WHO SHOULD INCORPORATE...

To begin an analysis of when it is appropriate to convert your business to a corporate entity or to incorporate a new activity, we must apply the specifics of the business to the characteristics associated with a corporation and evaluate whether or not it will be in the taxpayer’s best interest to incorporate. 

The four (4) underlying factors of the business operations with which we must become acquainted are:

1.      Nature of the business and operations.

2.      Number of and relationships among the organizers

3.      Amount and nature of the assets to be contributed

4.      Participation of organizers in management

Advantages To Incorporation

Operating in the corporate form, whether as a “C” or “S” corporation, or as a Limited Liability Company (LLC/LLP), has several tax and non-tax advantages in comparison to operating a business as a sole proprietorship or partnership.

(1.)            Limited Liability

A corporation is not liable for individual obligations of its shareholders.  Likewise, because a corporation is legally a separate entity, creditors cannot appropriate the shareholders’ assets in satisfaction of corporate obligations.

However, merely forming a corporation will not guarantee that the shareholders’ liability will be limited.  The corporation must have a legitimate purpose and comply with specific corporate formalities, as follows:

1.      have a board of directors

2.      have corporate officers

3.      hold shareholder and director meetings and keep annual minutes

4.      have corporate bank accounts

5.      file tax returns

6.      have separate management

7.      be treated as a separate entity

8.      avoid co-mingling business and personal funds and activities

Otherwise, if the business is determined to have been actually operating as a non-corporate entity, the shareholders might be held personally liable for corporate obligations.

(2.)            Continuity of Life

This means that the corporation will continue to exist even after the death of a shareholder.

(3.)            Centralized Management

In a large corporation, the corporate shareholders elect the board of directors who in turn hire the company’s management staff.  In a closely held corporation, the benefits of centralized management may be irrelevant.

(4.)            Transferability

It is easier to sell shares of stock than to sell an interest in a non-corporate entity such as a partnership.

(5.)            Benefits

Some of the benefits to employees of corporations and limited liability companies are as follows: 

a.       group-term life insurance coverage

b.      accident or health plans

c.      dependent care assistance and cafeteria plans

d.      death benefit exclusion

e.      meals and lodging furnished for the convenience of the employer

f.       pension and profit-sharing plans

g.      deferred compensation

h.      availability of stock option plans

i.        lucrative employment contracts that allow for generous expense accounts to shareholder/member employees

Other Planning Considerations

If a person is currently an employee, he or she may want to consider utilizing a corporation.  This can result in the following set of circumstances:

1.      An individual forms a corporation or LLC in which he or she is the sole shareholder as well as the sole (or principal) employee.  (Note, however, that an LLC will require 2 members in order to file a separate tax return, and certain licensed professions may require formation of a limited liability partnership.)

2.      The corporation then contracts with a third party for the services of the shareholder-employee or managing member, in the case of an LLC.

3.      The third party compensates the corporation for the services of the individual, and the corporation typically distributes the net proceeds, after payment of expenses, to the employee-shareholder as compensation.

4.      The arrangements are usually structured so that, after the corporation pays all of its expenses, including compensation to the employee-shareholder, the corporation has no income tax liability other than perhaps a state minimum tax.

Incorporating My Sole Proprietorship or My Partnership – C Corp, S Corp, LLC, LLP...

Expenses – comparisons of corporate to non-corporate income tax deductibility

(1.)            Medical Expenses

a.       Increased deductibility of medical expenses is an attractive feature of corporations.  Under the Code, a corporation paying medical expenses and health insurance premiums of employees, spouses and dependents may deduct those costs and, in general, the employees may exclude those payments from gross income (certain provisions apply to C corporations only).

b.      Employees paying medical expenses out of their own pockets for themselves, their spouses, or their dependents may deduct them only to the extent they exceed 7.5% of adjusted gross income (AGI).  As a result, most employees are effectively precluded from deducting medical expenses.

c.      There are rules which are designed to assure that employer-provider medical benefits are provided to employees on a non-discriminatory basis, but these rules are typically not problematic when there are very few employees.

(2.)      § 67: The Two Percent Limitation on Certain Itemized Deductions

a.   Individuals are subject to § 67 of the Code, which limits the deductibility of employee business expenses (and other “miscellaneous itemized deductions”) to the excess of such expenses over 2% of AGI.  Thus, while an employee will “lose” two percent of his deductions, a corporation is not subject to this limitation.

(3.)      Other Deductions Limited by Adjusted Gross Income

a.   When using a corporation, an individual’s AGI is lower than if he or she did not use a corporation because the corporation pays expenses before paying the employee’s salary.

b.   As a result, deductions which are limited by AGI are restricted less when a corporation is used.

c.   Section 68 of the Code reduces certain itemized deductions by the lesser of three percent of the individual’s AGI in excess of the cap or 80% of itemized deductions.  A lower AGI  results in fewer itemized deductions being lost.

d.      There is a similar effect with respect to the phase-out of personal exemptions, which begins to occur at the same adjusted gross income level.

(4.)            Insurance and Death Benefits

A corporation is entitled to deduct, and the employee may exclude from gross income, the cost of disability coverage, $5,000 of employee death benefits, and up to $50,000 of coverage for employee life insurance.

(5.)            Audit Issues

a.   It is widely believed that deductions are more easily sustainable if taken by a corporation rather than by an individual.  This may be true because of the fact that corporations are not necessarily viewed as attractive audit targets because they zero out their income.

b.   Additionally, your corporation may be very small when compared to other corporations, and therefore may not be worth the time it takes the IRS to conduct an audit.

Other Tax Advantages

(1.)            Fiscal Years: § 444

a.   The ability to adopt a fiscal year end provides some corporations with the opportunity to defer taxes from one year to the next.  For example, if a corporation could adopt a fiscal year end of January 31, it could then pay a bonus on that date to the employee-shareholder equal to the corporation’s net income.  The corporation’s net income is zero, and the employee’s income is deferred a tax year.

b.   “S” corporations and LLCs must use a calendar year end unless they can establish a business purpose for a different year end, which is very difficult to do.

c.   Certain individuals and professions are required to utilize a calendar year because the corporations are considered personal service. 

(2.)            Payroll Tax Deferral

a.   The use of a corporation allows for the deferral of payroll taxes over the course of a calendar year, as compared to the individual working directly for a studio, production company, or other employer.

b.   In the latter case, payroll taxes will be withheld on a current basis if the individual is an employee or estimated taxes will be due quarterly if the individual is an independent contractor.

c.      In the case of a corporation, on the other hand, the third-party payments are received free of withholding, and then the corporation can make a compensatory payment to the owner-employee at the end of the fiscal year, thus deferring payroll taxes.

(3.)            Alternative Minimum Tax

a.   In computing alternative minimum taxable income, no deduction is allowed to an individual for miscellaneous itemized deductions or taxes, both state, income, and property.  These deductions for entertainers or entertainment industry persons working as employees include: agent commissions, manager commissions, legal, accounting, investment expenses, and all unreimbursed business expenses.  For other industries, it may include all expenses for tax preparation, planning, investment expenses and, again, all unreimbursed business expenses.  Using a corporation avoids this limitation because expenses are taken at the corporate level.  Thus, all of these expenses, sometimes 40% of one’s income, become deductions when they are taken at the corporate level.

Foreign Issues:  Should A Loan-Out Corporation Be Used For Foreign Services?

(1.)      In General

a.   Tax planning for those individuals who are working outside the United States merits an entire presentation in its own right.  Nevertheless, there are a few general considerations which can be taken into account in connection with the decision whether or not to use loan-out corporations outside the United States.  We strongly urge you to contact us before negotiating an overseas contract.

(2.)            Get Foreign Advice

Probably the most important step in advising U.S. taxpayers whether to use loan-out corporations in connection with their provision of services outside the United States is to determine the tax consequences in the host countries.  If the host country will not impose any tax, then there should be no drawback to using the loan-out corporation.  Unless you are dealing with a country that is precluded by treaty from imposing tax, it is imperative to obtain good local tax advice in connection with the foreign services.

(3.)            Beware of Taxes Other Than Income Taxes

Don’t forget to consider all potential taxes, in addition to income and withholding taxes, including local, provincial, payroll, goods-and-services, value-added, unemployment, and retirement taxes.

“C” Corporation vs. “S” Corporation vs. Limited Liability Company “LLC”

A limited liability company, or LLC, is a type of company that is formed to protect its owners’ personal assets from the risks of owning real estate or other businesses, especially those with high liability risks.  LLCs combine the liability protection of corporations with the flexibility and tax benefits of partnerships.

Like a partnership, an LLC is not a taxable entity, although it is a separate legal entity.  A schedule K-1 is prepared to pass the income or loss of the LLC to the shareholders.  Like a corporation, the owners’ personal assets are protected from the risks of the LLCs business.

The owners of an LLC are called “members”.  The people who run the LLC are “managers.”  Because all of the members have liability protection, LLCs have largely replaced limited partnerships as the entity of choice for real estate investors or any business which previously operated as a partnership.

One advantage of an LLC is its flexibility.  Members can agree to an arrangement that is as formal or casual as they desire.  Unlike corporations, for example, officers, directors, share certificates, and minutes are all optional.

The first step in forming an LLC is filing Articles of Organization.  Next an “Operating Agreement” is prepared.  This is an agreement between the members that covers the obligation to contribute capital, allocation of profits and losses, shares of distributions, management, buyout rights, death, marital dissolution, insurance, and other specific business issues.

In regard to real estate, a separate LLC is not necessary for each property, but some business owners prefer to form an LLC for each entity.  This is especially true if a property has special risks (e.g., swimming pools, or foreign operations).  An LLC cannot protect an owner who is personally negligent (e.g., negligently manages the business).  The owner can still be sued personally for his management.

LLCs have, by and large, replaced the use of limited partnerships for real estate investment.  While LLCs and “S” corporations are both taxed as so-called pass-through entities, the “S” corporation is strongly discouraged for the ownership of appreciating assets because “S” corporations are not easily dissolved without tax consequences, and “S” corporation shareholders may not be able to maximize their depreciation deductions because of basis and at risk provisions.  An LLC’s debt can be included in a member’s basis, thus increasing the opportunity to shelter income through depreciation because of increased basis. 

The formation and dissolution of LLCs generally have no tax consequences to their owners.  In addition, there may be more than one class of economic interest held in the LLC, thus permitting special allocations of income, loss and cash flow among the members.  Finally, while an “S” corporation cannot include shareholders who are corporations, partnerships, non-qualified trusts or foreign shareholders, none of these limitations apply to LLCs. 

What is the annual cost of maintaining an LLC?

You should speak with us regarding the annual cost of preparing tax returns for the LLC.  Generally speaking, the LLC is subject to an annual California Franchise tax, which is $800.00 plus an amount determined by the gross receipts of the LLC.  The following chart illustrates the annual franchise tax.  Please note that these fees are adjusted annually.

Does an LLC require more than one member?

California law only requires one LLC member, but a two-member LLC may be formed by a  husband and wife.  When a single owner wants to form an LLC, he or she must understand that although it will be recognized as a separate legal entity for liability purposes, it will be ignored for Federal income tax purposes, and will therefore NOT file its own return.  As a result, many of the tax benefits will be lost.  It is recommended that entities which will have only one member incorporate under subchapter “S” instead.

Can I prevent others from knowing that I own the LLC?

It has become increasingly popular to use an LLC to create anonymity by structuring the company so that publicly filed documents (e.g., the Annual Statement of Information, or LLC-12) do not indicate the owners of the LLC or their addresses.

What if I need to form multiple LLCs?

Producers, developers, and others, typically form a separate LLC for each new project.  In such cases, a generic Operating Agreement can be developed and then tailored for each subsequent project.

Once a company has chosen the corporation as the most effective form of entity for its business, it must choose between subchapter “S” and “C” corporations as well as LLC and LLP forms of organization.

Please refer to the attached chart.

DISCLAIMER:  The information contained in this document is provided for general background information only, and should not be utilized without in-depth discussions with your personal tax advisor.