BY NORMAN G. GRILL
As year end nears, business owners have a variety of specific tax issues to consider. But don”™t let that prevent you from pondering some big-picture matters, as well. Case in point: business structure.
Big choices
Three popular entity types are the C corporation, the S corporation and the limited liability company (L.L.C.). All three limit their owners”™ exposure to personal liability for company debts and obligations. (Note, however, that no business entity can shield an owner from the consequences of his or her own actions, such as malpractice or sexual harassment.)
General and limited partnerships have become less common since the L.L.C. structure became available. Why? L.L.C.s offer most of the flexibility and potential tax advantages of a partnership combined with the liability protection of a corporation.
Compared with corporations, L.L.C.s generally are easier to set up, have fewer restrictions and require less in the way of corporate formalities. Members have flexibility in the allocation of profits and losses. These profits and losses are passed through to the owners, who report their shares on their personal income tax returns, which in many cases will save taxes.
The biggest disadvantage of a C corporation is generally double taxation. Profits are subject to corporate income tax at the entity level and then to personal income tax when they”™re distributed as dividends to the shareholders.
To the extent the corporation is able to distribute profits in the form of salaries and bonuses, however, the deduction for wages paid eliminates double taxation. (There are restrictions on what”™s considered reasonable compensation and can be deducted.)
Like partnerships and L.L.C.s, S corporations are “pass-through” entities ”” thus, there”™s no double taxation. S corporations have limitations, however. They can”™t have more than 100 shareholders (though most members of the same family are treated as a single shareholder) or more than one class of stock. Also, eligible S corporation shareholders are limited to individuals, certain trusts and tax-exempt organizations and employee stock ownership plans.
Despite double taxation, C corporations offer some advantages. For example, they may be able to deduct employee benefits for owners, such as health reimbursement plans and long-term care insurance. Such deductions may not be available to S corporations and L.L.C.s.
Additionally, because of the graduated tax rates of a C corporation, a business may be able to build up and retain capital at a lower current tax rate than it would under an L.L.C. or S corporation structure. For instance, C corporations typically pay tax at a 15 percent rate for the first $50,000 of profit, though sometimes a corporation is subject to a flat 35 percent tax on all earnings. Because the earnings of an L.L.C. or S corporation “flow through” to the owner”™s personal tax return, they could easily push the owner into a tax bracket higher than 15 percent ”” even if the business itself has a net profit of $50,000 or less.
Now that the top individual rate has gone back up to 39.6 percent, it”™s higher than the top corporate rate (still 35 percent). At the top individual brackets, there”™s also a higher long-term capital gains tax rate to consider. Thus, someone in the highest ordinary-income tax bracket of 39.6 percent would be subject to a maximum 20 percent rate on the income that would otherwise be subject to a maximum long-term capital gains rate of 15 percent.
Also new for 2013 is the 0.9 percent Medicare tax on earned income exceeding certain thresholds. By itself, the tax may not be worthy of special planning. But this additional tax burden could bring situations in which paying tax at the corporate level is advantageous. As with any tax discussion, the optimal solution depends on the specifics of your situation.
Assuming you”™re eligible to do so, changing entity types is largely an administrative issue ”” though a fairly ambitious one. But there is generally a tax impact to a business structure change. So make sure you work with your tax advisor when considering such a move.
This has been a general discussion of a complex subject and is not intended as advice to anyone. Always discuss your particular situation with your tax adviser before making business entity decisions.
Norm Grill, CPA (N.Grill@GRILL1.com) is managing partner of Grill & Partners L.L.C., (www.GRILL1.com) certified public accountants and advisers to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien, (203) 254-3880.
