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A
Product Orientated Business
Not sure you are selling a product? Do you collect
sales tax? Is the 'product' sold within your state (assuming you
are not a reseller)? If you answer no, then chances are, you're
a service-orientated business. If yes, you may be a product-orientated
business.
- Selling a product eliminates a personal service
corporation*, which brings a C corporation into the picture.
* A personal service corporation pays a flat 35%
tax at the corporate level. This is a complex definition, the
main part you want to ask is, and "Does the product generate
more than 50% of the overall revenue of the corporation?" If so, your entity may flunk the test and not be considered a
PSC.
Selling a Product without a Partner:
1. No partner would eliminate the LLC taxed as
a partnership as a possibility. Sometimes, an LLC will have an
advantage and therefore you may want to "bring in" a
partner for a 2-5% ownership.*
*If you bring a partner into an LLC, there are
two tests the IRS or someone else attempting to challenge the
partnership status will look for:
- Did the 2-5% partner make a separate capital
contribution for their interest?
- Does the 2-5% partner receive a K-1 at the
end of the year and distributions if any are made?
This applies to any percentage of ownership
with a partner in an LLC. The reason these are looked at is it
would be easy to 'put' someone's name on as the other member.
If the partner never makes a separate capital contribution or
received a distribution when they were made partner, the IRS or
a creditor would have a very good argument you have a single member
LLC and taxed as a sole proprietorship. This would be especially
bad news if a creditor were suing you personally. The suing party
may be able to prove these two points to the judge. If so, then
you may lose control of your entity if the judge deems
you do not have an official 'partner'. If you determine you can
bring on a partner and meet these tests then read the section
called, Selling a Product with a Partner.
2. Do you meet the S corporation requirements
as a shareholder? If you do then go to question number 3. Click
here to read the S corporation requirements. If not
the C corporation may be your choice of entity.
3. Does the individual who wants to form this
new entity earn income from other sources than this new business?
If not, then the salary will be all from this new business which
leaves the option open of saving SE taxes with the S corporation.
4. Are you looking for fringe benefits like the
ability to deduct 100% of your health insurance premiums, a $50,000
life insurance policy? If so, then this is a characteristic of
a C corporation. If you are the owner of more than 2% of
a S corporation, then you would not be entitled to fringe
benefits.*** In other words, most S corporation owners own more
than 2% of the stock, so they would not be entitled to fringe
benefits offered.
***Other fringe benefits include; Holiday gifts
of nominal value, incentive stock options, options under employee
stock purchase plan, employee accident and health plans, long
term care insurance and benefits, educational assistance programs,
employee achievement awards, meals and lodging and cafeteria plans,
qualified moving expense reimbursement.
5. Is it important for employee/owners to be able
to borrow against their qualified pension plan? If so,
the C corporation is your best entity. This is a minor reason
to consider the C corporation. You may determine the business
will start funding a qualified pension plan and you anticipate
some year down the road one of the best ways to access more money
to grow the business is through borrowing money from the C corporation's
qualified pension plan. If this is the case then this may be an
important consideration in your situation. In general, this may
leave room to take money out of your pension plan and not use
the pension plan for its intended purpose, to support you during
retirement.
6. Is a fiscal year end important? This
is especially important during the later months of the year. Many
people look to incorporate in November or December to defer paying
taxes. If they received that money personally they would pay tax
on it for this current year. But if you received the money in
a C corporation you could defer the tax for 12 months! Unfortunately,
many of these people attempting this strategy are a service
orientated business which means they would be a personal
service corporation, which means they have to have a calendar
year end! The S corporation will not deter your personal
income tax for 12 months. It is possible they may have saved some
SE taxes or the 2.9% if they were already above the $80,400 level.
Unfortunately, companies when they sell C corporations in November
and December each year do not tell you about this problem.
7. Will the new entity have losses? Expect
them to flow to your person return, or do you need them to carry
forward in a C corporation? If you are starting a new business
and this is your main source of income, you may have very little
in salary during that first year. If this is the case, having
losses flow through to you during that first year may not be that
beneficial since you have little income to offset. You may decide
to have that income loss flow through to your company and offset
profit in year two. This can only happen with a C corporation.
8. Do you expect to be expanding your business
the first few years and have a little profit, perhaps the
C corporation lower tax rates will be more beneficial for you.
For example, if this is a side business and you are already in
a high personal tax bracket, you may want a C corporation the
first few years and pay tax at lower tax rates. Some companies
do need to be realistic about what their net profits may be during
the first year or two. Many companies underestimate the cash flow
needed and expenses involved in getting the company off the ground.
9. Do you require a second class of stock?
Some companies have common and preferred stock for investors.
If this is your case then you can only be a C corporation.
10. Are you planning on going public? If so, then
a C corporation is your only option.
11. Would you be a personal holding corporation?
Meaning you are going to receive 40% as passive income and you
have less than 5 stockholders. If so, then you would want to be
an S corporation because a PHC will pay 39.6% on any undistributed
profits in your C corporation.
S vs. C Corporation of a Product
Business with
$40,000 in Net Profit with a One Owner Company
Earning $40,000 also as an Employee.
12. What are the expected net profits before
salary of your business? Let's take a couple of examples;
- The net profit before your salary is $40,000
first year.
1. Let's examine an S corporation.
- First, you must meet all the requirements
for an S corporation shareholder.
- Let's assume you are not intending on going
public.
- Let's assume a fiscal year end is not that
important.
- Let's assume the individuals do not have
to borrow from their pension plan (a C Corporation advantage).
- There are no losses to flow through to worry
about.
- Let's assume you still have a job that you
earn money as an employee where your health insurance is taken
care of and you are not concerned about C corporation fringe
benefits.
- Let's assume you earn $40,000 as a W-2 employee.
- Let's assume you do not have a large inventory
of receivables or other assets in the new business (this is
referring to how it is difficult to protect the stock of an
S corporation).
2. From a tax point of view, here is what the
net result would be with the S corporation;
- Corporate level tax =$0-a flow through
entity.
- Tax at personal level on $40,000 in net
profits less salary. You could take a $15,000 salary that
would be subject to 15.3% (because $40,000 as an employee
plus $15,000 equals $55,000, which is still less than the
$80,400 limit for SE taxes). $15,000@ 15.3%=$2295 plus personal
tax on the $15,000 plus the $25,000 flow through will add
to your personal income of $40,000 already in this example.
You would have a total of personal income of $40,000 + $15,000
+ $25,000=$80,000. This is taxed at the highest end in the
31% tax bracket.
Total tax; Up to $63,550 you pay $14,381.50
in tax and 31% tax on the remaining $80,000-$63,550=$16,450
x 31%=$5,099.50 in tax for a total of $14,381.50 + $5,099.50=$19,481.00.
Plus 15.3% on $55,000=$8415 in SE taxes. A grand total of
$8415 + $19,481.00=$27,896. You would also add a state
personal tax rate also.
3. Compare this to the tax rate if you were
a C corporation.
- In the C corporation, $40,000 in net profits
would be taxed at 15% tax=$6,000.
- Personally, you earned $40,000. That would
be taxed in the 28% rate. This would equal $3,937.50 in tax
on the first 15% and the other $40,000-$26,250=$13,750 x 28%=$3,850
in tax plus 15.3% on the $40,000=$6,120 or a total of personal
tax of $13,907.50.
- Corporate and personal tax =$6,000 + $13,907.50=$19,907.50.
Again this does not take into account state taxes.
4. Compare S corporation taxes vs. C corporation
taxes for a product business with one owner. The owner has a
$40,000 salary from another job, and the entity earns $40,000
in net profit. The C corporation will pay overall less tax then
the S corporation ($19,907.50 vs. $27,896) because of the lower
tax brackets of the C corporation and the individual, vs. just
having all the money flow to the individuals tax return with
an S corporation. Yes, with the S corporation we saved some
SE taxes but that did not make up for the 15% tax rate of the
$40,000 in net profits in the C corporation.
5. In this case, the C corporation would
be a better choice for an entity from a tax point of view.
6. Other advantages:
- Fiscal year end, a way to defer paying the
taxes the first year.
- Fringe benefits available. This may allow
for some additional deductions by the C corporation.
- Ability to protect the stock of the C corporation
by an LLC taxed as a partnership (you can not do this with
an S corporation)
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How to Keep Your Business in the Top 5%!