Q: Tax Playa, you've talked about S-corporations and sole proprietorships. What about regular, old-fashioned corporations?
Chris, Arlington VA
A: In my article on business entity choice, I go into the advantages and disadvantages of the three major forms of business entity formation: the sole proprietorship, the S-corporation, and the corporation. Today I will focus on the corporation...
The corporation is the oldest and in many ways the best form of business entity to choose. A few things to get out of the way before really diving in, though:
- It doesn't matter for tax purposes where you form your corporation. Whether you form it in Delaware, Nevada, or anywhere else, taxes must be paid. You will owe corporate income tax to the federal government, and you will owe state income tax based on where you do business. Where you actually incorporate matters much more for purposes of setting up strong protections between corporate activity and shareholder liability, which you may not need.
- An LLC is a disregarded tax entity. That is, filing for one and doing nothing else will result in the LLC being taxed as a sole proprietorship (partnership if more than one LLC member). However, an LLC can easily be taxed as any other type of entity--usually an S-corporation or a corporation. As a practical matter, I advise clients to form an LLC to get the legal protection, and then elect for the LLC to be taxed in the manner that makes sense for that client. For the purposes of this discussion, "corporation" can mean an actual corporation or an LLC taxed as one. "Incorporation" means either the onerous incorporation process, or the simple LLC filing process.
I've said before that the best profile of a business ready to be taxed as a corporation is one with consistently at least $20,000 in profits and which has an accounting regime strict enough not to commingle business and personal receipts, expenditures, assets, and liabilities. For companies too small to be worth the effort, stick to a sole proprietorship. For companies big enough but too undisciplined in accounting, stick to an S-corporation.
A corporation is a separate tax entity that pays its own taxes. Receipts are calculated and expenses are deducted. All of the same advantages given to other businesses (expensing, accelerated depreciation, etc.) are also available to corporations under the same rules.
Contributions of capital or other property to the corporation by shareholders give basis to the shareholders. In the same way, distributions of this capital reduce basis. If the corporation is sold, this basis may result in less capital gains tax getting paid.
A corporation has maximum freedom to pay fringe benefits. That means it can pay for a workplace retirement plan of up to 25% of compensation, and there are no separate limits on health expenses, HSA costs, and other fringes. In general, these rules are much more restrictive for the other two entity types.
Once taxable income is calculated, there may be a gain or a loss. If there is a net operating loss, it may be carried back up to two years, or carried forward for up to 20. Prior year returns may be amended, and taxes can be refunded.
If there is positive taxable income, tax is paid. The top corporate rate is 35%, but there is a graduated structure. The first $50,000 of corporate taxable income is taxed at a 15% rate, and income between $50,001-$75,000 is taxed at a 25% rate. As a result, corporate shareholders can essentially benefit from two separate and distinct graduated tax brackets (personal and corporate). The full corporate income tax bracket structure can be seen in the left-hand column of this page.
A corporation can elect at its formation to have a tax year different from the calendar year. The advantage here is that a taxpayer can straddle income and expenses between his personal tax year (which must end on December 31), and his corporate tax year (which can end in any month). In practice, I have never seen this to be worth it--but it is available.
A corporation can donate up to 10% of its taxable income to charity as a deduction, with a future-year rollover.
There are a few concerns to be aware of when dealing with corporations:
- Unlike sole proprietorships or S-corporations, corporate shareholders cannot simply "ATM" the corporate account without some tax consequences. Unless this money is to reimburse shareholders for a deductible business expense or to pay a salary, this is a dividend. As such, it faces double taxation (after-tax corporate income is taxable as a dividend to the individual). This has been ameliorated somewhat by the cut in corporate dividend's tax rate to 15%, but it is still to be avoided.
- Shareholders will want to avoid their corporation being reclassified by the IRS as a "personal service corporation." The IRS is well-aware that people can easily set up corporations and use their advantages to get around FICA, high personal tax rates, and other taxes. As such, any corporation which is in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts can be reconstituted as a personal service corporation and is liable to pay the highest corporate tax rate (35%) from dollar-one of taxable income. Diversifying corporate activities, ownership, and compensation for these services are several good ways of avoiding this dreaded designation.
- Any corporation which is "closely-held" (majority held by five or fewer shareholders) can have its fringe benefits restricted.
- Any group of sister corporations may be affiliated by the IRS, denying multiple graduated rate structures.
- Capital losses can only be carried forward. This is distinct from individuals, who can deduct up to $3000 of capital losses per year against ordinary income. Capital gains are also not tax-advantaged by any rates.
- Dividends are ordinary corporate income. This is helped somewhat by the fact that 70% of most dividends can be excluded from corporate income.
- Corporations need to pay quarterly estimated income tax in the same way that others liable for estimated income tax need to.
As always, work with someone who knows what he is doing.