One of your best individual clients is thinking about starting up a new business
ID: 2346126 • Letter: O
Question
One of your best individual clients is thinking about starting up a new business, and he is seeking your advice on which business form he should select. In particular, he's trying to decide whether to operate the business as a partnership or a C corporation. Explain to him the significant tax and nontax issues that will arise from choosing each of these entities as compared to the other, including how income will be treated by the entity, the overall tax burden, and the effect of distributions of property or earnings from the entity to your client.Explanation / Answer
A sole proprietor files on Schedule C of Form 1040 and pays self-employment tax on self-employment income. The sole proprietor also pays income tax. A C-Corporation files form 1120 generally and pays its own income tax. Corporations are not subject to self-employment tax, but the owners of the corporations are again subject to income tax on amounts distributed to them as dividends, interest, compensation, etc. Therefore, income is taxed twice. Additional tax considerations include the deductibility of health insurance, retirement, and fringes/plan items (the owner of a C-Corporation can also be an employee with benefits deductible to the corporation). A sole proprietor may employ his/her spouse and in turn get self-coverage through the spouse, as a slight loophole. C-Corporations get the benefit of Section 1202 and 1244 stock sales (exclude portion of gain / get a portion of ordinary loss treatment on final disposition). Sole proprietorships must sell all the assets and liabilities of a business separately, as stock cannot simply be transferred. A sole proprietor without employees will end up with a lot less paper work than a person who organizes a C-Corp and then proceeds to act as an employee of the C-Corp. The paperwork can be both time consuming and expensive, not to mention the cost of mistakes. This includes IRS tax forms, but also things like corporate bylaws, certificates, registrations, meetings, etc. Legally, a sole proprietor will be liable for debts arising in the ordinary course of business.... although a sole proprietor can also technically elect C-Corp status with the IRS and continue with sole proprietor status for everything else (generally, noting de-facto corporations and corporations by estoppel, etc.). With a C-Corporation, the corporation itself is generally liable, not the owner who retains personal protection with respect to personal assets. There are instances, however, where the owners of C-Corporations can be legally liable for the corporate debts, such as when an owner acts fraudulently.
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