Whether you are a new business or an existing business, selecting the best legal entity affects not only profitability and operations, but also your tax bill and your risk exposure. Proper business planning should tie together your business strategies with your personal tax, investment and estate planning goals. Apart from protecting the owners from liabilities, income taxation is probably the most important factor when choosing an entity structure. There are 4 main types of business entities: C-corp, S-corp, Partnership, and an LLC.
The C corporation or “regular” corporation is subject to “double taxation.” This means that the corporation pays tax on its net profits, and when dividends are paid to its shareholders, the shareholders also pay tax on those dividends. If a C corporation has net losses, it must use them against its own income, either carrying the losses back to obtain refunds of prior years’ taxes, or carrying them forward to offset future years’ income, or both. C corporation shareholder/employees generally receive income as either salary or dividends. The corporation can deduct compensation paid to employees, while dividends are not deductible, and therefore are paid after tax. At the employee level, wages will generally be taxed at a higher rate than dividends because wages are ordinary income with rates up to 35 percent, and they are also subject to employment tax. Qualified dividends, on the other hand, are currently taxed at a maximum federal rate of 15 percent, without employment tax. Remember that dividends must be paid to all shareholders pro rata, while compensation can be customized.
S corporations, partnerships and limited liability companies (LLCs) generally are “pass-through” entities for tax purposes. This means that the net profits or losses of the entity are reported directly on the owners’ individual income tax returns, and the entity pays no tax itself.
When considering which entity is best for you, do not limit your consideration exclusively to the tax benefits with the various entity structures. Think ahead to what types of assets the business will have, how you will finance the business, what will happen when you are winding down or liquidating the business and how or when you intend to take distributions from the business. Sometimes it makes sense to change your business structure after you have been operating in your initial form in order to accommodate new goals or facts. Make certain you thoroughly understand the tax consequences before making a change. For more details on business entities read the CBIZ Business Tax Planning Guide.
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