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A Subchapter S corporation is the same as a corporation, except that it has met the appropriate IRS requirements that allow it to elect not to be taxed at the corporate level. Instead, all profits are deemed to have been distributed to the shareholders and must be reported on their personal income taxes (even if the profits are retained by the company and not actually distributed). Additionally, shareholders who work for the corporation must be paid "reasonable" wages (i.e., don't try to hide company profit by inflating your salary). In the past, the highest corporate tax rate was higher than the highest individual rate, so it made sense for highly profitable corporations to try to elect Subchapter S status. Today the situation is reversed, and thus new businesses are often electing to establish themselves as limited liability companies instead.

A limited liability company (LLC) is designed to provide the limited liability features of a corporation and the flexibility of a partnership. Owners of the LLC are called members. LLCs, like corporations, are charted under state law. Many states now support the formation of single-member LLCs. Though not necessarily required, many LLCs will have the organizational cost of establishing a legal operating agreement outlining ownership interest, member responsibilities, etc., in addition to the cost of registering the LLC with the state. Without an operating agreement, the default laws in the state's statute will govern the LLC. For tax purposes, the profits of an LLC pass through to its members. In the case of a single-member LLC, profits are accounted for on Schedule C just as with a sole proprietorship. For multi-member LLCs, taxation is the same as that of a partnership. The disadvantages of an LLC are as follows:

  • Forming an LLC is more complex than forming a partnership but less complex than forming and operating a corporation.
  • The members must pay tax on all profits, even those retained by the business.
  • Members actively involved in running the business will owe self-employment tax to cover the Medicare and Social Security contribution that an employer would usually pay.
  • Members may become personally liable as a result of their own acts or conduct (but they may avoid liability for the acts of other members).
  • Members' medical insurance premiums are not directly tax deductible from business income (they can be deducted as an adjustment to income but do not reduce self-employment tax).

Although corporations and LLCs are touted as protecting their owner's personal assets, in practice this may not always be the case. As the owner of a new business, you may be asked to personally guarantee business credit card applications, lease agreements, etc. If this is the case, then you may find yourself forfeiting your legal liability in those instances. Also, in corporations and LLCs with fewer than 10 members the courts may "pierce the corporate veil" and hold shareholders responsible for corporate debts if the corporation has failed to observe required formalities (such as annual meetings), has intermingled personal and corporate assets, significantly undercapitalized the business, etc. If limited liability is an important reason you are choosing to organize as a corporation or LLC, make sure to get a list of guidelines from your attorney and accountant as to how to best maintain your corporate veil.

Good luck weighing the pros and cons of the various business structures available. If you have any questions, please email me at fictionaddiction@juno.com or post your query to the BookThink Open Shop Bookstores Forum but keep in mind that I'm not a lawyer or an accountant, so please double-check all advice with the appropriate members of your power team.

Stay tuned for the remaining parts of this article:

Part IV - Registering Your Business
Part V - Creating Your Business Logo

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