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by G. Scott Haislet, CPA
What is the best entity for my business?
The answer to this question is complicated and depends on a number of factors, including the nature of your business, where you conduct your business and who owns the business (i.e., do you own the business outright or have a partner or investors?). Generally, there are four types of entities that you can consider: sole proprietorship, S corporation, C corporation, and LLC (limited liability company). You should consult a CPA before you settle on the type of entity for your business.
For this article, I’ll discuss the tax and non-tax issues involved in selecting a business entity. Note that I’m focusing on California business taxes.
An LLC or corporation will be tax neutral when compared to a sole proprietorship (an unincorporated business). In addition, the LLC or corporation (S or C) will bear additional taxes, fees, and professional fees (e.g., tax return preparation) that can otherwise be avoided with a sole proprietorship.
California charges an $800 minimum tax for incorporating or forming an LLC. That's true whether you have one or multiple shareholders or members.
Also, California charges a 1.5 percent corporation income tax on net income of an S corporation subject to the $800 minimum tax. The 1.5 percent corporation income tax is in addition to the income taxes paid by shareholders of the corporation that are "passed through."
The rate for C corporations is 8.84 percent on net income of the corporation. Small C corporations often intend to shift net income to the shareholders by paying wages to the shareholders. These wages are a deduction for the corporation but income to the individual shareholder. In such cases, often the 8.84 percent rate does not come into play. The same technique applies to avoid C corporation federal income taxes as well.
In addition to the $800 per-annum minimum taxes, LLCs also pay a California fee for gross income of the corporation (i.e., gross revenue without regard to deductions or expenses). That fee is determined on a scale. LLCs with gross income of at least $250,000 are subject to that fee. The fee is avoided, of course, if the business is a sole proprietorship (not a corporation or LLC).
On the positive side, an S corporation shareholder may avoid individual self-employment taxes that would otherwise apply to a sole proprietor. However, the savings is usually minor and is offset by additional taxes and expenses of maintaining an S corporation.
Certain businesses can benefit with C corporation status if the business is truly a stand-alone enterprise with capital as a significant component of its operations ("capital" meaning property, plant, equipment, inventory and receivables). Such a capital-intensive business can benefit by relatively low federal tax rates on the first $100,000 of its annual income. In other words, as a corporation's assets build over time, they are paid for with taxable income taxed at a lower rate.
Each of these considerations is complicated. There is no absolute tax convention that says use S corporation, C corporation, LLC, or otherwise. Consultation with an experienced CPA is a must. Entity selection has far-reaching and long-term tax impacts, some of which cannot be undone later.
Incorporation (including establishing an LLC) may provide legal liability limitation to some extent, but it is not a complete shield for all claims. An individual or entity may be subject to tort claims or contract claims.
If the business owner (as shareholder or LLC member) personally acted in the transaction giving rise to the tort claim, the plaintiff will correctly sue the entity and the individual owner.
On the other hand, if the individual owner can demonstrate that she personally had no involvement in the transaction or occurrence that triggered the tort claim, then presumably the entity shield will protect the individual owner. A plaintiff will still name the individual owner in the lawsuit, as plaintiffs tend to name as defendants every person who could conceivably be charged with liability.
While an individual owner may or may not get a shield from a corporation or LLC, the individual or entity must always consider insurance as defense for reasonably foreseeable tort claims. Consider that the sole proprietor's savings on taxes, fees and entity overhead would apply toward paying for additional insurance premiums against likely tort claims.
By contrast, if the corporation or LLC is the sole party to a contract, the individual's other assets and interests may be shielded. That's why banks and other contracting parties typically require some form of personal guarantee from the individual owner in addition to the contract with the corporation or LLC.
A corporation or LLC is separate from its shareholders or members. The entity must maintain its own checking account, books and records, separate from the shareholders or members. Withdrawals from a corporation are technically taxable dividends (usually with significantly negative tax consequences that can't be undone). In addition, a corporation's bylaws require the corporation to maintain corporation records and hold meetings. Failure to comply with these requirements can reduce the effectiveness of the corporation as a shield against liability. LLC formalities are, by contrast, significantly easier to meet than those associated with a corporation.
Incorporating in Another State:
Pitchmen have for years touted Nevada corporations for privacy and tax efficiency. But if you have a legitimate California business, you will have to register the Nevada corporation in California and will be subject to all the fees and taxes discussed above. The Nevada corporation costs just become an additional expense with little or no benefit.
Nevertheless, sometimes incorporating in a different state or domicile (e.g., Delaware) may have some advantages for business, tax or estate planning purposes, so consult with legal counsel in formulating the choice of domicile for entity creation. For example, the Delaware series LLC (not provided under California law) may allow an individual real estate investor to segregate various investment properties into a number of separate legal entities while avoiding some of the expenses associated with multiple California LLCs. A discussion of this technique is beyond the scope of this article. You should consult with legal counsel about such considerations.
G. Scott Haislet, owner of Lafayette Exchange Corporation, Lafayette, California, is an attorney and a CPA specializing in taxation, real estate, estate planning and 1031 exchanges. You can reach him at (925) 283-1031 or firstname.lastname@example.org.
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