Small Business, Small Taxes, Small Problems!

Advantages and disadvantages of the different types of corporations Our lives and all of our business transactions would be so much easier if we all understood the way the tax laws work. Imagine how easy it would be to run our businesses if we did not have to worry about new tax laws and changing tax codes. See also Limited Liability Companies.

Consider this scenario: You are a new business owner, and you have just come back from your attorney's office. He has advised you to incorporate. Knowing about the advantages of being a corporation, and limited liabilities the "corporate veil" allows your company to have, the very next question is almost always asked:

What kind of corporation?
What are the tax benefits and differences of each?

There are many different types of entities, including LLPs, LLCs and other corporate entities.

An S Corp (a small business corporation) is basically a regular corporation that has elected small business status by all of its shareholders. The S Corporation pays no federal income taxes. All of the income and expenses are divided among, and passed through to its shareholders. The shareholders must then report the income and expenses on their own income tax returns. If there are corporate losses, those losses are passed on to the shareholders. Of course, the same is true when there are corporate profits.

The S Corp is in contrast to the way a regular corporation works, or what we call a C Corp. A C Corp does pay corporate income taxes on any and all profits of the corporate, at income tax rates starting at 15% of the first $50,000, 25% for the next $25,000, 34% for the next $25,000, 39% thereafter. Any losses are only allowed to be carried back three years, or carried forward 15 years against prior and/or future profits.

S Corp Advantages:

  • Allows the shareholder to deduct the initial start-up costs and losses normally incurred during the first few years of the business through their personal income tax returns.
  • As the S Corp begins to make money, the individual tax rates are less than the corporate tax rates for profits of usually $150,000 or less. It also avoids the "double taxation" of C Corp, whereas dividends are taxed in a C Corp and taxed again as individual income.
  • Allows the shareholders to withdraw those taxable profits during the course of the fiscal year, called "officer's draw", in addition to officer's salaries.
  • A C Corp can elect any fiscal year period without special permission from the IRS. This means that XYZ Inc. can have a June 30th year-end. This is a great advantage when a company is "bonusing-out" profits to shareholders. They won't have to account for the income until their individual year ends, usually December 31st. It also allows for timing differences and makes the deferring of income taxes easier when there are cash-flow, inventory and business cycles to consider. As an S Corp, unless you get special permission from the IRS, you are pretty much "married" to the December 31st year end.

C Corp Advantages:

  • Can have unlimited shareholders. An S Corp is limited to no more than 75 shareholders.
  • Can have more than one class of capital stock, such as common and preferred stock. An S Corp is only limited to one class of common stock. This is usually an advantage when creating different classes of corporate investors, with the declaration of dividends in each stock class.
  • Allows other entities, such as other corporations, trusts, partnerships and other legal entities to be shareholders.
These are only a few of the many advantages and disadvantages of each type of corporation, with many more pros and cons to consider. Keep in mind there are no standard rules to setting up a company, nor is it always better to start up as an S Corp or a C Corp. But planning and discussing the advantages of each is a step in the right direction before pouring your life's savings into the new venture.

Disclaimer: All materials presented on this web site are for informational purposes only and should not be considered as a substitute for any tax, accounting or legal advice. Some of the material may have changed due to new legislation. Please contact us for specific information.