Incorporation Tax Considerations

Continuing on when to incorporate your business and selecting an entity type that is right for you, we are going to examine the chief differences, advantages and benefits of important tax considerations. Comparing the Corporation and Limited Liability Company for incorporation consideration. These two entities share similarities and have broad differences, so before you incorporate, this should be weighed carefully.

We are going to have to branch out a bit from just discussing Corporations compared to LLC's and include a Corporation with a different tax classification, the Sub Chapter S Corporation. A standard "C" Corporation is taxed on a corporate level. This means that the corporation files its own tax return and pays taxes itself. The shareholders of a C Corporation pay taxes on income and distributions from the business. This means that shareholders are subject to what is called "double taxation". The IRS has a section of the tax code for Corporations, when you incorporate and complete an IRS form, that allow pass through taxation, that also has some limitations, which we will discuss briefly. Filing IRS Form 2553 and applying for the S Election redefines how the entity is taxed. The income is passed through the Corporation and the profit and losses are then reported on the shareholder's personal tax returns. This is quite similar to sole proprietorships and partnerships. This is a great advantage for some businesses, incorporating the strength of a Corporation for protection, with favorable taxation. The limitations are the number of shareholders and who/what can be a shareholder. C Corporations can have unlimited amount of shareholders and another Corporation can be a shareholder as well as open the door for foreign investors, who can own stock. S Corporations have to be owned by domestic individuals and are limited to 75 shareholders total. In most cases for small business, this is hardly a limitation. The chances are that if you're going to incorporate and have more than 75 shareholders, that you would have this process performed by a small army of attorneys.

Comparing Tax Scenarios When Incorporating
Right off the bat, the Limited Liability Company is the most flexible when it comes to taxation, there are many options. By default the LLC is taxed as a sole proprietorship, for single owner LLC's, or a partnership, for multiple owner companies. Corporations are taxed as a separate entity, by default. The corporation pays income taxes on revenue as well as the shareholders on income. S Corporations are a special IRS classification that allows pass through taxation to the shareholders and this is the only taxation method.

When you incorporate, a primary feature of being incorporated are the tax benefits. Deducting necessary business expenses in categories provides some relief from the overall tax bite on your business revenue. Corporations and LLC's vary with allowed deductions when it comes to employee benefit plans, contributions to retirement and healthcare. For example, corporate shareholders can deduct officer health plans, whereas LLC members pay income tax on that contribution as income. We're not going to perform a side-by-side comparison with allowed IRS deductions between incorporated entity types and tax classifications here, however we will illustrate the landscape and keep the focus on making the right decision for you when you choose to incorporate your business.

Limited Liability Company Taxation
This scenario is about a good as it gets. By default all profit and losses are passed through the business to its owners, who report it on their personal tax return. This is the same as a sole proprietor or partnership. Very simple taxation. The LLC can file for several different tax classifications by preparing IRS Form 8832. The LLC can opt for being taxed as a Corporation. Furthermore, if the LLC has this election, it can then elect Sub Chapter S as well. Being taxed as an S Corporation.

Why would you choose corporate taxation on an LLC?
C Corporations are taxed on the profits remaining in the business at year end. The tax rate is that of a Corporation, lower than that of an individual. This can be used as a tool for asset protection, LLC legal provisions protect the company assets in the event a member is sued. Another key to Corporation's and taxation is that you can choose a fiscal year when you incorporate, however this can be changed later with some paperwork. This is a month and your tax year ends on the last day of that month. This opens the door to additional flexibility, so that you can shift personal income from one year to another. When you incorporate an S Corporation, you will have a calendar year end so this is not possible. Corporations and LLC's electing to be taxed as a Corporation can choose a fiscal year end date for increased financial flexibility in regards to taxation. Corporations can write off 100% of medical expenses for employees and their dependents. An LLC that elects to be taxed as a Corporation has the same benefit.

Why would you choose S Corporation taxation on an LLC?
S Corporations are a strong choice for active businesses. Passive income businesses tend to lean toward the flexibility of a Limited Liability Company. The S Corporation will have a calendar year end date in December, just as an individual's personal tax year end date. This opens the door for shareholders to pay themselves a reasonable salary and still take distributions from the business. Distributions are void of Social Security and Medicare taxes. This is a 15.3% savings on income received as shareholder distributions.

Incorporating and Tax Advantages
Now that we have mentioned some of the chief characteristics of tax benefits and differences between the incorporated entities, we can bring this back around to selecting the type of business to incorporate.

LLC's can be taxed as any entity, sole proprietorships, partnerships, corporations and S corporations. Very flexible, so if taxation is your biggest factor when incorporating, this may be something you want to investigate further, all of the options are here.

Corporations are taxed on its income as well as the shareholders. This may seem like a disadvantage, however shareholders can be any legal entity or person, foreign and domestic and the number is unlimited.

S Corporations are taxed as sole proprietorships or partnerships and allow for Corporation allowed deductions, however lack the flexibility of ownership. Owners of an S Corporation must be a legal resident or legal alien and there can be no more than 75 shareholders. S Corporation's fiscal year end date is December 31, so the business and your personal tax year ends on the same day.

Before you incorporate, you should examine your true focus. Incorporating for tax advantages opens the door to a myriad of scenarios. Choosing what is right for you is important. Here are some general guidelines:

Pass Through Taxation: When a business has a single owner and by entity type is granted pass through taxation. This is a consideration when there is a passive income situation, such as holding accounts, stocks, mutual funds and bonds. Owning real estate is another passive investment consideration where business deductions and employee plans aren't important in the planned tax scenario before you decide to incorporate a business. This is how an LLC is taxed, by default, as well as sole proprietorships and partnerships.
Corporate Taxation: When an active business spends all or most of its income, this is recommended when health plans and contributions are a primary consideration. Asset protection is increased when a shareholder can keep profits in the company that do not appear on personal tax returns or financial statements.
S Corporation Taxation: When operating an active business and reducing shareholder tax responsibility on a portion of his/her income by 15.3%.

Next Section: Being Incorporated and Ownership