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Tax and Legal Aspect of of Businesses

Incorporation; Legal and Tax consequences

 

Based on your objective, line of business and legal status, we assist you in selecting a more suitable form of legal entity; (a) sole proprietorship, (b) corporation, (c) S corporation, (d) partnership, (e) limited liability company (LLC), etc. We explain the legal and tax implications of each entity to assist you in deciding on the type of entity.

 

We incorporate the business and file the necessary legal documents with government agencies. If appropriate, we include provisions such as “right of first refusal” or “spousal consent” in the bylaws, or draft a separate agreement or contract, to protect you from being forced to work with strangers in case of departure of a co-owner.

 

Following are the most commonly used business entities:

 

Sole Proprietorship

A sole proprietorship or sole ownership is the simplest version of doing business.  This is an individual conducting business without being a legal entity such as an LLC. If the individual wants to use a name other than her or his, she or he may select a fictitious name also known as “Doing Business As (DBA)”, which is generally registered with the County where the business is operated.

 

For liability purposes, a sole proprietor has unlimited personal liability to business creditors. Therefore, this type of entity may not be the best choice for risk averse business owners.

 

For income tax purposes, a sole proprietor is considered an individual taxpayer and files the IRS form Schedule C contained  in the income tax return, and is subject to quarterly estimated tax payments,  and is held liable for his or her taxes and the employees’ payroll taxes (trust fund  recover penalty).

 

A sole member of a limited liability company (LLC) is considered an individual for income tax purposes, unless elected to be treated as a corporation.

 

Tax Tip:  Based on tax practitioners’ experience, Schedule C s with revenue in excess of $100,000 are more susceptible to an IRS audit than an average taxpayer. Therefore, you may consider incorporating the business once the revenue exceeds $100,000 per year.

 

Corporation

A corporation is a legal entity established under state law for conducting business.

Provided that a corporation is incorporated properly and maintained in conformity with law, stockholders or owners of the stock of a corporation may not be held personally liable for the business debts.

 

The corporate officers may be held personally liable under the “duty of care” and other statutory responsibility to the stockholders. They may also be held liable for the employment tax purposes; trust fund recovery penalty.

 

For federal income tax purposes, a C corporation is recognized as a separate legal and taxpaying entity.

 

A corporation conducts business with the public, realizes revenue, deductions and net income or losses, pays taxes and distributes profits to shareholders also known as dividends.  The stockholders in turn pay income tax on the dividends.

 

Because the dividends are not tax deductible for the corporation, the stockholder may be paying income tax twice; once at the corporation and once in their own individual tax return. This is the theory of the double taxation. In addition, shareholders cannot deduct any losses of the corporation in their personal tax returns.

 

Tax Tip: To mitigate double taxation, it may be advisable to have an S corporation or a Limited Liability Company (LLC).

 

S Corporation

S corporations enjoy the same legal protection as C corporations. For federal tax purposes, S corporations elect to pass each individual stockholder’s share of the corporate profit, loss or credit through K-1 to the shareholders.

 

Shareholders of S corporations flow-through their share of the corporate income, losses or credits on their individual tax returns and pay tax at their individual tax rates. Therefore, S corporations avoid double taxation by elimination corporate income tax.

 

In addition, Stockholders of S corporation deduct their losses generated at S corporation up to the amount of their capital in the business known as “stock basis”.

 

In order to qualify for S corporation status, the corporation must meet the following IRS requirements:

 

1) Be a domestic corporation;

2) Have only allowable shareholders;

            i) including individuals, certain trusts, and estates; and,

            ii) may not include partnerships, corporations or non-resident alien shareholders.

3) Have no more than 100 stockholders;

4) Have only one class of share;

5) Not be an ineligible corporation;  certain financial institutions, insurance companies, and domestic international sales corporations.

 

Partnership

A partnership is created when two or more persons join forces together to carry on a trade or business for profit. Owners of a partnership are called “partners”. Each partner contributes cash, non-cash property, labor or talent, and shares in the profits and losses of the business.

 

Partner’s share of profits or losses may not be proportional to the contributed capital. Generally, partners of a “general partnership” are held jointly and severally liable for the business debts, regardless of their capital contribution. In other words, a 1% general partner may lose his or her wealth because of another partner’s misconduct. There are limited partnerships where the limited partners’ liability is limited to their respective capital only.

 

For federal tax purposes, a partnership files an annual IRS Form 1065 called “information tax return” to report the business income, deductions, gains, losses, etc.. However, it does not pay income tax. Instead, it “passes through” any profits or losses to its partners through K-1 and partners include it in their individual income tax returns the IRS Form 1040.

 

Partners who actively participate in running the business must pay Social Security and Medicare taxes in addition to income tax on their K-1 income. Partners are subject to quarterly estimated taxes.

 

Although, a general partnership doesn’t pay income taxes, it involves some of the most complicated tax issues.

 

Limited Liability Company (LLC)

A Limited Liability Company (LLC) is a legal entity created under state statute. States use different regulations, and you should check with your state to ensure that your desired entity is allowed.

 

Some types of businesses cannot be LLCs, such as banks and insurance companies. In California professional services such as medicine, law, accounting, and medicine cannot be LLCs.

According to knowledgeable authors, there is no legal reason for this restriction and it is purely politics. Owners of an LLC are called LLC members.

 

Generally states do not limit ownership of an LLC and members may be individuals, corporations and other LLCs. Most states such as California permit one member LLC or “single-member” LLCs (SMLLCs).

 

For federal income tax purposes, depending on election made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return (a “disregarded entity”).

 

Some lawyers elect domestic LLCs with at least two members to be taxed as partnerships and file the partnership tax returns.

 

Share of income, losses and credits of each member is reported under K-1 and each member includes it in their respective personal income tax returns.

 

An LLCs may elect to be treated as a corporation for federal income tax purposes by filing the Form 8832 and affirmatively electing to be taxed as a corporation.

 

And a Single Member LLC with only one member is considered as disregarded entity for income tax purposes, but a separate entity for purposes of employment tax and certain excise taxes, unless elects to be treated as a corporation.

 

Tax Tip:  Members’ of an LLC may deduct their losses up to the amount of their capital in the LLC. According to the IRS, since each member of an LLC has limited liability, investors are analogous to limited partners under IRC § 469. For purposes of passive loss rules, LLC members are treated as limited partners, even if the taxpayer is a member-manager.

 

Zaher Fallahi, CPA has practiced as a CPA since 1983. He has been known as Orange County Doctor's CPA, Los Angeles Doctor's CPA, has specialized in advising Dentists and Physicians and other medical and health care professionals with their taxes, accounting and incorporation since 1992. Zaher Fallahi, CPA, Esq, practices as Los Angeles Business Attorney and Orange County Business Attorney. Telephones: LA (310) 719-1040 and Orange County (714) 546-4272, e-mail: taxattorney@zfcpa.com

 

 

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Read Zaher Fallahi's article published by the American Bar Association  GLSA Section  https://glsa.memberclicks.net/legal-and-tax-implications-of-business-entities

 

To help with your incorporation, contact us at:

(310) 719-1040 (Los Angeles)

(714) 546-4272 (Orange County)

e-mail taxattorney@zfcpa.com

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