Not sure you are selling a product? Do you collect sales tax? Is the ‘product’ sold within your state (assuming you are not a reseller)? If you answer no, then chances are, you’re a service-orientated business. If yes, you may be a product-orientated business.

1. Selling a product eliminates a personal service corporation*, which brings a C corporation into the picture.

* A personal service corporation pays a flat 35% tax at the corporate level. This is a complex definition, the main part you want to ask is, and "Does the product generate more than 50% of the overall revenue of the corporation?" If so, your entity may flunk the test and not be considered a PSC.

Selling a Product without a Partner:

1. No partner would eliminate the LLC taxed as a partnership as a possibility. Sometimes, an LLC will have an advantage and therefore you may want to "bring in" a partner for a 2-5% ownership.*

*If you bring a partner into an LLC, there are two tests the IRS or someone else attempting to challenge the partnership status will look for:

1. Did the 2-5% partner make a separate capital contribution for their interest?
2. Does the 2-5% partner receive a K-1 at the end of the year and distributions if any are made?

2. Do you meet the S corporation requirements as a shareholder? If you do then go to question number 3. Click here to read the S corporation requirements. If not the C corporation may be your choice of entity.

3. Does the individual who wants to form this new entity earned income from other sources than this new business? If not, then the salary will be all from this new business which leaves the option open of saving SE taxes with the S corporation.

4. Are you looking for fringe benefits like the ability to deduct 100% of your health insurance premiums, a $50,000 life insurance policy? If so, then this is a characteristic of a C corporation. If you are the owner of more than 2% of a S corporation, then you would not be entitled to fringe benefits.*** In other words, most S corporation owners own more than 2% of the stock, so they would not be entitled to fringe benefits offered.

***Other fringe benefits include; Holiday gifts of nominal value, incentive stock options, options under employee stock purchase plan, employee accident and health plans, long term care insurance and benefits, educational assistance programs, employee achievement awards, meals and lodging and cafeteria plans, qualified moving expense reimbursement.

5. Is it important for employee/owners to be able to borrow against their qualified pension plan? If so, the C corporation is your best entity. This is a minor reason to consider the C corporation. You may determine the business will start funding a qualified pension plan and you anticipate some year down the road one of the best ways to access more money to grow the business is through borrowing money from the C corporation’s qualified pension plan. If this is the case then this may be an important consideration in your situation. In general, this may leave room to take money out of your pension plan and not use the pension plan for its intended purpose, to support you during retirement.

6. Is a fiscal year end important? This is especially important during the later months of the year. Many people look to incorporate in November or December to defer paying taxes. If they received that money personally they would pay tax on it for this current year. But if you received the money in a C corporation you could defer the tax for 12 months! Unfortunately, many of these people attempting this strategy are a service orientated business which means they would be a personal service corporation, which means they have to have a calendar year end! The S corporation will not deter your personal income tax for 12 months. It is possible they may have saved some SE taxes or the 2.9% if they were already above the $80,400 level. Unfortunately, companies when they sell C corporations in November and December each year do not tell you about this problem.

7. Will the new entity have losses? Expect them to flow to your person return, or do you need them to carry forward in a C corporation? If you are starting a new business and this is your main source of income, you may have very little in salary during that first year. If this is the case, having losses flow through to you during that first year may not be that beneficial since you have little income to offset. You may decide to have that income loss flow through to your company and offset profit in year two. This can only happen with a C corporation.

8. Do you expect to be expanding your business the first few years and have a little profit, perhaps the C corporation lower tax rates will be more beneficial for you. For example, if this is a side business and you are already in a high personal tax bracket, you may want a C corporation the first few years and pay tax at lower tax rates. Some companies do need to be realistic about what their net profits may be during the first year or two. Many companies underestimate the cash flow needed and expenses involved in getting the company off the ground.

9. Do you require a second class of stock? Some companies have common and preferred stock for investors. If this is your case then you can only be a C corporation.

10. Are you planning on going public? If so, then a C corporation is your only option.

11. Would you be a personal holding corporation? Meaning you are going to receive 40% as passive income and you have less than 5 stockholders. If so, then you would want to be an S corporation because a PHC will pay 39.6% on any undistributed profits in your C corporation.

S vs. C Corporation of a Product Business with
$40,000 in Net Profit with a One Owner Company
Earning $40,000 also as an Employee.

12. What are the expected net profits before salary of your business? Let’s take a couple of examples;

1. The net profit before your salary is $40,000 first year.

   1. Let’s examine an S corporation.

1. First, you must meet all the requirements for an S corporation shareholder.
2. Let’s assume you are not intending on going public.
3. Let’s assume a fiscal year end is not that important.
4. Let’s assume the individuals do not have to borrow from their pension plan (a C Corporation advantage).
5. There are no losses to flow through to worry about.
6. Let’s assume you still have a job that you earn money as an employee where your health insurance is taken care of and you are not concerned about C corporation fringe benefits.
7. Let’s assume you earn $40,000 as a W-2 employee.
8. Let’s assume you do not have a large inventory of receivables or other assets in the new business (this is referring to how it is difficult to protect the stock of an S corporation).

1. Corporate level tax =$0-a flow through entity.
2. Tax at personal level on $40,000 in net profits less salary. You could take a $15,000 salary that would be subject to 15.3% (because $40,000 as an employee plus $15,000 equals $55,000, which is still less than the $80,400 limit for SE taxes). $15,000@ 15.3%=$2295 plus personal tax on the $15,000 plus the $25,000 flow through will add to your personal income of $40,000 already in this example. You would have a total of person income of $40,000 + $15,000 + $25,000=$80,000. This is taxed at the highest end in the 31% tax bracket.

3. Compare this to the tax rate if you were a C corporation.

1. In the C corporation, $40,000 in net profits would be taxed at 15% tax=$6,000.
2. Personally, you earned $40,000. That would be taxed in the 28% rate. This would equal $3,937.50 in tax on the first 15% and the other $40,000-$26,250=$13,750 x 28%=$3,850 in tax plus 15.3% on the $40,000=$6,120 or a total of personal tax of $13,907.50.
3. Corporate and personal tax =$6,000 + $13,907.50=$19,907.50. Again this does not take into account state taxes.
   
   

4. Compare S corporation taxes vs. C corporation taxes for a product business with one owner. The owner has a $40,000 salary from another job, and the entity earns $40,000 in net profit. The C corporation will pay overall less tax then the S corporation ($19,907.50 vs. $27,896) because of the lower tax brackets of the C corporation and the individual, vs. just having all the money flow to the individuals tax return with an S corporation. Yes, with the S corporation we saved some SE taxes but that did not make up for the 15% tax rate of the $40,000 in net profits in the C corporation.

5. In this case, the C corporation would be a better choice for an entity from a tax point of view.

6. Other advantages:

1. Fiscal year end, a way to defer paying the taxes the first year.
2. Fringe benefits available. This may allow for some additional deductions by the C corporation.
3. Ability to protect the stock of the C corporation by an LLC taxed as a partnership (you can not do this with an S corporation)

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