35% for income over $10 million) theincome of an S corporation can be subject to a higher tax ratethan that of a C corporation. However, S corporations providemany advantages, such as the avoidance of double taxation ofearnings and no accumulated earnings tax.
Moreover, the IRS generally will not challenge compensationpaid to the owners as unreasonable. Bear in mind that a Ccorporation that makes an S election is subject to a built-ingains tax for 10 years.
The 1996 Small Business Job Protection Act significantlyimproved the flexibility of S corporations, but not all stateshave adopted its provisions. Some of these provisions include thefollowing:
C CORPORATIONS
A C Corporation is separate and distinct from itsshareholders. It is taxed on its earnings; after-taxdistributions to shareholders are taxed to them as dividends.
Corporations with taxable income of $1 million or more in anyof the three preceding years must make estimated tax payments ofat least 100 % of the current year’s tax. First quarterpayments and all payments made by small corporations may still bebased on 100% of the prior year’s liability.
A shareholder can be an employee of the corporation andreceive reasonable compensation and employee benefits, which area deductible corporate expense. However, the IRS can reclassifycompensation paid in excess of what is deems reasonable as anondeductible dividend.
The taxpayer Relief Act of 1997 changed the treatment for netoperating losses. Most corporate losses may now be carried backtwo years and/or carried forward 20 years as a deduction againstincome earned in those years. Losses arising in tax yearsbeginning before Aug. 5, 1997, are still subject to the threeyear carry back and 15 year carry forward rules.
A C corporation with gross receipts of $5 million or more,other than a personal service corporation, must use the accrualmethod of accounting, but may use any fiscal year it chooses.
C Corporations that retain too much earnings without a validbusiness purpose could be subject to the accumulated earningstax. Closely held investment corporations may be consideredpersonal holding companies subject to a personal holding companytax if they do not distribute sufficient dividends.
Corporations are subject to an AMT of 20% based on thecorporation’s regular taxable income increased by taxpreference items and increased or decreased by adjustments. TheAMT does not apply to small business corporations for tax yearsbeginning after 1997.
SOLE PROPRIETORS
Operating as a sole proprietor is the simplest form ofconducting a business. But, after operations have expanded, asole proprietor may want to change to a different form ofbusiness.
A sole proprietorship’s net income is subject to bothindividual income and self-employment tax. If the owner activelyparticipates in the business, its losses are fully deductibleagainst other income. Losses exceeding the years taxable incomemay be carried back and/or forward.
In general, operating as a sole proprietor doesn’t offeryou protection from liability. However, recently enacted"check the box" regulations permit the formation of asingle member limited liability company (LLC) that is treated assole proprietor for tax purposes and provides liabilityprotection. Not all states permit single member LLCs. (New Jerseydoes require two NJSA 42:2B-2).
PARTNERSHIPS
The income and expenses of a partnership flow through to thepartners; the partnership itself is not a taxable entity,avoiding the double taxation of partnership income and gain.
General partners are subject to unlimited liability, butlimited partners are subject to liability only to the extent oftheir investments. A limited partner, unlike a general partner,is not subject to self-employment tax on partnership incomeunless he or she receives compensation for performing servicesfor the partnership.
Partnership can deduct nonacquisition partnership lossesagainst other income, up to their tax basis and the amount towhich they are "at risk" in the business. The passiveactivity loss limitation provisions may also limit the amount ofcurrently deductible losses. Partners, unlike S corporationshareholders, get basis for the partnership’s debt. Partnerscan also increase their basis when a change in ownership occurs.This is not available to S corporations.
With the passage of the Taxpayer Relief Act of 1997, thepartnership taxable year ends for a partner on the death of thatpartner, effective for partnership years beginning after Dec. 31,1997.
LIMITED LIABILITY COMPANIES
Many people view LLCs as superior to S corporations andpartnerships. The LLC offers liability protection similar to acorporation and, for LLCs treated as partnerships for taxpurposes, the tax flexibility of a partnership.
In addition, the stringent S corporation rules don’tapply. The new "check the box" regulations have madequalifying an LLC for partnership taxation much simpler, and havemade LLCs more flexible. (Not all states follow theseregulations.)
In general, the members of an LLC, except those who wouldqualify as limited partners had the entity been formed as alimited partnership, are subject to self-employment tax.
The information set forth above constitutes general answersto certain questions pertaining to Law and is notintended to replace the advice of an attorney after acareful review of the individual facts of your case.