Entity Choices

There are many types of paperwork in this business to worry about, but one of the most important to start out with is the business itself. There are many different types of business structures to consider when starting out. Everyone that is getting in this business wants to know what type of entity to use for their business, but the right answer is that it depends on the situation. Most investors don’t realize it but the first decision that they make for an entity may be great at that time, but it may change drastically as time goes on and their business changes. Don’t get tied in and caught up in an entity or name and realize that you can start them and end them very easy, and they are all replaceable. So let’s run down the different types of entities and what makes them good. Here is where I also let you know that I am not an attorney or a CPA, blah blah blah. Of course the age old types that we as investors should never use are sole proprietorship and partnerships. These types of structures are not advantageous from a tax standpoint for one, but the other reason is the lack of liability protection. For both of these types of entities there is no barrier between yourself and your company. The sole proprietorship is you interfacing with the public directly with no shield. The partnership is worse because you may be liable for the actions of your partner as well. So the next up is the corporation(general). The corporation is a structure where ownership is held via stock. Because of this structure there is a lack of liability for the stockholders. The only exposure that there is becomes the investment in the company itself. A corporation may have as many stockholders as it likes. Here are some more things to consider;Advantages *Owner’s personal assets are protected from business debt and liability *Corporations have unlimited life extending beyond the illness or death of the owners *Tax free benefits such as insurance, travel, and retirement plan deductions *Transfer of ownership facilitated by sale of stock *Change of ownership need not affect management *Easier to raise capital through sale of stocks and bonds Disadvantages *More expensive to form than proprietorship or partnerships *More legal formality *More state and federal rules Closed Corporation: There are a few minor, but significant, differences between general corporations and closed corporations. In most states where they are recognized, closed corporations are limited to 30 to 50 stockholders. In addition, many closed corporation statutes require that the directors of a closed corporation must first offer the shares to existing stockholders before selling to new shareholders. This type of corporation is particularly well suited for a group of individuals who will own the corporation with some members actively involved in the management and other members only involved on a limited or indirect level.S Corporation: With the Tax Reform Act of 1986, the S Corporation became a highly desirable entity for corporate tax purposes. An S Corporation is not really a different type of corporation. It is a special tax designation applied for and granted by the IRS to corporations that have already been formed. Many entrepreneurs and small business owners are partial to the S Corporation because it combines many of the advantages of a sole proprietorship, partnership and the corporate forms of business structure. S Corporations have the same basic advantages and disadvantages of a general or closed corporation with the added benefit of the S Corporation’s special tax provisions. When a standard corporation (general, closed or professional) makes a profit, it pays a federal corporate income tax on the profit. If the company declares a dividend, the shareholders must report the dividend as personal income and pay more taxes. S Corporations avoid this "double taxation" (once at the corporate level and again at the personal level) because all income or loss is reported only once on the personal tax returns of the shareholders. However, like standard corporations (and unlike some partnerships), the S Corporation shareholders are exempt from personal liability for business debt. S Corporation Restrictions: To elect S Corporation status, your corporation must meet specific guidelines. As a result of the 1996 Tax Law, which became effective January 1, 1997, many of these qualifying guidelines have been changed. A few of these changes are noted below: *Prior to the 1996 Tax Law, the maximum number of shareholders was 35. The maximum number of shareholders for an S Corporation has been increased to 75. *Previously, S Corporation ownership was limited to individuals, estates, and certain trusts. Under the new law, stock of an S Corporation may be held by a new "electing small business trust." All beneficiaries of the trust must be individuals or estates, except that charitable organizations may hold limited interests. Interests in the trust must be acquired by gift or bequest -- not by purchase. Each potential current beneficiary of the trust is counted towards the 75 shareholder limit on S Corporation shareholders. *S Corporations are now allowed to own 80 percent or more of the stock of a regular C corporation, which may elect to file a consolidated return with other affiliated regular C corporations. The S Corporation itself may not join in that election. In addition, an S Corporation is now allowed to own a "qualified subchapter S subsidiary." The parent S Corporation must own 100 percent of the stock of the subsidiary. *Qualified retirement plans or Section 501(c)(3) charitable organizations may now be shareholders in S Corporations. *All S Corporations must have shareholders who are citizens or residents of the United States. Nonresident aliens cannot be shareholders. *S Corporations may only issue one class of stock. *No more than 25 percent of the gross corporate income may be derived from passive income. *An S Corporation can generally provide employee benefits and deferred compensation plans. *S Corporations eliminate the problems faced by standard corporations whose shareholder-employees might be subject to IRS claims of excessive compensation. Not all domestic general business corporations are eligible for S Corporation status. These exclusions include: * A financial institution that is a bank; *An insurance company taxed under Subchapter L; * A Domestic International Sales Corporation (DISC); or *Certain affiliated groups of corporations. Keep in mind, these lists of qualifying S Corporation aspects are not all-inclusive. In addition, there are specific circumstances in which an S Corporation may owe income tax. For more detailed information about these changes and other aspects regarding S Corporation status, contact your accountant, attorney or local IRS office. How to File as an S Corporation: To become an S Corporation, you must know the mechanics of filing for this special tax status. Your first step is to form a general, close or professional corporation in the state of your choice. Second, you must obtain the formal consent of the corporation's shareholders. This consent should be noted in the corporation's minutes. Once the filing is approved, your company must complete Form 2553, Election by a Small Business Corporation. This form must be filed with the appropriate IRS office for your region. Please consult the IRS' instructions for Form 2553 to determine your proper deadline for completing and submitting this form. You must prepare and submit the IRS Form 2553 as part of your incorporating process. Limited Liability Company’s (LLC) or LLCs have long been a traditional form of business structure in Europe and Latin America. LLCs were first introduced in the United States by the state of Wyoming in 1977 and authorized for pass-through taxation (similar to partnerships and S Corporations) by the IRS in 1988. With the recent inclusion of Hawaii, all 50 states and Washington, D.C. have now adopted some form of LLC legislation for both domestic and foreign (out of state) limited liability companies. Many real estate investors believe LLCs present a superior alternative to corporations and partnerships because LLCs combine many of the advantages of both. With an LLC, the owners can have the corporate liability protection for their personal assets from business debt as well as the tax advantages of partnerships or S Corporations. It is similar to an S corporation without the IRS restrictions. The income or loss from the LLC passes through the company to the personal income tax return of the owners. This is especially important when dealing with rental property. As your rental property is considered a passive investment, by allowing the funds from your rentals to flow through to your personal return it tremendously reduces the tax implications of owning real estate. This is the primary reason that owning rental property has always been a preferred investment vehicle of the rich. One of the main disadvantages of LLC is the same as with S Corps is that at the end of the year you must allow all income to “flow through” to the tax return, which on a good year could be painful to your return. This fact also means that you cannot regulate the income that you make with a salary. It is also important to note that an LLC may also elect to be taxed as a C Corp instead of the “default” election as an S Corp. This is a separate election that you must take via a form 8832 when forming the LLC or within the first 6 months of operation. This is an uncomplicated version and does have certain inherent disadvantages due to the informality and the lack of documentation for certain financial and operations issues that may be impacted if a suit were imminent. It is important to understand that a corporation is the only entity that can stand on its own as a person can, which helps in corporate credit, but is not necessarily the top choice in all cases. The choices are many, but it is important to decide one way or another, don’t delay get a business going so that when it is time to get started you are prepared.