CHOOSE AN OWNERSHIP STRUCTURE:

1. What is a corporation (C-Corp)?

A corporation is a separate and distinct legal entity. This means that a corporation can open a bank account, own property and do business, all under its own name. The primary advantage of a corporation is that its owners, known as stockholders or shareholders, are not personally liable for the debts and liabilities of the corporation. For example, if a corporation gets sued and is forced into bankruptcy, the owners will not be required to pay the debt with their own money. If the assets of the corporation are not enough to cover the debts, the creditors cannot go after the stockholders, directors or officers of the corporation to recover any shortfall.

A corporation is managed by a board of directors, which is responsible for making major business decisions and overseeing the general affairs of the corporation. Like representatives in Congress, directors are elected by the stockholders of the corporation. Officers, who run the day-to-day operations of the corporation, are appointed by the directors.

One major disadvantage of a traditional corporation is double taxation. A traditional corporation, known as a "C-corporation," pays a corporate tax on its corporate income (the first tax). Then, when the C-corporation distributes profits to its stockholders, the stockholders pay income tax on those dividends (the second tax).

2. What is a S-Corporation (S-Corp)?

A traditional corporation, known as a C-corporation, is taxed as a separate entity, leading to double taxation of corporate income and dividends to shareholders. An S-corporation, on the other hand, is a corporation that elects to be treated as a pass-through entity (such as a sole proprietorship or partnership) for tax purposes. Since all corporate income is "passed through" directly to the shareholders who include the income on their individual tax returns, S-corporations are not subject to double taxation. One way to avoid double taxation is to make a special election to be taxed as a pass-through entity, like a partnership or a sole proprietorship. That way, there is only one level of taxation. The corporate profits "pass through" to the owners, who pay taxes on the profits at their individual tax rates. Corporations that make this tax election are known as "S-corporations."

3. What is a Limited Liability Company (LLC)?

Limited liability companies are a relatively new type of business entity that combine the personal liability protection of a corporation with the tax benefits and simplicity of a partnership. However, there are still other important differences. The following discusses the main advantages and disadvantages of corporations versus LLCs.

4. What is a Sole Proprietorship?

The vast majority of small businesses start out as sole proprietorships. These firms are owned by one person, usually the individual who has day-to-day responsibilities for running the business. Sole proprietors own all the assets of the business and the profits generated by it. They also assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the public, you are one in the same with the business.

5. What is a Partnership?

In a Partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, and what steps will be taken to dissolve the partnership when needed. Yes, it's hard to think about a breakup when the business is just getting started, but many partnerships split up at crisis times, and unless there is a defined process, there will be even greater problems. They also must decide up-front how much time and capital each will contribute, etc. Types of Partnerships that should be considered:

1. General Partnership - Partners divide responsibility for management and liability as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
2. Limited Partnership and Partnership with limited liability - Limited means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short-term projects or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.
3. Joint Venture - Acts like a general partnership, but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such as well as distribute accumulated partnership assets upon dissolution of the entity.

COMPARE THE FORMS OF OWNERSHIPS:

1. Corporations compared to sole proprietorships and partnerships:

Corporations enjoy many advantages over partnerships and sole proprietorships. But there are also disadvantages. We cover the most important ones below.

Advantages of Corporation:

Stockholders are not liable for corporate debts. This is the most important attribute of a corporation. In a sole proprietorship and partnership, the owners are personally responsible for the debts of the business. If the assets of the sole proprietorship or partnership cannot satisfy the debt, creditors can go after each owner's personal bank account, house, etc. to make up the difference. On the other hand, if a corporation runs out of funds, its owners are usually not liable.

Please note that under certain circumstances, an individual stockholder may be liable for corporate debts. This is sometimes referred to as "piercing the corporate veil." Some of these circumstances include:

• If a stockholder personally guarantees a debt.
• If personal funds are intermingled with corporate funds.
• If a corporation fails to have director and shareholder meetings.
• If the corporation has minimal capitalization or minimal insurance.
• If the corporation fails to pay state taxes or otherwise violates state law (like defrauding customers).

Self-Employment Tax Savings. Earnings from a sole proprietorship are subject to self-employment taxes, which are currently a combined 15.3% on the first $90,000 of income. With a corporation, only salaries (and not profits) are subject to such taxes. This can save you thousands of dollars per year.

For example, if a sole proprietorship earns $80,000, a 15.3% tax would have to be paid on the entire $80,000. Assume that a corporation also earns $80,000, but $40,000 of that amount is paid in salary, and $40,000 is deemed as profit. In this case, the self-employment tax would not be paid on the $40,000 profit. This saves you over $5,000 per year. Please note, however, that you should pay yourself a reasonable salary.

Continuous life. The life of a corporation, unlike that of a partnership or sole proprietorship, does not expire upon the death of its stockholders, directors or officers.

Easier to raise money. An corporation has many avenues to raise capital. It can sell shares of stock, and it can create new types of stock, such as preferred stock, with different voting or profit characteristics. Plus, investors be assured that they are not personally liable for corporate debts.

Ease of transfer. Ownership interests in a corporation may be sold to third parties without disturbing the continued operation of the business. The business of a sole proprietorship or partnership, on the other hand, cannot be sold whole; instead, each of its assets, licenses and permits must be individually transferred, and new bank accounts and tax identification numbers are required.

Disadvantages of Corporation:

Higher cost. Corporations cost more to set up and run than a sole proprietorship or partnership. For example, there are the initial formation fees, filing fees and annual state fees. These costs are partially offset by lower insurance costs.

Formal organization and corporate formalities. A corporation can only be created by filing legal documents with the state. In addition, a corporation must adhere to technical formalities. These include holding director and shareholder meetings, recording minutes, having the board of directors approve major business transactions and corporate record-keeping. If these formalities are not kept, the stockholders risk losing their personal liability protection. While keeping corporate formalities is not difficult, it can be time-consuming. On the other hand, a sole proprietorship or partnership can commence and operate without any formal organizing or operating procedures - not even a handwritten agreement.

Unemployment tax. A stockholder-employee of a corporation is required to pay unemployment insurance taxes on his or her salary, whereas a sole proprietor or partner is not. Currently, the federal unemployment tax is 6.2% of the first $7,000 of wages paid, with a maximum of $434 per employee.

If you pay any required state unemployment tax, you can receive an offset credit of 5.4%, effectively lowering the federal rate to 0.8%, for a maximum of $56.00 per employee per year.

Advantage of a Partnership:

• Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement.
• With more than one owner, the ability to raise funds may be increased.
• The profits from the business flow directly through to the partners' personal tax returns.
• Prospective employees may be attracted to the business if given the incentive to become a partner.
• The business usually will benefit from partners who have complementary skills.

Disadvantages of a Partnership:

• Partners are jointly and individually liable for the actions of the other partners.
• Profits must be shared with others.
• Since decisions are shared, disagreements can occur.
• Some employee benefits are not deductible from business income on tax returns.
• The partnership may have a limited life; it may end upon the withdrawal or death of a partner.

Advantages of a Sole Proprietorship:

• Easiest and least expensive form of ownership to organize.
• Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.
• Sole proprietors receive all income generated by the business to keep or reinvest.
• Profits from the business flow directly to the owner's personal tax return.
• The business is easy to dissolve, if desired.

Disadvantages of a Sole Proprietorship:

• Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
• May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.
• May have a hard time attracting high-caliber employees or those that are motivated by the opportunity to own a part of the business.
• Some employee benefits such as owner's medical insurance premiums are not directly deductible from business income (only partially deductible as an adjustment to income).

2. Corporations Compared to Limited Liability Company:

Limited liability companies are a relatively new type of business entity that combine the personal liability protection of a corporation with the tax benefits and simplicity of a partnership. However, there are still other important differences. The following discusses the main advantages and disadvantages of corporations versus LLCs.

Advantages of Corporations:

Profits are not subject to social security and medicare taxes. Like a sole proprietorship or a partnership, salaries and profits of an LLC are subject to self-employment taxes, currently equal to a combined 15.3%. With a corporation, only salaries, and not profits, are subject to such taxes.

Greater Acceptance. Since limited liability companies are still relatively new, not everyone is familiar with them. In some cases, banks or vendors may be reluctant to extend credit to limited liability companies. Moreover, there are restrictions as to the type of business that an LLC may conduct in some states.

Greater variety of, and fewer taxes on, fringe benefits. Corporations offer a greater variety of fringe benefit plans than any other type of business entity. Various retirement, stock option and employee stock purchase plans are available only for corporations. Plus, while sole proprietors, partners and employees owning more than 2% of an S-corporation must pay taxes on fringe benefits (such as group-term life insurance, medical reimbursement plans, medical insurance premiums and parking), stockholder-employees of a C-corporation do not have to pay taxes on these benefits.

Income Shifting. Although C-corporations are subject to double taxation, they also offer greater tax flexibility. In a C-corporation, you can use income shifting to take advantage of lower income tax brackets.

To illustrate, let's take the example of a company that earns $100,000. With a sole proprietorship, a business owner who is married (filing jointly) would be in the 25% income tax bracket. With a corporation, assume that the business owner takes $50,000 in salary and leaves $50,000 in the corporation as a corporate profit. The federal corporate tax rate is 15% on the first $50,000. Furthermore, the business owner is now in the 15% tax bracket for his or her personal income tax. This can reduce your overall tax liability by over $8,000.

Advantages of LLCs

Fewer corporate formalities. Corporations must hold regular meetings of the board of directors and shareholders and keep written corporate minutes. Members and managers of an LLC need not hold regular meetings, which reduces complications and paperwork.

No ownership restrictions. S-corporations cannot have more than 100 stockholders, and each stockholder must be an individual who is a resident or citizen of the United States. Also, it is difficult to place shares of an S-corporation into a living trust. None of these restrictions or difficulties apply to an LLC (or a C-Corporation).

Ability to deduct operating losses. Members who are active participants in the business of an LLC are able to deduct operating losses of the LLC against their regular income to the extent permitted by law. Shareholders of an S-corporation are also able to deduct operating losses, but not shareholders of a C-corporation.

Tax flexibility. By default, LLCs are treated as a "pass-through" entity for tax purposes, much like a sole proprietorship or partnership. However, an LLC can also elect to be treated like a corporation for tax purposes, whether as a C-corporation or an S-corporation.

3. C-Corporations compared to S-Corporations:

C-corporations are subject to double taxation; that is, one tax at the corporate level on the corporation's net income, and another tax to the shareholders when the profits are distributed to them. S-corporations, on the other hand, have only one level of taxation. All of their income is allocated to their stockholders. However, C-corporations have greater tax planning flexibility and can shield stockholders from direct tax liability. In addition, S-corporations are subject to limitations, such as the number and type of stockholders it can have.

A traditional corporation, known as a C-corporation, is taxed as a separate entity, leading to double taxation of corporate income and dividends to shareholders. An S-corporation, on the other hand, is a corporation that elects to be treated as a pass-through entity (such as a sole proprietorship or partnership) for tax purposes. Since all corporate income is "passed through" directly to the shareholders who include the income on their individual tax returns, S-corporations are not subject to double taxation. Moreover, the accounting for an S-corporation is generally easier than for a C-corporation. There are, however, certain restrictions placed on S-corporations:

• The S-corporation must not have more than 100 stockholders, and each of them must consent. (A married couple is treated as one stockholder).
• Each stockholder must be an individual who is a citizen or resident of the United States, or an estate or qualifying trust of such person.
• The corporation must have only one class of stock. (However, voting differences within a class of stock are permissible). Preferred stock is not allowed.
• The corporation must use the calendar year as its fiscal year unless it can demonstrate to the IRS that another fiscal year satisfies a business purpose.

As a separate legal entity, a corporation must submit a tax return each year with the IRS. For corporations with a fiscal year ending December 31, tax returns are due on March 15. A corporation must file a tax return even if it does not have income or no tax is due. C-corporations file tax returns on Form 1120 or 1120A.

Although S-corporations do not pay federal taxes at the corporate level, they still must prepare a separate tax return. S-corporations file their returns on Form 1120S.

For 2005, the federal income tax rate for a C-corporation is as follows: Income: Tax Rate:

Some states, including California, also have a state corporate income tax. Corporations that anticipate a tax liability of $500 or more must estimate their taxes and make quarterly estimated tax payments. Corporations with employees are required to pay federal (and sometimes state) payroll and unemployment taxes.

4. Limited Liability Company Compared to S-Corporation: