One of the most important tax decisions an owner can make about his new business is made at formation. One common mistake is to jump to the conclusion that every business needs to be a corporation. In actuality, corporations have only a small niche where they are applicable. The tax problem with a corporation is that under the current federal tax system every dollar taken out of a corporation is taxed twice. Yes, you heard correctly—two times. This happens due to the preconceived notion that the corporation and ownership of a corporation are two different persons. Because there are two different persons the corporation (the business) is taxed first when it makes a profit, and the owner is taxed when they receive the profit made by the corporation as a dividend. Both taxes are income taxes one resulting from management’s decisions, and the other resulting from the owner’s decision to invest. As with many norms, there is an exception to the double taxation for corporations. However, as with most exceptions, the IRS tightly monitors its use. To avoid double taxation of a corporation the US tax law in subchapter C allows management to obtain a reasonable salary. Management’s salary is a business expense as opposed to a dividend or payout to shareholders. There is another way to completely avoid the double taxation regime altogether, and that is to treat the corporation as an “S Corporation” under Subchapter S. S Corporations have the benefit of being a passed through entity for taxation purposes. Pass through taxation allows the owners to directly claim the profits and losses of the company on their personal taxes—hence the name pass through.
Another option, especially for foreign nationals, is to form a limited liability company (LLC). The LLC allows its owners to retain the limited liability of the corporation, and to decide on the type of taxation they prefer. The owner has the ability to under the “check the box” regulations to decide whether he would like to be taxed as a corporation—double taxation—or as a partnership, also called pass through taxation like the S Corporation (an S Election can also be taken by the LLC if the prerequisites for an S Corporation are met). Thus, the LLC has two distinct tax benefits. The LLC has only a single income tax on company profits, and an LLC allows its owners to claim losses. However, it should be noted, owners single member LLC’s and Managing Members for multi-member LLC’s will be subject to self-employment as well as income tax on income generated from the business.