So you have a killer idea and want to take your shot at becoming an entrepreneur? Granted, your success or failure will largely depend on the quality of your business plan and your ability to execute it, but several seemingly small decisions made when your vision is but a dream can come back to haunt you should your venture prove to be a success.
When you first start up your company, you will have to choose the type of corporate structure it will be governed by. At this stage, many aspiring entrepreneurs are on a shoestring budget and can not avail themselves to the advice of a quality tax attorney. If you’re attempting to decide upon a corporate structure without the benefit of advice from a professional, there are several salient factors which should guide your decision. The three main options for your new company is to make it a “C” corporation, an “S” corp, or a “limited liability company” (LLC).
A “C corp” is a corporate entity which pays its own taxes. Unlike an S corp or LLC, profits from a C corp do not flow through to the owner(s). The vast majority of public companies are C corp’s as are most large corporations. From an entrepreneur’s viewpoint, there are several benefits of a C corp — but one large drawback. The first benefit is that a C corp can deduct fully the cost of the company owner’s health insurance, whereas an S corp or LLC forces the owner to report paid health insurance as a benefit thus paying taxes on it.
The second benefit of a C corp is that your effective tax rate could be much lower than with an S corp or LLC if you plan to leave $50,000 – $100,000 a year in earnings within the company to help it grow. Currently, C corp’s only pay 15% tax on the first $50,000 in earnings. S corp’s and LLC’s entail tax at the earned income rate which varies depending upon your tax bracket — but you can plan on it being at least 25% if your company thrives.
The final benefit of a C corp is in the scenario where you might lose a lot of money during the initial year(s) before your company becomes profitable. A C corp structure allows you to carry forward the loss indefinitely, so you will eventually be able to claim it against profits when they finally occur. An S corp or LLC has the loss pass through to you, and if you do not have personal income that year to deduct it against, then it is lost forever — which could cost you tens of thousands of dollars in additional future taxes.
As to the drawback of a C corp, this relates to a scenario where your company is a huge success. As indicated, C corp’s pay their own taxes on an ascending scale based upon profits. If the company is making into the six figures, then its tax rate will be right at 35%. Then, if you desire to send the money to yourself it must come in the form of dividends. You again pay tax on these dividends at a current rate of 15% — and insiders predict these will soon go up to 20%. Therefore, a C corp entails double taxation — 35% off the top, and then 15%-20% again of what is paid out to you.
As indicated, profits earned by a company organized as an S corp or LLC “pass through” to the owner. This means that the company itself pays no taxes, but you are personally assessed tax liability — at your usual rate — for the earnings of the company. Consequently, with an S corp or LLC the money made by the company is treated no differently than money you make as an employee or entrepreneur.
In terms of taxes, S corps are identical to LLC’s. The difference relates to who is allowed to own them. S corp owners are limited to U.S. citizens, and only actual people — not other companies — can be owners. A LLC allows foreign owners along with corporate owners.
Whichever structure you select, make sure you hire a qualified accountant to actually do your first year’s taxes when they are due. Mistakes in this arena can prove deadly. Furthermore, a good accountant or tax attorney could potentially fix any problems you made forming the company — and the damage can be greatly limited if it is before you file your first corporate tax return. If you must skip the expense and form the company yourself online at the very start, then plan to incur this expense at the end of your first year of operation.
If you’re an aspiring entrepreneur, the most important step is the first one. Don’t let the complexities of corporate structures be an obstacle — a little research and several online legal form sites can make it relatively painless. Hopefully the above advice helps at least one HardyMag reader live out his entrepreneurial dreams.