Tax Help: Which to Choose? C Corporation, Sub S or LLC

There are basically three considerations that will determine what type of entity to choose:

The first is economic.  If you are going big, meaning public, you will choose a C corporation. If not, it will eventually choose you. 

The second consideration is limited liability corporation (LLC).  If you prefer to be solo but expect to be exposed to liability, the corporate form may be the better choice.

The third consideration is tax implication.  This is what this blog is trying to explain.  Let’s start at the beginning;  If you are a self employed individual and earn $50,000 a year, we will report this income on your personal tax return.  You simply add an additional form to your return called Schedule C.  On a Schedule C, you report your income and your expenses.  What is left is your income, which you pay tax.

C Corporation will be the same.  It is a legal “individual” entity (the correct term is entity).  It reports its income and expenses and the difference is the net in which the C corporation pays tax on.  So far so good?  But recall that the corporation is owned by someone.  That person paid for the stock of the corporation for a reason, which is to make money. 

The corporation compensates the person who owns its stock by paying the dividend.  The dividend is part of the profit that the corporation just paid tax on.  The individual takes the money from the corporation and tells the IRS about it.  Now he has a dividend to pay tax on.  So let us trace the money now that the stock owner just paid income tax on.  This money came from the corporation. 

The corporation just paid income tax on this money.  It gave the stock owner part of its income as a dividend.  The stock owner turns around and pays tax again on the dividend.  So the tax now is paid twice on the same money which is the dividend.

That is the background for creating Sub S and LLC.  The idea was to pay taxes only once while maintaining the benefit of a corporation that protects the owners against legal liability.  So let us start with Sub S.  Sub S corporation is really nothing but an S corporation that requested tax relief from the IRS by filing a form and asked to be treated differently for tax purposes.  

Filing with the IRS will provide the tax help to the corporation by exempting the corporation from paying income tax on the profits.  It lets the owners report this income on their personal tax return.  They call the corporation then a pass through.  It passes through the income to the owners without paying tax on the money.  Thus a Sub S is a pass through corporation that avoids double taxation.

LLC is also a pass through company.

It's confusing to dissect. Have a question? Comment? Let us know about it.

Tax Help: Ordinary Income vs. Capital Gains - Tax Planning is Key

If your company offered you a stock bonus for free, would you take it? Would you rather pay something for it?  Intuitively, the answer is why pay money if they're for free.  The correct answer is, however, you may be better off paying for it.

To make my point, here is an extreme case, and why extreme?  To drive the point I want to shock you as to the consequences of the wrong decision.

John is an executive in his company.  He is offered 100,000 stocks for free.  Each stock is traded on the exchange for $100.  So how much is he getting free?  $10 million.  Let us say that after one year the company is kicking butts and he sells the stock for $200.  So now he collects $20 million.  Uncle Sam comes in and wants his cut.  Assuming 40% tax rate, John must write a check for $8 million.

Now let John be a little stupid and decide to pay for the stock that was originally available for free. Say John offers to pay one penny per stock.  John writes a check for 100,000 pennies.  Yes, we pay a $1,000 dollars for those stocks. John sells the stock just as explained above for $20 million.  What is his tax?  It's not $8 million anymore, but it is only $4 million.  The tax is now $4 million (assuming 20% rate)

What happened?  We simply played a little trick.  We converted the amount paid to John from being considered as a compensation (salary) subject to ordinary income rate (in this case we assumed 40%) to a capital gain when we created a basis for the stock (basis here means we created a cost) How much did the trick save? $4 million dollars.  Does it happen?  You bet you.

NFA Tax Help can help provide tax planning, advice, and tax resolution to any tax problem.