Incorporation and Business Transactions
Disclaimer: The following Business Formation material is intended for general information only and not legal or tax advice.
Zaher Fallahi, Attorney At Law and Certified Public Accountant (CPA), is a Law and CPA firm. We are licensed in California and Washington D. C., and assist clients with their incorporation, legal and tax implication of all types of legal entities. Consultation is available via Toll Free 877-687-7558.
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The following are the most commonly used types of legal entities:
I- C Corporation
A chapter C corporation is a legal entity established under the state statute for carrying out a trade or business. If a corporation is properly formed and maintained according to all corporate formalities, its stockholders may not be held personally liable for its debts. However, corporate officers may be held personally liable for breach of “duty of care” or other pertinent legal duties to the stockholders. Under the circumstances, state and federal taxing authorities may hold corporate officers personally liable for not turning over their employees’ withheld employment taxes, or its sales taxes. This is also known as “trust fund recovery penalty” and could be 100% of the actual taxes.
Taxation of C Corporations and Shareholders
For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. C corporations pay income tax on their net income, and their stockholders pay income tax on the dividends they receive from the corporation. This is called double taxation. Qualified stockholders may convert it into an S corporation or an LLC to avoid this kind double taxation.
Piercing The Corporate Veil
Stockholders of a corporation may be held personally liable for the corporation’s debts because of the following:
(1) Failure to have reasonable corporate capitalization, based on facts and circumstances of the industry;
(2) Lack of continuous compliance with the corporate formalities;
(3) Committing conducts to defraud the corporation or creditors;
(4) Failure to respect the corporate separateness.
More often than not, small corporations lose their corporate veil protection in court because of not seeking timely legal advice, or using advice of advisors with insufficient corporate law knowledge
Tax Planning Opportunity
Because the new tax law has reduced C Corporation’s highest tax rate from 35% to flat 21% (Corporate Tax Rate), it may be advantageous to convert other entities into C corporations. This should be done in light of highest individual tax rates (Individual Tax Rates and Brackets ) and taking into consideration of the (New 20% Deduction for Pass-Throughs) establish new is the luckiest beneficiary of the law, and creating a new tax planning opportunity.
II- S Corporation
From legal perspective, S chapter corporations are entitled to the same protection as C corporations. For tax purpose, however, they file annual informational tax reruns, and pass-through to each individual stockholder their share of the corporate profits, losses or credits. In turn, S corporation shareholders include their share of the information in their respective individual income tax returns, and avoid double taxation. Similar to LLCs, stockholders of S corporations may deduct their losses only up to the amount of their stock basis in their S corporation. In order to be eligible for S status, the IRS requires the following:
(1) be a domestic corporation;
(2) have no more than 100 shareholders;
(3) have only one class of stock;
(4) have only allowable shareholders:
(i) individuals, certain trusts, and estates and,
(ii) may not include partnerships, corporations or non-resident alien shareholders; and,
5) Not be an ineligible corporation: certain financial institutions, insurance companies, and domestic international sales corporations.
Stockholders of S Corporations may deduct 20% of their shares of the Qualified Business Income: (New 20% Deduction for Pass-Throughs ).
III- Sole Proprietorship/Sole Ownership/Unincorporated Business
Sole Ownership is carrying out a business without being a legal entity such as corporation. Under the circumstances a business owner may use a fictitious name called Doing Business As (”DBA”). A DBA must be registered with the county where the business is conducted. Contrary to what some business owners believe, registering a DBA in not establishing a corporation or any other form of legal entity.
For liability purposes, a sole proprietor is personally liable to everyone dealing with the business, and this type of entity is not a preferred form of entity for prudent business owners. Some proprietors buy large insurance policies to cover their business liabilities. However, the business owner must lose a lawsuit in court, and the insurance company may pay the owner’s judgment. Losing a lawsuit adversely affect the owner’s credit, which is crucial to a business owner.
A risk-averse business owner may choose a business entity such as an LLC, to take advantage of the “corporate veil” legal theory. The corporate veil protects a business owner from her personal liability, provided the entity is properly formed and maintained in compliance with applicable statutory requirements.
Taxation of Sole Proprietors
From tax viewpoint, a sole proprietor is an “individual taxpayer” and includes her business income and expenses on IRS Form Schedule C, Profit or Loss from Business, as part of her annual tax return Form 1040. A sole proprietor must make the IRS and FTB quarterly estimated payments for her own income taxes, and may be held personally liable for her employees’ withheld payroll taxes, sales and excise taxes. This is called “responsible persons” liability and may impose 100% penalties on un-paid taxes.
Under the Internal Revenue Code §172, a sole proprietor can deduct her business net operating losses (”NOL”), and by carrying them forward, may eliminate or reduce her future profits and produce substantial tax benefits. Sole proprietors may deduct 20% of their Qualified Business Income: (New 20% Deduction for Pass-Throughs ).
IV- Partnerships (General and Limited)
Under the Internal Revenue Code §76, a partnership is created when two or more individuals join together to carry on a trade or business for profit. Owners of a partnership are called “partners” and contribute cash, skill, property or labor as their partnership capital.
Although partners’ shares of income, deductions, gains and losses are proportional to their contributed capital, customarily, they may be determined by the partnership agreement and based on Treasury Reg. §704; the “substantial economic effect” theory. The partnership agreement delineates partners sharing of profits and losses as well as matters such as assumption and indemnification.
All partners of a general partnership are held liable to the creditors of their partnership regardless of the amount of their capital in the general partnership. However, liabilities of limited partners in a limited partnership are limited to their respective capital amount.
Taxation of Partnerships and Partners
For federal and state tax purposes, partnerships must file their annual informational tax returns and report their income, deductions, gains, losses, and credits from their business operations. Although , partnerships do not pay income tax per se, they report their partners’ share of business operations through Form K-1. Partners pay their own taxes by including their K-1 information in their annual personal income tax returns. Partners who engage in running partnership operations, pay Social Security and Medicare taxes in addition to income taxes. Partners of partnerships must make the IRS and FTB quarterly estimated tax payments toward their individual annual tax liabilities.
Partners of partnerships may deduct 20% of their share of the Qualified Business Income: (New 20% Deduction for Pass-Throughs ).
V- Limited Liability Company (LLC)
A Limited Liability Company (”LLC”) is a form of legal entity created by state statute. Owners of LLC s are called LLC members, receive”membership certificates’ for their ownership, and they may be individuals, corporations, or other LLCs.
State and federal taxing authorities may impose different regulations on LLCs. Check with your state and the federal regulations to find out whether your intended entity is permitted. For instance, some types of businesses such as banks and insurance companies are not allowed to be LLCs. In California professional services such as law, accounting, medicine, and types of some engineering, are not permitted to be LLCs.
Unlike partners of general partnerships, liabilities of LLC members are limited to their respective LLC capital. Unlike stockholders of a corporation, LLC members may receive LLC income or losses disproportionate to their LLC ownership. For example a 5% LLC owner may be receive 25% of the LLC’s profits and losses. Although LLC managing members may be held personally liable for their employees’ withheld payroll taxes, and sales taxes, their obligations to other LLC liabilities are limited to their capital in the LLC.
Although there is no limitation on the citizenship of LLC owners or C corporation stockholders, the federal regulations may impose unexpected restrictions. One example would be the laws of U.S. sanctions against foreign countries which have been in effect since the early 1800s. As such, counselors advising international clients investing in the U.S. via an LLC or a corporation may explore the U.S. Treasury Office of Foreign Assets Control (“OFAC”) Regulations to determine the clients’ eligibility for investment in the U.S.
Members of an LLC may deduct their pass-through losses up to the amount of their LLC capital. Since each member of an LLC has limited liability, investors are akin to limited partners under Internal Revenue Code § 469— passive activity losses and credits limited. IRS treats LLC members as limited partners, even if the member-managers who engage in running the LLC.
State law provides LLC members protection through ”charging order”. Under charging order a judgment-creditor receives the membership interest and respective distribution, but is not entitled to any LLC management or voting rights. This is contrary to a corporate stockholder’s judgment-creditor who may obtain corporation management and voting rights of the debtor shareholder.
Taxation of LLCs and LLC Members
For federal income tax purposes, an LLC is a disregarded entity, but may elect to be taxed as a partnership or a corporation (C or S). Most domestic LLCs with two members or more elect to be taxed as partnerships. California imposes a gross receipt tax (franchise fee) on LLCs regardless of their profitability. Furthermore, California annual S Corporation tax is the greater of $800 or 1.5% of its net income. Members of LLCs may deduct 20% of their shares of the Qualified Business Income: (New 20% Deduction for Pass-Throughs ).
The owner of a single member limited liability company (”SMLLC”) not elected to be taxed as a corporation, is treated an individual for income tax purposes. Generally, sole proprietors with gross sales in excess of $100,000 per year have more exposure to be audited than average taxpayers. Additionally, sole proprietors with no annual gross income or repeated losses are more susceptible to an IRS audit.
VI- General Tax Planning Ideas
Visit our CPA Website for General Tax Planning .
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