In our last post, we began discussing the importance of careful planning when selecting the legal form one’s business will take. As we noted, this decision can impact a number of aspects of the business and its owners. The first factor we mentioned which needs to be considered is liability protection.
In addition to this factor, it is also important to consider the issue of income, particularly the desirability of distinguishing between active and passive income for tax purposes. Active income refers to one’s salary, while passive income refers to income from dividends, rentals or royalties—in other words, income which isn’t received for the performance of job-related duties.
When the business form is an LLC, it isn’t possible to distinguish between active and passive income, and owners can therefore end up paying significantly more in employment taxes. When the business form is an S-corporation, though, income can be categorized so that there is ultimately a lighter employment tax burden. It is also possible to do this with a C-corporation, but because dividends are taxed after corporate tax is levied, there is essentially double taxation.
Where exactly business owners want to allocate business earnings can also impact the chosen business form. In some cases, C-corporations may have a lower tax rate than S-corporation, which can be leveraged to fund business growth by retaining earnings in the business and having them be taxed at the corporate tax rate.
Another potential issue is whether the business’ assets are likely to appreciate. If so, it may be beneficial to set the business up as an LLC since when business assets are sold, no distribution is recognized and no tax obligations arise until the assets are actually sold. Contrast that with C- and S- corporations, where business assets are distributed to owners upon dissolution, resulting in tax obligations.
Getting the business form right from the start is important to ensure a business has the best chances of success. Deciding which business form is appropriate is not always a straightforward matter, but having the guidance of an experienced business attorney can be a great help.