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Throughout this chapter, the differences of how income and deductions are reported have been explained for different entities, but these differences are not the only reasons for choosing a form of business organization. When you are deciding on which form of business organization to choose, tax, financial, and many other factors come into play, including:

● Personal liability

● Access to capital

● Lack of profitability

● Fringe benefits

● Nature and number of owners

● Tax rates

● Social Security and Medicare taxes

● Restrictions on accounting periods and account methods

● Owner's payment of company expenses

● Multistate operations

● Audit chances

● Filing deadlines and extensions

● Exit strategy

Each of these factors is discussed below.

Personal Liability

If your business owes money to another party, are your personal assets – home, car, investments – at risk? The answer depends on your form of business organization. You have personal liability – your personal assets are at risk – if you are a sole proprietor or a general partner in a partnership. In all other cases, you do not have personal liability. Thus, for example, if you are a shareholder in an S corporation, you do not have personal liability for the debts of your corporation.

Of course, you can protect yourself against personal liability for some types of occurrences by having adequate insurance coverage. For example, if you are a sole proprietor who runs a store, be sure that you have adequate liability coverage in the event someone is injured on your premises and sues you.

Even if your form of business organization provides personal liability protection, you can become personally liable if you agree to it in a contract. For example, some banks may not be willing to lend money to a small corporation unless you, as a principal shareholder, agree to guarantee the corporation's debt. For example, SBA loans usually require the personal guarantee of any owner with a 20 % or more ownership interest in the business. In this case, you are personally liable to the extent of the loan to the corporation. If the corporation does not or cannot repay the loan, then the bank can look to you, and your personal assets, for repayment.

There is another instance in which corporate or LLC status will not provide you with personal protection. Even if you have a corporation or LLC, you can be personally liable for failing to withhold and deposit payroll taxes, which are called trust fund taxes (employees’ income tax withholding and their share of FICA taxes, which are held in trust for them) to the IRS. This liability is explained in Chapter 29.

Access to Capital

Most small businesses start up using an owner's personal resources or by turning to family and friends. However, some businesses need outside capital – equity and/or debt – to get started properly. A C corporation may make it easier to raise money, especially now. For example, access to equity crowdfunding, which allows businesses to raise small amounts from numerous investors, is effectively limited to C corporations (S corporations cannot have more than 100 investors; partnerships and LLCs would have difficulty in divvying up ownership among an ever-changing number of owners). Equity crowdfunding for accredited investors (net worth more than $1 million, excluding a principal residence or income exceeding $300,000) obviously works best for C corporations (unless the shareholder limit on S corporations is waived by a legislative change that was pending when this book was published; see the Supplement for any update).

For non-accredited investors (those who do not qualify as accredited investors because they don't have annual income of $200,000, or $300,000 with a spouse), equity crowdfunding investments are capped at up to 10 % of annual income for those with income over $100,000, or up to $2,000 or 5 % of annual income, whichever is greater, for investors with annual income under $100,000.

Lack of Profitability

All businesses hope to make money. But many sustain losses, especially in the start-up years and during tough economic times. The way in which a business is organized affects how losses are treated.

Pass-through entities allow owners to deduct their share of the company's losses on their personal returns (subject to limits discussed in Chapter 4). If a business is set up as a C corporation, only the corporation can deduct losses. Thus, when losses are anticipated, for example, in the start-up phase, a pass-through entity generally is a preferable form of business organization. However, once the business becomes profitable, the tables turn. In that situation, C corporations can offer more tax opportunities, such as fringe benefits. Companies that suffer severe losses may be forced into bankruptcy. The bankruptcy rules for corporations (C or S) are very different from the rules for other entities (see Chapter 25).

Fringe Benefits

The tax law gives employees of corporations the opportunity to enjoy special fringe benefits on a tax-free basis. They can receive employer-provided group term life insurance up to $50,000, health insurance coverage, dependent care assistance up to $5,000, education assistance up to $5,250, adoption assistance, and more. They can also be covered by medical reimbursement plans. This same opportunity is not extended to sole proprietors. Remember that sole proprietors are not employees, so they cannot get the benefits given only to employees. Similarly, partners, LLC members, and even S corporation shareholders who own more than 2 % of the stock in their corporations are not considered employees and thus not eligible for fringe benefits.

If the business can afford to provide these benefits, the form of business becomes important. All forms of business can offer tax-favored retirement plans. Corporations make it possible to give ownership opportunities to employees. Corporations – both C and S – can offer employee stock ownership plans (ESOPs) in which employees receive ownership interests through a plan that is much like a qualified retirement plan (see Chapter 16). Certain C corporations can offer employees an income tax exclusion opportunity for stock they buy or receive as compensation. For 2017, 50 %, 75 %, or 100 % of the gain on the sale of qualified small business stock (explained in Chapter 7) is excludable from gross income, depending on when the stock was acquired, as long as the stock has been held for more than five years. C corporations can also offer incentive stock option (ISO) plans and nonqualified stock option (NSO) plans (see Chapter 7). The tax law does not bar S corporations from offering stock option plans, but because of the 100-shareholder limit (discussed earlier in this chapter), it becomes difficult to do so.

Nature and Number of Owners

With whom you go into business affects your choice of business organization. For example, if you have any foreign investors, you cannot use an S corporation, because foreign individuals are not permitted to own S corporation stock directly (resident aliens are permitted to own S corporation stock). An S corporation also cannot be used if investors are partnerships or corporations. In other words, in order to use an S corporation, all shareholders must be individuals who are not nonresident aliens (there are exceptions for estates, certain trusts, and certain exempt organizations).

The number of owners also presents limits on your choice of business organization. If you are the only owner, then your choices are limited to a sole proprietorship or a corporation (either C or S). All states allow single-member LLCs. If you have more than one owner, you can set up the business in just about any way you choose. S corporations cannot have more than 100 shareholders, but this number provides great leeway for small businesses.

If you have a business already formed as a C corporation and want to start another corporation, you must take into consideration the impact of special tax rules for multiple corporations. These rules apply regardless of the size of the business, the number of employees you have, and the profit the businesses make. Multiple corporations are corporations under common control, meaning they are essentially owned by the same parties. The tax law limits the number of tax breaks in the case of multiple corporations. Instead of each corporation enjoying a full tax benefit, the benefit must be shared among all of the corporations in the group. For example, the tax brackets for corporations are graduated. In the case of certain multiple corporations, however, the benefit of the graduated rates must be shared. In effect, each corporation pays a slightly higher tax because it is part of a group of multiple corporations. If you want to avoid restrictions on multiple corporations, you may want to look to LLCs or some other form of business organization.

Tax Rates

Both individuals and C corporations (other than PSCs) can enjoy graduated income tax rates. The top tax rate paid by sole proprietors and owners of other pass-through businesses is 39.6 %. The top corporate tax rate imposed on C corporations is 35 %. (There is some political support for reducing the top corporate tax rate.) Personal service corporations are subject to a flat tax rate of 35 %. (The domestic production activities deduction in Chapter 21 effectively lowers the top rate to less than 32 % for corporations that are eligible to claim it.) But remember, even though the C corporation has a lower top tax rate, there is a 2-tier tax structure with which to contend if earnings are paid out to you as dividends – tax at the corporate level and again at the shareholder level.

While the so-called double taxation for C corporations has been eased by lowering the tax rate on dividends, there is still some double tax because dividends remain nondeductible at the corporate level. The rate on qualified dividends for most taxpayers is 15 % (zero for taxpayers who are in the 10 % or 15 % tax bracket; 20 % for those in the 39.6 % tax bracket).

The tax rates on capital gains also differ between C corporations and other taxpayers. This is because capital gains of C corporations are not subject to special tax rates (they are taxed the same as ordinary business income), while owners of other types of businesses may pay tax on the business's capital gains at no more than 15 % (zero if they are in the 10 % or 15 % tax bracket; 20 % if they are in the 39.6 % tax bracket). Of course, tax rates alone should not be the determining factor in selecting your form of business organization.

Social Security and Medicare Taxes

Owners of businesses organized any way other than as a corporation (C or S) are not employees of their businesses. As such, they are personally responsible for paying Social Security and Medicare taxes (called self-employment taxes for owners of unincorporated businesses). This tax is made up of the employer and employee shares of Social Security and Medicare taxes. The deduction for one-half of self-employment taxes is explained in Chapter 13.

However, owners of corporations have these taxes applied only against their salary and taxable benefits. Owners of unincorporated businesses pay self-employment tax on net earnings from self-employment. This essentially means profits, whether they are distributed to the owners or reinvested in the business. The result: Owners of unincorporated businesses can wind up paying higher Social Security and Medicare taxes than comparable owners who work for their corporations. On the other hand, in unprofitable businesses, owners of unincorporated businesses may not be able to earn any Social Security credits, while corporate owners can have salary paid to them on which Social Security credits can be generated.

There have been proposals to treat certain S corporation owner-employees like partners for purposes of self-employment tax. To date, these proposals have failed, but could be revived in the future.

The additional Medicare surtaxes on earned income and net investment income (NII) are yet another factor to consider. The 0.9 % surtax on earned income applies to taxable compensation (e.g., wages, bonuses, commissions, and taxable fringe benefits) of shareholders in S or C corporations; it applies to all net earnings from self-employment for sole proprietors, partners, and limited liability company members. The 3.8 % NII tax applies to business income passed through from an entity in which the owner does not materially participate (i.e., one in which the owner is effectively a silent investor).

Restrictions on Accounting Periods and Accounting Methods

As you will see in Chapter 2, the tax law limits the use of fiscal years and the cash method of accounting for certain types of business organizations. For example, partnerships and S corporations in general are required to use a calendar year to report income.

Also, C corporations generally are required to use the accrual method of accounting to report income. There are exceptions to both of these rules. However, as you can see, accounting periods and accounting methods are important considerations in choosing your form of business organization.

Owner's Payment of Company Expenses

In small businesses it is common practice for owners to pay certain business expenses out of their own pockets – either as a matter of convenience or because the company is short of cash. The type of entity dictates where owners can deduct these payments.

A partner who is not reimbursed for paying partnership expenses can deduct his or her payments of these expenses as an above-the-line deduction (on a separate line on Schedule E of the partner's Form 1040, which should be marked as “UPE”), as long as the partnership agreement requires the partner to pay specified expenses personally and includes language that no reimbursement will be made.

A shareholder in a corporation (S or C) is an employee, so that unreimbursed expenses paid on behalf of the corporation are treated as unreimbursed employee business expenses reported on Form 2106 and deducted as a miscellaneous itemized deduction on Schedule A of the shareholder's Form 1040. Only total miscellaneous itemized deductions in excess of 2 % of the shareholder's adjusted gross income are allowable; if the shareholder is subject to the alternative minimum tax, the benefit from this deduction is lost.

However, shareholders can avoid this deduction problem by having the corporation adopt an accountable plan to reimburse their out-of-pocket expenses. An accountable plan allows the corporation to deduct the expenses, while the shareholders do not report income from the reimbursement (see Chapter 8).

Multistate Operations

Each state has its own way of taxing businesses subject to its jurisdiction. The way in which a business is organized for federal income tax purposes may not necessarily control for state income tax purposes. For example, some states do not recognize S corporation elections and tax such entities as regular corporations.

A company must file a return in each state in which it does business and pay income tax on the portion of its profits earned in that state. Income tax liability is based on having a nexus, or connection, to a state. This is not always an easy matter to settle. Where there is a physical presence – for example, a company maintains an office – then there is a clear nexus. But when a company merely makes sales to customers within a state or offers goods for sale from a website, there is generally no nexus. (However, a growing number of states are liberalizing the definition of nexus in order to get more businesses to pay state taxes so they can increase revenue; some states are moving toward “a significant economic presence,” meaning taking advantage of a state's economy to produce income, as a basis for taxation.)

Assuming that a company does conduct multistate business, then its form of organization becomes important. Most multistate businesses are C corporations because only one corporate income tax return needs to be filed in each state where they do business. Doing business as a pass-through entity means that each owner would have to file a tax return in each state the company does business.

Audit Chances

Each year, the IRS publishes statistics on the number and type of audits it conducts. The rates for the government's fiscal year 2016, the most recent year for which statistics are available, show a very low overall audit activity of business returns.

The chances of being audited vary with the type of business organization, the amount of income generated by the business, and the geographic location of the business. While the chance of an audit is not a significant reason for choosing one form of business organization over another, it is helpful to keep these statistics in mind.

Table 1.2 sheds some light on your chances of being audited, based on the most recently available statistics.

Table 1.1 Federal Corporate Tax Rate Schedule

Table 1.2 Percentage of Returns Audited

*Fiscal year from October 1 to September 30.

Source: IRS Data Book.

Many tax experts agree that your location can impact your audit chances. Some IRS offices are better staffed than others. There have been no recent statistics identifying these high-audit locations.

Past audit rates are no guarantee of the likelihood of future IRS examinations. The $458 billion tax gap for 2008–2010 (the most recent statistics), which represents the spread between what the government is owed and what it collects, has been blamed in large part on those sole proprietors/independent contractors who underreport income or overstate deductions. While the IRS has indicated that it would increase audits of certain sole proprietors and other small businesses, due to budgetary constraints, the number of audits is still on the decline.

Filing Deadlines and Extensions

How your business is organized dictates when its tax return must be filed, the form to use, and the additional time that can be obtained for filing the return. Pass-throughs (partnerships and S corporations) reporting on a calendar year must file by March 15; they can obtain a 6-month filing extension. Calendar year C corporations don't have to file until April 15 (the same deadline for individuals, including Schedule C filers); they too have an extended due date of October 15. The September 15 extended due date gives S corporations, limited liability companies, and partnerships time to provide Schedule K-1 to owners so they can file their personal returns by their extended due date of October 15.

Table 1.3 lists the filing deadlines for calendar-year businesses, the available automatic extensions, and the forms to use in filing the return or requesting a filing extension. Note that these dates are extended to the next business day when a deadline falls on a Saturday, Sunday, or legal holiday.

Table 1.3 Filing Deadlines, Extensions, and Forms for 2017 Returns

*The scheduled due date is April 17, 2018.

**The scheduled extended due date is September 17, 2018.

Exit Strategy

The tax treatment on the termination of a business is another factor to consider. While the choice of entity is made when the business starts out, you cannot ignore the tax consequences that this choice will have when the business terminates, is sold, or goes public. The liquidation of a C corporation usually produces a double tax – at the entity and owner levels. The liquidation of an S corporation produces a double tax only if there is a built-in gains tax issue – created by having appreciated assets in the business when an S election is made. However, the built-in gains tax problem disappears a certain number of years after the S election, so termination after that time does not result in a double tax.

If you plan to sell the business some time in the future, again your choice of entity may have an impact on the tax consequences of the sale. The sale of a sole proprietorship is viewed as a sale of the underlying assets of the business; some may produce ordinary income while others trigger capital gains. In contrast, the sale of qualified small business stock, which is stock in a C corporation, may result in tax-free treatment under certain conditions. Sales of business interests are discussed in Chapter 5.

If the termination of the business results in a loss, different tax rules come into play. Losses from partnerships and LLCs are treated as capital losses (explained in Chapter 5). A shareholder's losses from the termination of a C or S corporation may qualify as a Section 1244 loss – treated as an ordinary loss within limits (explained in Chapter 5).

If the business goes bankrupt, the entity type influences the type of bankruptcy filing to be used and whether the owners can escape personal liability for the debts of the business. Bankruptcy is discussed in Chapter 25.