Every entrepreneur seeking to start a small business must decide under what form the business will operate. As I discussed in a previous post, if the small business owner does not decide, the state will decide on that entrepreneur’s behalf.
A corporation is a legal entity that exists distinctly from its owners. As publicly traded companies must almost always be corporations, most large companies take this business form.
Forming a corporation requires filing Articles of Incorporation with the Secretary of State’s office. Because of its distinct existence, its owners—known as shareholders—are not liable for any of the debts or obligations of the business. If the business is sued or goes bankrupt, plaintiffs and creditors will have access only to those assets belonging to the business.
Unless the shareholders were personally involved in the alleged wrongdoing or personally guaranteed business debt, plaintiffs and creditors cannot reach any of the personal assets of the shareholders. The corporate form therefore serves as a liability shield.
The legal distinction between the corporation and its shareholders can sometimes be taken to the extreme. This is nowhere more prevalent than with the issue of taxation. A corporation is taxed as a separate legal entity, meaning that profits are taxed according to rates and rules unique to this business form.
Then when those profits are passed to the shareholder’s as dividends, they are taxed again as the personal income of the shareholder. This is the case even where there is only one shareholder.
So, as an overly simplistic example, if a corporation wholly owned by a single shareholder has an annual profit of $100,000, those profits would be subject to federal income tax at the corporate level—which at this time would amount to approximately $22,250—leaving $77,750 to distribute to the shareholder or retain for future investment in the business: an effective corporate tax rate of 22%.
If the sole shareholder decided to distribute all of the profits, those profits would then be subject to another layer of taxation at the shareholder’s individual level. If the shareholder had an effective tax rate of 12%, the federal government would take an additional $9,330, leaving $68,420 of the original $100,000 profit, a total effective tax rate of 31.6%.
This is without considering any corporate and personal income tax the state may impose. As of 2013, Arkansas, for example, has a top corporate tax rate of 6.5%—though the 6% rate would probably apply in the example above—and a top personal income tax rate of 7%.
As with almost all federal taxes, there is a booming tax-avoidance industry surrounding the corporate income tax. This tax is extremely complex and makes various deductions, loopholes, and credits available. In addition, various tax-planning strategies exist that allow the business to show little or no profit despite actually making money.
While these tax-planning strategies—which include paying deductible salaries to shareholders working for the business and increasing discretionary business expenses to enhance the lifestyle of the shareholders—are available, the double taxation often makes the corporation an undesirable business entity for the small business owner.
For small businesses, therefore, Congress has created the S Corporation, which allows the company’s profits to pass through to the shareholders to be taxed only at the individual level, somewhat similarly to the LLC. This helps avoids the issue of double taxation.
There are several important restrictions associated with operating as an S Corporation, however, which I will discuss in a future post. It is therefore important to speak with your tax advisor about your individual circumstances before making a decision. A false step could result in incursion of double taxation as described above.