Many don't know about business entities when starting business

1. Individual

2. Partnership

3. LLC

4. Subchapter S Corporation

Most Lawyers and CPA’s will tell you to create an LLC. They will tell you an LLC is taxed only once, since it pays taxes only on the individual level and not on the corporate level. It also protects the individual from from most corporate liabilities.

The only time I recommend to set up an LLC, is when my client is purchasing Real Estate. My entity of choice is a C Corporation. Here are the reasons:

1. It is the only entity that is not required to have a December 31 year end.

2. It is the only entity that pays corporate taxes.

3. Hospitalization expense to a more than 2% shareholder is deductible.

Let’s examine each item separately.

1. December 31- This is the worst possible year end. Many businesses shut down for the 2 weeks that include Xmas and New Years. If they are not physically closed, they might as well, nothing is getting done. Vacations, Holidays, constant partying etc. Now if it’s your year end, you have numerous decisions to make, year end bonuses? Raises? How did I do this year? How much tax do I owe? Can I take a bonus? Should I buy that piece of Equipment? When should we take a physical count of the inventory? All these decisions have to be made quickly. Wouldn’t it be great to do all of these things when your business isn’t so crazy and your employees weren’t hung over? Pick any of the other 11 months to end your year, the closing will be a lot smoother.

2. C Corp Stands alone- When a company is first created it is crucial not to commingle funds . The C Corporation pays it’s own taxes on its year end profits, unlike the above entities that flow from the business to the individual. The beauty of this, is as follows: Suppose the C Corp has a June 30th year end and is showing a $50,000 profit. (let’s assume a cash basis and a profitable business going forward). There will be approx $50,000 in the check book at June 30th. The Federal corp tax is 15%, so the corp would pay $7500 on September 15th of that year, plus $1750 of estimated taxes towards the new fiscal year. That would leave $40,250 for cash flow going into the new fiscal year. (in order to keep the example simple, forget about state and city taxes for now). As the business continues to be more and more profitable, we look at the profit and loss statements on a monthly basis and issue payroll bonuses to working shareholders based on a simple formula. 50% of month end profit stays in the business and 50% is paid as payroll to the working shareholder. When the payoll is paid to the working shareholders all applicable payroll taxes are paid. The shareholder does not have to worry about quarterly estimated taxes on the money he takes out of the business. This is fantastic for cash flow of the business, since taxes are paid at the moment the money changes hands. Most new business people I encounter do the complete opposite, they take out of the business what they need to live and let the business keep the rest. In order for a business to succeed, especially in the beginning, the Business must come first and then the owner. I believe this is the single reason why so many small businesses fail. The other entites (LLC, S Corp, etc.) are constantly commingling their funds. With a profit of $50,000 on December 31, the $50,000 is added to whatever the individuals income is for the previous year. Let’s assume the highest bracket of 35% , $17,500 would have to be paid on April 15th as well as the applicable Fica and medicare tax (assume no other payroll) of 15.3%, $7650. (yes, there is a deduction for one half, but it’s a deduction and not a credit). Using the same assumptions as above, $50,000 is in the checkbook as of April 15th, $25150 plus $6288 (1st quarter estimate) for a grand total of $31438, has to be distributed to the shareholder in order for the taxes to be paid on the business earnings. This leaves the business with $18562. Compare this with the $40250 that the C Corp has, and you can see why I love C Corporations for running successful businesses.

3. Family healthcare insurance coverage can run as high as $20,000. If a working shareholder who owns more than 2 % of the company receives family or single coverage as part of their compensation package, the insurance premium is not deductible in the other entities. (it can be deducted on their personal returns, again it’s not a dollar for dollar exchange). The insurance premium is deductible on a C Corporation. This can be a big difference especially in the early stages of the business and if there is more than one shareholder.

Here are the usual questions I receive after discussing with potential clients the above:

Why did my old CPA recommend an LLC and my next door neighbor who is a CPA, JD and CFP also recommend an LLC?

Most CPA’s are not business people, most are tax professionals. They look at the world through the eyes of the IRS, only the opposite, they look for maximum tax avoidance in everything. The only problem is, if you don’t make any money you will never have a tax problem.

If I currently own an LLC, should I switch it to a C Corp?

If the business is in operation for a few years and is profitable, I usually advise the shareholder not to switch entity types. The main reason, if it ain’t broke, don’t fix it! Normally we make suggestions to realign shareholder compensation with corporate cash flow, and we will work with the LLC or Sub S.

The only thing you need to worry about in a C Corp is making a lot of money. The tax code discusses something called unreasonable compensation. Shareholders are allowed to be compensated reasonably for the work they are doing, anything over that amount should fall to the bottom line and be paid out as dividends. Dividends are not deductible to the C Corp but are taxable to the shareholder when they are received. Selling a C Corp can some times be tricky. This is why tax professionals do not recommend C Corps.

As my grandmother (may she rest in peace) used to say, “ This should be your biggest problem!” When the business is successful, the solutions to all problems are relatively simple.

Written by Robert Rimberg who blogs at www.rimbergonlinebookkeeping.com/blog/