tax of a C corporation, most C corporation owners make sure there are no profits at the end of the year. Instead, they use all the write-offs allowed to reduce their net income.
The potential for double taxation does not occur with the other good entities, a limited liability company or a limited partnership. In those entities profits and losses flow through the entity directly to the owner. Thus, there is no entity tax but instead there is a tax obligation on your individual return. Depending on your situation, an LLC or LP with flow-through taxation may be to your advantage or disadvantage. Again, one size does not fit all.
It should be noted here that a corporation with flow-through taxation features does exist. The Subchapter S corporation (also known as the S corporation or S corp), named after the IRS code section allowing it, is a flow-through corporate entity. By filing Form 2553, “Election by a Small Business Corporation,” the corporation is not treated as a distinct entity for tax purposes. A copy of Form 2553 (and other useful tax forms) is found at http://www.corporatedirect.com/start-your-own-corporation/.
With the timely filing of Form 2553, profits and losses flow through to the shareholders as in a partnership.
While a Subchapter S corporation is the entity of choice for certain small businesses, it does have some limits. It can only have one hundred or fewer shareholders. All shareholders must be American citizens or resident aliens, who are foreign citizens working and paying taxes in America. Individuals may list their revocable living trust as a shareholder. That said, corporations, limited partnerships, multiple member limited liability companies, and other entities, including certain trusts, may not be S corporation shareholders. A Subchapter S corporation may have only one class of stock.
In fact, it was the above-named limitations that led in part to the creation of the limited liability company. Because many shareholders wanted the protection of a corporation with flow-through taxation but could not live within the shareholder limitations of a Subchapter S corporation, the limited liability company was authorized.
The Subchapter S corporation requires the filing of Form 2553 by the 15th day or the third month of its tax year for the flow-through tax election to become effective. A limited liability company or limited partnership receives this treatment without the necessity of such a filing.
Another issue with the Subchapter S corporation is that flow-through taxation can be lost when one shareholder sells his stock to a nonpermitted owner, such as a foreign individual or trust. By so terminating the Subchapter S election, the business is then taxed as a C corporation and the company cannot reelect S status for a period of five years. (At http://www.corporatedirect.com/start-your-own-corporation/ is a form that Sub S Shareholders can sign stating that they won’t transfer their shares to a non-permitted shareholder). If you are worried about losing your S corporation status and flow through taxation, the problem can be eliminated by using a limited liability company.
Still, there are plenty of good reasons to use an S corporation, including the minimization of self-employment taxes, as we will explore in Chapter 4.
Both C and S corporations require that stock be issued to their shareholders. While limited liability companies may issue membership interests and limited partnerships may issue partnership interests, they do not feature the same transferability and liquidity (or ease of selling) of corporate shares. Neither limited liability companies nor limited partnerships have the ability to offer an ownership incentive akin to stock options. Neither entity should be considered a viable candidate for a public offering. If stock incentives and public tradability of shares are your objective, you must eventually become a C corporation.
Rich Dad Tips
• If you think you may want to go public at some point in the future but want initial losses to flow through, consider starting with an S corporation or a limited liability company.
• You can always convert to a C corporation at a later date, after you have taken advantage of flowing through losses.
Limited Liability Companies
The limited liability company is a good entity to use in certain situations. Because it provides the limited liability protection of a corporation and the flow-through taxation of a partnership, some have referred to the LLC as an incorporated partnership.
There are two more features that make the LLC unique:
• Flexible management structure
• Flexible allocation of profit and loss These features will be illustrated in our next case.
Case No. 4: Thelma/Millennium Salsa
Thelma was looking to start a salsa business with two partners, Pepe and Hans. They had taken the beneficial step of preparing a business plan. They analyzed the market and their competition. They calculated their expenses, projected conservative revenues, and figured that Millennium Salsa could break even in two years.
The problem was that each partner had his or her own agenda that was difficult to reconcile. They had agreed that for their efforts each was to receive a one-third interest in Millennium Salsa. But beyond that it was looking doubtful that they could structure the business in such a way that it would work. Pepe was putting in $200,000 of start-up money to get the business going. He wanted no part of managing the business but wanted, first, to use any losses to offset other income; and, second, that all of the first profits be paid directly to him until he was paid back $300,000, or one and one half times what he had invested. Hans, on the other hand, was putting his salsa recipe into the company. It was a well-known and world-famous recipe renowned for its freshness and long shelf life, but beyond that, Hans’s contribution to the company would be limited. He had offered to work for the company, but for Thelma and Pepe, who both knew of Hans’s odd work habits and culinary eccentricities, that was more of a threat than a promise.
Thelma was going to work in the business. Her contribution was to spend the next two years—or however long it took—working for a very low wage to make a go of it. She had learned from her cousin Louise that a general partnership was a bad entity to use. The last thing Thelma wanted was for Hans to be out obligating their business to another bizarre food project like the edible mold fiasco.
The management of the business, and keeping Hans out of it, was one issue. But an even bigger issue was how to satisfy Pepe’s demands for all the losses to flow through to him and the first $300,000 in profits to go to him.
Thelma knew that in a Subchapter S corporation when profits and losses flowed through the entity, they flowed rigidly according to the shareholder’s ownership percentage. If you owned 50 percent, then 50 percent flowed through to you. In the case of Millennium Salsa, each person would have a one-third interest in whatever entity was to be used. But they needed to initially distribute more than one third to Pepe.
How could they satisfy Pepe’s demands? Thelma knew she had to figure out some way to get it done or Pepe would not agree to the project.
Thelma went to her part-time bookkeeper, who told her she had to use an S corporation. Thelma was told that Pepe’s demands
