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1. As stated here, the Social Security and Medicare taxes totaled 15.3 percent, while most people think in terms of 7.65 percent being withheld from their payroll checks. We use the 15.3 percent, as that includes not only the employee contribution but also the employer contribution of 7.65 percent. In the case of stockholders/employees, you can envision the corporations’ cash and the stockholders’ cash as being held in one big bucket. Any disbursement for taxes by the corporation and/or the stockholders/employees comes out of that bucket.
How Incorporating Can Result in Tax Savings
2. If you own an S corporation that was a C corporation at one time, the S corporation may have to pay its own taxes on certain income, such as some capital gains.
3. Robert A. Cooke. How To Start Your Own S Corporation. 2001, New York: Wiley, 2d edition.
The Alternatives to Forming a Corporation
A he corporate form of doing business can answer the needs of many businesses, and within the corporate form there is more flexibility in that either a C corporation or an S corporation can be elected. Also, a change from a C corporation to an S corporation and vice versa can be made, albeit that change can be made only once every five years. Even then, it may be that another form of business structure would better fit your situation. In case that is true, this discussion of those other forms should provide some help in making a decision.
We have already discussed this at some length. Beyond simplicity, it is difficult to find a reason to do business in this form, given its exposure to unlimited liability. For small businesses with a taxable income of less than $90,000, there is an additional disadvantage in that all taxable
INCORPORATE YOUR BUSINESS
income is subject to Social Security and Medicare tax, even the income that is reinvested in the business rather than providing a spendable income to the owner.
Like the sole proprietorship, a general partnership is the default organization if two or more people start a business together. Although it does, like a corporation, allow for additional owners, there is strenuous bookkeeping involved in keeping track of who owns how much of the business and who takes home how much of the profits. In this basic form, it provides no limited liability. There is a further disadvantage in our general partnership in that the bookkeeping when partners enter or withdraw from the partnership is complex and definitely requires guidance from a knowledgeable tax professional to get it right. Failure to handle the bookkeeping correctly can lead to a tax disaster.
If there are no changes in ownership during a year, the bookkeeping for a partnership is little different from that for a sole proprietor. Indeed, he could visualize the partnership as two or more sole proprietors working together in a business venture. The taxable income is computed as in the example in Chapter 2 and then allocated to each partner. This allocation is computed in accordance with the partnership agreement (every partnership should have one), or if that is not addressed in the agreement, the taxable income is allocated in the same percentage as each partner’s ownership in the partnership (commonly called the partnership interest) is to the total ownership. The result is that the taxable income allocated to each partner is taxed at the partner’s individual tax rate, and net income includes earnings that are retained in the partnership and not distributed to
The Alternatives to Forming a Corporation
the partner. We have already heard about that situation, as it arises in an S corporation as discussed in Chapter 2. Also, if the partnership business is small and there are many partners, so each share of the taxable income is less than $90,000, each partner ends up paying Social Security tax on money he or she may never receive. And all partners pay Medicare tax on all of their share of taxable income.
If you get an uncontrollable urge to form a partnership, first look at forming a limited liability company (LLC), which is discussed later.
Despite this preference for LLCs, there are still many general partnerships in existence.
This is a special form of partnership in which the inactive, or passive, partners do not participate in management and are therefore granted limited liability by state law. There has to be one general partner who does have unlimited liability for the debts of the partnership, although this disadvantage can sometimes be overcome by forming a corporation (with limited liability) to be the general partner. This business form is little used today as, again, a limited liability company is usually easier to manage.
Limited Liability Company (LLC)