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F117.SBE
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@212 CHAP 2
┌────────────────────────────────────────────────┐
│SELECTION OF LEGAL ENTITY -- OVERVIEW OF CHOICES│
└────────────────────────────────────────────────┘
"The hardest thing in the world to understand is
Income Tax." -- Albert Einstein
Choosing the "best" legal form or entity for your business is rarely
an easy decision to make. Each form of business, sole proprietorship,
partnership, and corporation, has its own benefits and shortcomings,
which vary in degree depending on the kind and size of your business,
your tax situation, profitability, personal predilections, and numerous
other factors, some of which may seem important to you, others of which
may not. Thus there is often no "right" answer as to which legal enti-
ty you should select for operating your business.
The following is a thumbnail sketch or overview of some of the major
advantages and disadvantages of sole proprietorships, partnerships, and
corporations. Where there are differences between a general partner-
ship and a limited partnership, or between a regular ("C") corporation
and an S corporation, separate comments are shown for each. Otherwise
the comments regarding partnerships apply to both general and limited
partnerships, and the comments regarding corporations relate to both
regular and S corporations.
As a general rule, it seems that some types of businesses are much more
likely than others to benefit from adopting a certain legal form, as in
the case of the following (press <Enter> key for details on highlighted
words):
.ΣProfessional service firmsΦ(law, accounting, medicine, etc.); \113
.ΣCapital-intensive firmsΦthat need to accumulate capital; \114
.ΣReal estate rentalΦbusinesses, in general; and \115
.ΣAuthors, inventorsΦand software developers receiving royalty \116
income for licensing intellectual property.
SIMPLICITY IN OPERATION AND FORMATION:
.ΣProprietorshipΦ Simplest to establish and operate. \110
.ΣGeneral PartnershipΦ Relatively simple, informal, but is usually \111
desirable to have formal written agreement
between partners.
.ΣLimited PartnershipΦ More complex and expensive than other unin- \112
corporated forms of business to establish.
Requires written agreement, filing of cer-
tificate. Managed by general partners only.
.ΣRegular CorporationΦ Requires most formality in establishment and\135\231
operation, generally.
.ΣS CorporationΦ Same as regular corporation, but requires \234
close oversight by a tax advisor, an
additional cost.
LIABILITY FOR DEBTS, TAXES AND OTHER CLAIMS:
. Proprietorship Owner has unlimited personal liability.
. General Partnership Partners all have unlimited personal
liability.
. Limited Partnership General partners are personally liable;
limited partners are liable only to the ex-
tent of their investment, generally.
. Corporation Stockholders not generally liable for corp-
orate debts, but often have to guarantee
loans, as a practical matter, if corporation
borrows money. Also, corporate officers may
be liable for failure to withhold and pay
over to IRS, withholding taxes on employees'
wages.
FEDERAL INCOME TAXATION OF BUSINESS PROFITS:
. Proprietorship Taxed to owner at individual tax rates of up
to 31% or more in 1992.
. Partnership Taxed to partners at their individual tax
rates.
. Regular Corporation Taxed to corporation at rates higher than
those of individuals (maximum of 34% or 39%
in 1992).
. S Corporation Taxed to individual owners at their individ-
ual rates (but certain gains are taxable to
the corporation as well).
DOUBLE TAXATION IF PROFITS WITHDRAWN FROM BUSINESS:
. Proprietorship No.
. Partnership No.
. Regular Corporation Yes. (But not onΣreasonable compensationΦ \105
paid to owners who are employees of the
corporation.)
. S Corporation No, in general.
DEDUCTION OF LOSSES BY OWNERS:
. Proprietorship Yes.
. Partnership Yes. Limited partner's deductions generally
cannot exceed the amount he or she has in-
vested in a limited partnership interest
(except for real estate, in some instances).
. Regular Corporation No. Corporation must carry over initial
losses until able to offset against future
profits, if ever.
. S Corporation Yes, in general, for federal tax purposes.
Loss for a shareholder limited to investment
in stock plus amount loaned to corporation.
SOCIAL SECURITY TAXES ON EARNINGS OF OWNER FROM BUSINESS:
. Proprietorship 15.3% of owner'sΣself-employmentΦearnings \262
in 1992, up to $55,500 of income, plus
2.9% of S/E income between $55,500 and
$130,200. Half the S/E tax is deductible
for income tax purposes.
. Partnership 15.3% of each partner's share of self-
employment earnings from the business in
1992, on up to $55,500 of such earnings,
plus 2.9% on excess over $55,500 (up to
maximum S/E income of $130,200).
. Corporation Owner/employee of corporation pays 7.65% on
his or her salary and corporation also pays
7.65%. TotalΣSocial Security (FICA) taxΦis \258
15.3% of up to $55,500 of salary in 1992
(plus 2.9% on excess over $55,500, up to
maximum S/E income of $130,200).
UNEMPLOYMENT TAXES ON EARNINGS OF OWNER FROM BUSINESS:
. Proprietorship None.
. Partnership None.
. Corporation Yes. State and federalΣunemployment taxesΦ \260
apply to salaries paid to owners.
RETIREMENT PLANS:
. Proprietorship Keogh plan. Deductions, other features now
generally the same as for corporate pension
and profit sharing plans. But participant
who is owner cannot borrow from Keogh plan.
. Partnership Keogh plan. Same as for sole proprietorship
except that prohibition on borrowing from
plan applies to any 10% or greater partner.
. Regular Corporation Corporate retirement plans no longer signif-
icantly better than Keogh plans. Deduction
limits same now as for Keogh. But partici-
pants can borrow from plan, within limits.
. S Corporation Plans now essentially identical to regular
corporate retirement plans, except that a
"shareholder-employee" (owning 5% or more of
the stock) of S corporation cannot borrow
from retirement plan.
TAX TREATMENT OF MEDICAL, DISABILITY, AND
GROUP-TERM LIFE INSURANCE ON OWNERS:
. Proprietorship Not deductible, except part of medical ex-
penses may be an itemized deduction on
owner's tax return, including medical in-
surance premiums. But 25% of medical in-
surance on owner is now allowed as a
deduction from adjusted gross income.
. Partnership See proprietorship, above.
. Regular Corporation Corporation may be able to deduct the
Σmedical insuranceΦpremium or reimbursements \241
paid under medical reimbursement plan.
Generally not taxable to the employee, even
if employee is an owner, if plan is not con-
sidered discriminatory. Similar treatment
is provided forΣdisabilityΦcoverage and up \240
to $50,000 of coverage (per employee) for
Σgroup term life insuranceΦplans. \242
. S Corporation Fringe benefits for 2% shareholders may be
deductible by corporation, but such expense
will be treated like additional (taxable)
compensation to shareholder-employees who
own more than 2% of the stock of the
company.
TAXATION OF DIVIDENDS RECEIVED ON INVESTMENTS:
. Proprietorship Dividends received on stock investments are
fully taxable to owner.
. Partnership Dividends taxable to individual partners.
See proprietorship, above.
. Regular Corporation Dividends are taxable to the corporation.
However, aΣspecial deductionΦis allowed for \245
70% of the dividends received, generally
(unless stock is purchased with borrowed
money), an important tax advantage.
. S Corporation Dividends are taxable to individual share-
holders of the S corporation, as in the case
of dividends received by a partnership.