Corporate status

guest commentary by David Potts

Businesses have the option of choosing different legal structures in which to operate. The most common legal structures are proprietorship, partnership, limited liability company, and corporation. Each type of entity has different income tax considerations.

According to the most current statistics posted on the Internal Revenue Service website, business returns filed in 2008 by type were: 15,985,591 proprietorships (excluding returns claiming earned income credit); 3,348,845 partnerships; and 6,636,025 corporations. (A limited liability company can be taxed as a proprietorship, partnership, or corporation and therefore are included in the above statistics).

If you are one of the nearly 20 million businesses not operating as a corporation, the beginning of the year is a good time to review whether or not your company’s legal structure is appropriate for your business or whether it is a good time to incorporate your business.

Keep in mind that I’m not an attorney and therefore I don’t offer legal advice. I’m a CPA. My point of view as to which legal structure a business should operate within is primarily based on tax considerations. My legal expertise is limited to the general knowledge that a business when incorporated can shield the owner’s personal assets from the liabilities generated by the owner’s business. This shield isn’t available to proprietors and general partners. But this general knowledge when combined with income tax considerations is enough to advise people to consider incorporating their business.

But when contemplating incorporation, consider consulting an attorney. There could be important factors that affect your decision unrelated to income taxes and where only an attorney could advise you. But for our discussion, let’s focus on the income tax considerations of incorporating a business.

A corporation is a legally separate entity from its owners and therefore the corporation pays income taxes on the money it makes. Income made by proprietorships and partnerships is reported on the owner’s tax return and the owners pay the income tax.

However, the stockholders of a corporation can make an election under Subchapter S of the Internal Revenue Code to report the corporation’s income on their income tax returns and pay the additional tax instead of the corporation paying the tax.

Corporations which have made this election are generically referred to as S corporations. The reason stockholders would elect to report the income of the corporation on their own income tax return is to avoid the double taxation associated with corporate taxation. Double taxation is when the corporation first pays income tax on the money it earns at the corporate level, and then the stockholders pay income tax when these earnings are distributed to them as dividends on their individual returns.

There are other advantages for stockholders to elect be taxed as an S corporation such as the ability to shift income among family members in lower tax brackets to reduce income taxes; the ability to minimize Social Security taxes by holding owners salaries below the FICA limit; and the tax-free withdrawal of the corporation’s earnings (with some exceptions). And if you’re the type of person that stresses over the thought of your income tax being examined by the IRS, although I won’t guarantee it, it appears operating your business as an S corporation significantly reduces your audit risk.

In reviewing the Internal Revenue Service Data Book for 2009, 1.5% of all proprietorships (on 2008 returns not claiming earned income tax credit) were audited. For those same returns with the gross revenues in excess of $100,000 the percentage of returns examined increased to 3.7% of returns filed. The audit rate for S corporations? 0.4%.  So in 2009 (for 2008 income tax returns), proprietorships as a whole were three times more likely to be audited than S corporations. Proprietorships with revenues over $100,000 were nine times more likely to be audited then S corporations. Will these trends continue? Who knows, but change tends to be slow in large government organizations.

It is relatively easy for a corporation to qualify to be taxed as an S corporation. If you haven’t incorporated your business, incorporate. To elect to be taxed as an S corporation, the corporation must be a domestic corporation; have no more than 100 shareholders; have only one class of stock; and shareholders must be United States citizens or residents, estates, certain types of trusts, or certain tax exempt charitable organizations.

Certain corporations are not allowed to elect to be taxed as S corporations, e.g., certain financial institutions and insurance companies. The shareholders must consent to the election to be taxed as an S corporation. If the corporation (or limited liability company) has been in existence and operated as a C corporation, the election must be filed by the 15th day of the third month of the initial S corporation year. For calendar year corporations this is March 15. For new corporations or limited liability companies, the election is due by the 15th day of the third month from the date the new corporation first had shareholders, first acquired assets, or began operating the business.

I am biased toward S corporations. However there are valid reasons for a business to be structured and taxed differently than an S corporation. For example, my preference for real estate investment is the limited liability company. But since we are beginning a new year, it might make since to ask the question “Is an S corporation the best structure for my business to operate?”

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

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