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Understanding Corporation
Taxation
Corporations
are established by filing an Article or Certificate of Incorporation
with the appropriate State agency. Typically the Articles of
Incorporation include:
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Name of the corporation
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Registered office and agent
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Name of Incorporator
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Initial Board of Directors
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Business Purpose
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Par or No-Par Value of Stock
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Authorized Shares of Stock
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Classes of Shares of Stock
For
Tax purposes, corporations may be taxed as a regular "C" corporation,
or an "S" corporation. A "C" corporation is a separate taxable entity.
"S" corporations are "pass-through" entities where most of the income
and expenses "pass-through" to the shareholders for tax purposes.
"C" Corporation
This is a
regular business corporation, taxed as a separate business entity at
the Federal and State levels. The corporation will file an 1120 U.S.
Corporate Business Tax Return, and pay tax on its net income. Net
Operating Losses may be carried forward and shareholders do not pay tax
on "phantom income." When the corporation distributes dividends to the
shareholders, the shareholders are subject to income tax on their
individual 1040 U.S. Income Tax Return.On the sale of business assets,
the corporation is taxed on its income, and the shareholders are also
taxed on the dividends distributed.
"S" Corporation
This is a
pass-through type entity. That means most of the income and deductions
earned by the corporation is treated as if it were earned by the
shareholders.The sale of business assets results in one level of
taxation since generally the "S" corporation pays no tax. (There is an
exception for "S" corporations that were converted from "C"
Corporations.)
Sole Proprietorships Compared
S Corporations
All of
the business income of a sole proprietor reported on a Schedule C is subject
to self employment tax. If an "S" Corporation pays a
shareholder no wages, the amount retained is not subject to FICA taxes.
Further, an "S" Corporation's contribution to a qualified retirement
plan for the shareholder/employee is generally not subject to FICA
taxes. A sole proprietor's contributions to a KEOGH or SEP Plan are
subject to self employment tax. As long as the shareholder- employees
of "S" Corporations set their salaries at a low, but reasonable, level,
the balance could be considered a dividend payment, not subject to
self-employment taxes.
Limited Liability Companies
Compared to "S" Corporations.
1. Limitation of Liability. Both the LLC and the "S"
Corporation provide similar limits on liability.
2. Pass-Through Entities.
Even though an "S" Corporation and an LLC treated as a partnership are
both "pass-through entities", there are many restrictions that apply to
an "S" Corporation that do not apply to LLCs. These "S" Corporation
restrictions include a limitation of 75 shareholders, the fact that
shareholders can only be individuals, estates, and some trusts, and
there can only be one class of stock. This greatly limits the "S"
Corporation as an entity for transferring interest between generations.
Other restrictions include prohibitions agreement. Corporation electing
"S" status if it is not a domestic corporation.
3. Limitation on
"S" Corporation Deductions. "S" Corporation shareholders can
deduct losses only to the extent of their basis in stock plus the
amount of any debt for shareholder loans made to the "S" Corporation.
(See IRC Section 1366). Even if the "S" Corporation Shareholder
personally guarantees the corporation's debt, as is the typical
creditor's requirement for most newly formed "S" Corporations, losses
cannot be deducted on that debt. In contrast, LLC members are treated
as partners for tax purposes and obtain additional basis in their LLC
membership interest for their allocated share of LLC debts. This could
result in increased deductions for LLC members compared to "S"
Corporation members.
4. Foreign
Members. The LLC may have different tax treatment for
foreign members than a partnership/corporation in their home country.
Also, foreign business associates may not be familiar with the Limited
Liability Company as a business entity.
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