By Dan Barney
Estate Planning & the Law
Corporations are a backbone of the American Economy because they offer many advantages not available in other forms of business.
Last week, we reviewed the legal characteristics of an LLC, (Limited Liability Corporation) as they relate to small or family owned corporations.
The LLC offers “pass thru taxation” meaning that pass directly to the owners who then pay tax on those earnings. With an LLC there is no separate tax to the LLC itself.
However, the normal corporation, the “C” corporation, has a disadvantage tax-wise. Normally, such a corporation is taxed under subchapter “C” of the tax code.
This section taxes the corporation as a separate entity at rates normally higher than those of an individual; then when earnings are distributed to shareholders, they are taxed again as dividends and the shareholder again pays taxes on those dividends.
A form of effective “Double Taxation.”
For small companies or those closely held by a family this is a significant disadvantage.
• The “S” Corporation. Congress has attempted to alleviate this problem by providing special tax treatment for those corporations that elect to be taxed under Subchapter “S” – these are commonly known as “S” Corporations.
What most people don’t realize is that “S” corporations are the same as large “C” corporations so far as the legal aspects of the company under state law. It is only the election to be taxed as an “S” corporation that creates a differentiation.
This election is designed to provide the benefits of incorporation to small companies while providing a break from double taxation.
Upon submission of an election to the IRS, the earnings of a company are taxed one time –directly to and upon the tax forms of the individual shareholders.
The income of such a company is attributed to each shareholder on a pro rata basis based upon their ownership in the company. This share of earnings is transferred to each shareholder via a K-1 form and the tax character of each earnings component is carried directly onto the shareholders tax forms as if they were earned by the individual.
There are special requirements to qualify as an “S” corporation. These include the fact that there can be no more than 100 shareholders and these shareholders can only be individuals or qualified entities.
Thus, the special benefit is specifically tailored to protect small companies and individual shareholders.
• Conclusions. “S” corporations have been created to provide special taxation for small companies to eliminate double taxation.
The S Corp retains the same liability protection afforded by a corporation but does not offer the same degree of protection available from an LLC.
The bottom line for this discussion is that the choice of an entity requires detailed analysis of each individual situation in order to balance the tax issues, liability and operational characteristics of the various choices available.