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At Team Oliver, we handle dozens of owner/operated businesses like engineering firms, light manufacturing, retail, and service based industries.
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Choosing the right business structure
Of all the decisions you make when starting and
operating your business, the most important one
is probably the type of legal structure you select
for your company. Not only will this decision have
an impact on how much you pay in taxes, but it
will also affect the amount of paperwork your
business is required to do, the personal liability
you face and your ability to raise money.
Two common business structures:
• A subchapter S corporation
• A limited liability company
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Subchapter S corporations , also known as just S corporations, and LLCs possess several similarities:
They offer their owners limited liability protection, and both are pass-through tax entities. Pass-through
taxation allows the income or loss generated by the business to be reflected on the personal income
tax returns of the owners. This special tax status eliminates any possibility of double taxation for S
corporations and LLCs.
Tax structure and flexibility
The primary choice is between flow-through entities and a separately taxed entity--a corporation. In a
flow-through entity, you are taxed on the net income of the business as if it occurred in your personal
financial space; the business finances and your individual finances are treated as one for tax purposes.
In that case you have less control over your taxes, for you can’t keep earned income out of your
personal statements once it gets through the gauntlet of business expenses related to producing that
income. While those business expenses do give you some levers to pull, you’ll end up paying taxes on
what your business produces as accounting income, whether or not a dime of it finds its way into your
personal checking account.
More flexible is the corporate form, specifically the C corporation, in which the business exists as a
wholly separate legal entity. As such, it’s taxed as a separate entity for all the income it generates.
That income can be kept within the corporation as retained earnings; as such, none of it flows into your
personal finances. The happy result: You pay no personal income taxes on this income.
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Double taxation
But alas, we may not stay happy for long. When
you finally pass some of that business income
into your personal checking account, in the form
of dividends (or wage compensation, if you work
for the corporation you own), that income is
taxable--for the second time. This is known as
double taxation. If it’s not managed well, the C
corporation can clearly cost you more in taxes
than would a flow-through business form. But if
managed correctly, you can save in taxes and
reinvest funds in the business that have been
subjected to relatively lower tax rates.
While C corporations are subject to double
taxation by the federal government, S
corporations as flow-through entities are exempt,
at least at the federal level. But at the state level-
-watch out. There are still some states that tax S
corporation profits at the corporate level. Your tax
professional will know.
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Income splitting
With corporate forms, you can decide how to pay yourself and others in the business. You can pay
yourself and your investors in the form of wage compensation, dividends, stock, stock options, or some
combination of the above. Sharp-penciled entrepreneurs and their tax professionals navigate these
choices with business and personal needs in mind; they can reduce the total taxes and the timing of
those taxes at least to a degree. This is known as income splitting.
Treatment of losses
We’ve talked so far mainly about income--positive income--and the taxation of that income. What about
negative income--losses? We talked about the relatively inflexible taxation of income with flow-through
entities. While that’s a negative for income, it can have a positive flip side in the case of losses. When
you’re in the investment phase, and even beyond, if your business produces a net operating loss, you
can write off that amount against future income or current income generated from another source (like
a job). While a flow-through entity isn’t flexible in the sense that you can choose how much of this loss
to take, it’s nice to think that, in the initial stages of a business, you can organize in such a way as to
capitalize on these losses, then evolve to another form later on.
Capital gains treatment
So far we’ve covered earned income--profits and earnings from business activity. But many businesses
with fixed or investment assets also produce capital gains over time, as many have done in recent
years from real estate holdings, for example. We know that personal long-term capital gains--for assets
held for more than one year--are taxed at preferential rates for individuals. As such, they are taxed
preferentially for flow-through entities, for the individual is the entity.
On the other hand, the corporate form does not generally recognize separate tax rates. So businesses
with considerable capital gains may be set up as C corporations for other reasons but then, using
one popular strategy, hold real estate assets personally or in some other entity, lease them out to the
business, and pay taxes on them personally.
If this looks complex; yes it is! That’s why you should contact Team Oliver before making any major
decisions regarding your business structure and its tax implications.
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