"C" Corporations
Regular or "C" corporations are companies that pay income taxes separately from the shareholders. Since dividends are double taxed (once at the corporate level as profits, and again as investment income to the shareholders), closely held "C" companies rarely declare dividends. The big advantage to a "C" corporation tax status is that you can load up on fringe benefit plans, thus subsidizing some of your personal lifestyle. Also, investments made through a "C" corporation can yield some tax advantage, since dividends received by one "C" corporation from stock held in another "C" corporation (all publicly held companies are "C" corporations) receive a 80% tax exemption.

Generally "C" corporation status is used by people with a mature business who no longer have large personal cash needs, but want to tuck money away for retirement, child care, various insurance needs, etc. Also, the tax rate structure and quarterly estimate complexity for individuals tend to cause companies with profits over $1,000,000 to become "C" corporations.

If Congress keeps the cap on dividend tax rates at the 10% and 15% tax rates, C-corporations may become more attractive than S-corporations for small business owners. This occurs because the big advantage of C-corporations is that you can load up on fringe benefit plans. The disadvantage is that dividends are double taxed (once at the corporate level, and again on your personal return). However, combined payroll taxes are roughly 10%. So, if you are double taxed at 10% on C-corporation dividends versus the same 10% if you took the profit out as wages, the main disadvantage of a C-corporation status goes away while all the advantages remain.

Limited Liability Companies
Because limited liability companies (LLCs) are so flexible as to fit almost any tax classification, the IRS responded with a regulation called "check the box." Essentially, if you form an LLC the IRS will let you choose what tax status you wish. Also, it is easier to change tax status with an LLC, since you keep the same employer identification number. This allows enormous flexibility in tax planning, but can also cause much more confusion for business owners and even their accountants and attorneys.

We suggest that you think about utilizing the LLC for new start-up businesses (or one you acquire). Usually there are losses for the first and possibly second year of a new business, most often because of equipment writeoffs. With the LLC you can "check the box" for partnership status during those first couple years to provide unlimited tax loss flow-through to your personal return. Then when the business starts to make a profit, you can switch the status to "S" corporation so that a portion of the profits will be exempt from self-employment and payroll taxes.

Tax Traps
In all types of business status, watch for fringe benefit disallowances. For example, partners in partnerships and more than 2% shareholders in "S" corporations are prohibited from deducting any participation in a cafeteria plan, group medical plan, or any other fringe benefit offered to employees, except retirement. Retirement plan contributions for sole proprietors and partners do not count against the self-employment tax, and the maximum contribution for any profit sharing type of plan (Keogh, SEP, SIMPLE, profit sharing, 401(k), etc.) or money purchase (sometimes called defined contribution plans) are limited to less than the maximum for employees. Be sure to ask your tax advisor about any fringe benefit plans you are considering offering.

Tax Payments
A number of business owners have asked us about comparing quarterly estimated payments to regular payroll withholding. Sole proprietors and partners have no choice but to use the quarterly estimate method. If you pay yourself wages as a sole proprietor or partner in a partnership, then you can cause yourself a huge tax headache as the IRS forces you to reclassify the tax payments. We have seen refunds of payroll withholding from sole proprietors who improperly declared wages on themselves while the IRS simultaneously assessed them for missing their quarterly estimated tax payments, then assessing them penalties and interest, and finally levying the business owner. The net result is that the reclassification and demand for payments exceeds the refund of improperly transmitted payroll tax withholding.

If you are a "S" corporation (as most small businesses are), you have the option of utilizing either the withholding method or the quarterly estimated tax method, or a combination of both. We feel the payroll withholding method is often superior for several reasons. First, you can make "bite sized" payments each pay period rather than choke on huge quarterly payments. Second, if you are late on a quarterly payment, you can be assessed an underpayment penalty at the year end, even if you are entitled to a refund in some cases. There is no such penalty for not giving the government money fast enough with withholding. If you saved the tax payments in a money market all year and withheld all of it in a big lump sum at year end, there still would be no underpayment penalty, and you would keep the interest income instead of letting the government earn interest on your money. Third, by taking out a bit of withholding as you go, you do not have to worry about forgetting the quarterly estimate dates, which come at somewhat irregular intervals.