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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 depend-
ing on the kind and size of your business, your tax situa-
tion, 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 entity you should select for oper-
ating your business.
The following is a thumbnail sketch or overview of some of
the major advantages and disadvantages of sole proprietor-
ships, partnerships, and corporations. Where there are
differences between a general partnership and a limited
partnership, or between a regular ("C") corporation and an
S corporation, separate comments are shown for each. Other-
wise, the comments regarding partnerships apply to both
general and limited partnerships, and the comments regard-
ing 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, etc.); \113
.ΣCapital-intensive firmsΦneeding to accumulate capital; \114
.ΣReal estate rentalΦbusinesses, in general; and \115
.ΣAuthors, inventorsΦand software developers receiv- \116
ing royalty income for licensing intellectual
property.
SIMPLICITY IN OPERATION AND FORMATION:
.ΣProprietorshipΦ Simplest to establish and operate. \110
.ΣGeneral PartnershipΦ Relatively simple, informal, but \111
is usually desirable to have for-
mal written agreement between the
partners.
.ΣLimited PartnershipΦ More complex and expensive than \112
other unincorporated forms of
business to establish. Requires
written agreement, filing of cer-
tificate. Managed by general
partners only.
.ΣRegular CorporationΦ Requires most formality in estab- \135\231
lishment and operation, generally.
.ΣS CorporationΦ Same as regular corporation, but \234
requires close oversight by a
tax advisor, an additional cost.
LIABILITY FOR DEBTS, TAXES & OTHER CLAIMS:
. Proprietorship Owner has unlimited personal
liability.
. General Partnership Partners all have unlimited per-
sonal liability.
. Limited Partnership General partners are personally
liable; limited partners are li-
able only to the extent of their
investment, generally.
. Corporation Stockholders not generally li-
able for corporate debts, but
often have to guarantee loans,
as a practical matter, if cor-
poration is to borrow 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 and 1993.
. Partnership Taxed to partners at their indiv-
idual tax rates.
. Regular Corporation Taxed to corporation at rates
higher than those of individuals
(maximum of 34% or 39% in 1992
and 1993).
. S Corporation Taxed to individual owners at
their individual rates (but cer-
tain gains are taxable to the
corporation as well).
DOUBLE TAXATION IF PROFITS ARE WITHDRAWN
FROM THE BUSINESS:
. Proprietorship No.
. Partnership No.
. Regular Corporation Yes. (But major exception exists
forΣreasonable compensationΦ that \105
is paid to owners who are employ-
ees of the corporation.)
. S Corporation No, in general.
DEDUCTION OF LOSSES BY OWNERS:
. Proprietorship Yes.
. Partnership Yes. Limited partner's deduc-
tions generally cannot exceed
the amount he or she has invested
in a limited partnership interest
(except for real estate, in some
instances).
. Regular Corporation No. Corporation must carry over
any initial losses until able to
offset them against future prof-
its, if ever.
. S Corporation Yes, in general, for federal tax
purposes. Loss for a shareholder
is limited to investment in his
or her stock, plus amount loaned
to corporation.
SOCIAL SECURITY TAXES ON EARNINGS OF
OWNER FROM THE BUSINESS:
. Proprietorship 15.3% of owner'sΣself-employmentΦ \262
earnings in 1993, up to $57,600
of income, plus 2.9% of S/E in-
come over $57,600, to $135,000.
Half of 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 1993, on up to
$57,600 of such earnings, plus
2.9% on excess over $57,600 (up
to maximum S/E income of
$135,000).
. Corporation Owner/employee of corporation
pays 7.65% on his or her salary
and corporation also pays 7.65%.
TotalΣSocial Security (FICA) taxΦ \258
is 15.3% of up to $57,600 of sal-
ary in 1993 (plus 2.9% on excess
over $57,600, up to maximum S/E
income of $135,000).
UNEMPLOYMENT TAXES ON EARNINGS OF
OWNER FROM THE BUSINESS:
. Proprietorship None.
. Partnership None.
. Corporation Yes. ΣUnemployment taxesΦ (state \260
and federal) 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 a par-
ticipant who is owner cannot bor-
row from a Keogh plan.
. Partnership Keogh plan. Same as for sole
proprietorship except that the
prohibition on borrowing from
plan applies to any 10% or
greater partner.
. Regular Corporation Corporate retirement plans no
longer are significantly better
than Keogh plans. Deduction
limits same now as for Keogh.
But participants can borrow from
corporate plan, within limits.
. S Corporation Plans now essentially identical
to regular corporate retirement
plans, except that "shareholder-
employee" (owning 5% or more of
the stock) of S corporation can-
not borrow from retirement plan.
TAX TREATMENT OF MEDICAL, DISABILITY, AND
GROUP-TERM LIFE INSURANCE ON OWNERS:
. Proprietorship Not deductible, except that part
of medical expenses may be an
itemized deduction on owner's
tax return, including medical
insurance premiums. But 25% of
medical insurance on owner is
now allowed as a deduction in
computing adjusted gross income.
. Partnership See proprietorship, above.
. Regular Corporation Corporation may be able to de-
duct theΣmedical insuranceΦprem- \241
ium or reimbursements paid under
a medical reimbursement plan.
Generally not taxable to the em-
ployee, even if employee is an
owner, if plan is not considered
discriminatory. Similar treat-
ment is provided forΣdisabilityΦ \240
coverage and up to $50,000 of
coverage (per employee) for
Σgroup term life insuranceΦplans. \242
. S Corporation Fringe benefits for 2% sharehol-
ders may be deductible by corpor-
ation, but such expense will be
treated like additional (taxable)
compensation to shareholder-
employees who own more than 2%
of the stock of the company.
(But may not be subject to FICA
tax in the case of medical insur-
ance, if such coverage is provid-
ed to employees generally by the
S corporation.)
TAXATION OF DIVIDENDS RECEIVED
ON INVESTMENTS:
. Proprietorship Dividends received on stock in-
vestments are fully taxable to
owner.
. Partnership Dividends taxable to individual
partners. See proprietorship,
above.
. Regular Corporation Dividends are taxable to the cor-
poration. But Σspecial deductionΦ \245
is allowed for 70% of the divi-
dends received, generally (unless
stock is purchased with borrowed
money), an important tax advan-
tage.
. S Corporation Dividends are taxable to indiv-
idual shareholders of the S cor-
poration, as in the case of divi-
dends received by a partnership.
