S corporations combine the most beneficial aspects of partnerships and corporations. Like standard C corporations, a properly formed, properly capitalized and properly maintained S Corporation should protect the owners from liability other than their capital contribution. S corporations, however, avoid the double-taxation problems of C corporations.

In making an “S” election with the IRS, the corporation elects to pass corporate income, losses, deductions and credits through to the shareholders (in proportion to their percentage of ownership) for federal tax purposes. Each shareholder must then report the flow-through of income and losses his or her personal tax return and pay taxes at his or her standard income tax rate.

S corporations are often a good choice for start-ups because of the limited liability, flow-through tax treatment, and possible payroll tax advantages they offer. Not everyone, however, can be the owner of an S-corp. There be no more than 75 shareholders, other corporations cannot serve as shareholders, foreign citizens cannot be shareholders, and only one class of stock may be issued.

For taxation purposes, S corporations must file IRS Form 1120S U.S. Income Tax Return for an S Corporation to report all income, gains, losses and deductions for the company. The company may also need to make estimated payments for (a) the tax on built-in gains, (b) the excess net passive income tax and (c) the investment credit recapture tax. Additionally, like all businesses, the S corporation must pay employment taxes, including Social Security, Medicare and unemployment.

Corporations, whether C corporations or S corporations, are formed by filing articles of incorporation with the Secretary of State. So long as they are properly formed, properly capitalized and properly maintained, they should shield the owners from personal liability for the debts and obligations of the company, except for the amount of their capital contribution.

The owners are called shareholders, and are issued shares of stock. The shareholders elect a board of directors, who then elect officers to carry out the day to day business of the corporation. Often times in small corporations, the same individual or individuals can serve as shareholders, directors, and officers.

To be properly formed, a corporation must have an organizational meeting and issue shares. It is not enough to merely file articles of incorporation with the secretary of state. Each year it must hold annual meetings of shareholders and directors and file an annual report with the secretary of state.

When it comes to taxes, a corporation has its own tax identification number and pays taxes just like an individual. IT must file an annual form 1120 U.S. Corporation Income Tax Return as well as quarterly estimated taxes. A corporation generally is entitled to the same deductions as a sole proprietor and can take additional special deductions only available to corporations.

C corporations may offer several tax advantages, however, with respect to deductibility of retirement contributions, group insurance premiums, and other benefits. The main downside to forming a C-corporation is double-taxation: the corporation itself pays taxes on profits when the income is earned and the shareholder also pays tax on dividends. For this reason, few small businesses are C-corporations.

The LLC is still considered a relatively new business structure, although it’s been around for more than 30 years. The LLC, like a corporation, is a separate legal entity from its owners. It is formed by filing articles of organization with the Secretary of State. An operating agreement is recommended, but not required. So long as it is properly formed, properly capitalized and properly maintained, it should limit the owner’s personal liability for debts and actions of the LLC to the amount invested in the company. LLCs are owned by members and can be managed either by the members or managers. Neither members nor managers must live in North Carolina. It is

LLCs are desirable because they are flexible as to management participation and allocation of profits and losses, yet they provide limited liability. It is also possible to make an S-election for an LLC so that it is taxed the same way as an S-corporation. This is valuable when the owner wants to treat some profits as dividends to minimize income tax. LLCs and S-corporations (which we will discuss in detail in another post) are similar in that they both pass-through income directly to the owners, but they have vastly different rules on deductions, salary and self-employment taxes.

LLCs do require an annual report to be filed with the Secretary of State.

LLCs are classified as either single-member or multiple-member, and the designation has a big impact on how taxes are reported. Single-member LLCs owned by an individual report all income and expenses on a schedule to Form 1040. Multiple-member LLCs report all income and expenses on a partnership tax return Form 1065. LLCs are responsible for all employment-related taxes and must issue W-2s and 1099s as required. Members of the LLC are subject to self-employment taxes on all earnings or shares of the profits.

Although no formalities are required to form a partnership, we highly recommend a written partnership agreement. As with the sole proprietorship, a partnership should use adequate insurance to mitigate personal risks.

From a tax perspective, a partnership is not a separate tax entity. Partnerships file an annual informational return (reporting all income, deductions, gains and losses) on behalf of the business; but all profits and losses are passed through directly to the partners and are reported on their respective tax returns. Partners are not employees of the company and must be supplied with a K-1 by the company each year.

When people are starting a business, they are often very confused and overwhelmed as to how to choose an entity, or even whether they need one. Many entrepreneurs look at limiting their legal liability but never consider the tax implications of their business entity. The only entities which provide limited liability to owners (with respect to both tort and contract liability) are S corporations, C corporations, and limited liability companies. Before selecting the entity, it is essential to review the tax implications as well as the legal ones.

In a series of blog posts, I will discuss the various available entities (sole proprietorship, partnership, limited liability company, C-corporation and S-corporation) and some tax issues associated with each.

Sole Proprietorship:
Many entrepreneurs start their businesses as sole proprietorships, where the owner and the business are one and the same (sometimes known as “hanging out a shingle”). This is certainly the simplest way to begin. There are no formalities required. But, if the business is sued or has a hefty tax debt, you are financially responsible. Many risks of having a sole proprietorship can be addressed with insurance.

From a tax perspective, the business profits are reported on the owner’s personal income tax filings under his/her Social Security number, and the income will be taxed at the owner’s standard personal income rate. The owner must file form 1040, and 1040 ES Declaration of Estimated Tax For Individuals. The owner is responsible for paying self-employment taxes. There are many deductions available as well.

Once you hire employees, you should consider forming a limited liability entity to protect yourself from the acts of the employee.