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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.