S vs C Corporations    Which Option is Right     For Your Venture?

Whether you're setting up a new company or you've been in business for years, you need to evaluate which legal structure is best for your enterprise. No one option is best for every type of operation. The right choice depends on several factors including the number of owners, taxes and your business goals.

Be Reasonable     Dividend distributions avoid payroll taxes so it's generally advantageous to take as much income as possible in the form of dividends, rather than compensation. But the law requires you to take a "reasonable" salary.     In 2007, you pay 7.65 percent for both the employee and employer share of Social Security and Medicare taxes. Social Security must be paid on the first $97,500 in salary. (In 2006, 7.65 percent of $94,200.)     Be careful if you go for higher dividends and a lower salary. Keep good records to justify your compensation. The IRS will be looking for factors such as what duties you perform for the company, whether you're an officer, how profitable the business is, what you would pay someone else to do your job and what the standards are in your industry.     If the IRS reclassifies your dividends into salary, it can result in a substantial tax bill, as well as hefty penalties and interest.

These concerns lead many business owners to organize as S corps. The legal structure is identical to a C corporation but S status provides an escape from double taxation.

Since choosing a business structure can be a complicated process with long-range consequences, you should consult your tax adviser. Here are some of the pros and cons of S corps:

ADVANTAGES

Limited Liability

Like any corporate organization, an S corp allows you and any co-owners to restrict personal liability. If, for example, your company is unable to pay its debts, the business assets would be open to creditors but your personal belongings would be off limits. However, you don’t have total protection from liability — if your company is in the business of offering advice, for example, you won't be protected if the advice you personally offer is wrong.

Avoid Double Taxation

An S corporation allows you to avoid two-tiered taxation — that is, paying corporate taxes and then paying personal taxes on the same income. An S corp pays no federal taxes. Earnings — and losses — are passed through to the owner. And because income is taxed to the owner, you can avoid problems arising from the corporate alternative minimum tax. An S corporation must, however, still file a tax return, and some states impose taxes.

Treatment of Losses

If you think you might have operating losses in the first couple of years in business, an S corp may be a wise choice. Let's say you invest $100,000 in your venture and wind up with a loss of $25,000. The deficit is passed through to you and any other owners — on a pro rata basis — so you can take the loss against other income on your personal tax returns. However, you cannot take current-year losses that exceed your adjusted basis in the company.

Easy Termination

A corporation's S status can be terminated either voluntarily or involuntarily. Voluntary termination requires a vote of shareholders owning more than 50 percent of the company’s total outstanding voting shares. Involuntary termination can result from not following the restrictions placed on S corps (See box below).

Shareholder FICA

Pro rata taxable income and dividend distributions are free of FICA taxes (Medicare and Social Security). Company contributions to a retirement plan on behalf of a shareholder-employee are also generally not subject to FICA taxes. In a family business, you may be able to get some tax advantages by shifting the owners’ income to other family members by making them employees or shareholders or both.

Warning: The prospect of major employment tax savings may tempt you to cut your compensation and take large dividend distributions instead of salary. But the IRS keeps a keen eye on “reasonable compensation.” If the tax agency finds that compensation is inadequate, it can recharacterize your dividend distributions as wages, which means you become liable for unpaid employment taxes, penalties, and interest. (See box above.)

DISADVANTAGES

Appreciated Assets

If your company owns any assets that have appreciated, they cannot be distributed to you and your co-owners without generating a tax bill.

Asset Withdrawal

Taking money or assets out of an S corporation can be an administrative headache. For example, the withdrawal must be characterized for tax

Other S Status Restrictions   1. The corporation must be domestic.   2. There must be no more than 75 shareholders.   3. The shareholders must be U.S. citizens, resident aliens, estates, certain types of trusts or tax-exempt entities.

purposes as compensation, a dividend, a loan, or other payment. Compensation means payroll taxes are due and W-2 forms and payroll tax returns must be filed. A loan requires a loan document.

Single Stock Class

It can be difficult to raise cash through a stock offering because an S corporation can issue only one class of stock, which must have identical rights regarding dividends and the distribution of company assets if the business is liquidated.

Ultimately, an S corp provides a good option for a small enterprise that would otherwise be significantly taxed under the traditional corporate model. When selecting or considering a new legal structure, business owners should always review their options with their tax lawyer. Call Ronald J. Cappuccio, J.D., LL.M.(Tax) at (856) 665-2121.

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