Figuring out the type of business to open is only half the battle of an entrepreneur. Your choice of business structure will largely determine how your business income will be taxed. The most popular and familiar legal forms of business are C corporations, S corporations and Limited Liability Companies (LLCs).

These may look like just a few simple words on a page, but they could mean thousands of dollars to your bottom line. Many business owners choose S corporations because they provide limited liability, income flow-through to their individual income tax returns and tax-free merger benefits. But like other business structures, S corporations have their disadvantages. If you already have or intend to elect this entity or any other entity, you should understand how they are structured so you can establish a financial plan.

C corporations

With the C corporation, income may be subject to tax at two levels: first, to the corporation at corporate tax rates and then, again to the shareholders when distributed as dividends. Not surprisingly, tax planning for closely held corporations often centers around finding tax-efficient ways to withdraw profits from the company. Traditionally, double taxation has been one of the C corporation's biggest drawbacks.

However, double taxation can be avoided if owners working in the business draw reasonable salaries. The corporation deducts the salaries and the owners pay tax on the amounts they receive. Since the enactment of the Jobs and Growth Relief Reconciliation Act of 2003, the lower rates on dividends have temporarily lessened the impact of double taxation. Owners of closely held companies should consider renewing their compensation/dividend decisions carefully in view of the dividend rate break. In some situations, paying a bonus will result in more overall tax (income and FICA) than paying a dividend.

When incorporating a new small business, consider taking the precautionary measure of qualifying the stock as "Section 1244" stock. If you later suffer a loss on the stock, you would be able to deduct it as an ordinary loss up to $50,000 ($100,000 if married filing jointly), with any excess treated as capital loss. Ordinary loss treatment is a significant advantage because of the limitations on deducting capital losses - they are deductible only to the extent of capital gains and up to $3,000 of ordinary income per year. You should speak with your financial team about this option.

S corporations

Many business owners elect subchapter S status for their corporations to avoid the double taxation issue. S corporations are treated as a regular corporation. When forming S corporations, you must first incorporate under your state law. An S corporation generally does not pay federal corporate taxes. The company passes through its income, losses, deductions and credits to the owners for inclusion on their tax returns. Furthermore, you must designate directors, officers and shareholders who function in the same manner as their regular corporation counterparts. Recent tax laws increased the maximum number of S corporation shareholders to 100 and with only one class of stock. Beginning in 2005, family members (including current and former spouses) are allowed to elect to be treated as one shareholder for purposes of determining the number of S shareholders of an S corporation. Some of the rules for S corporations can be confining, so be sure you can live with these restrictions before deciding to elect S status.

Those currently with C corporations should proceed with caution when deciding to convert to the S election because of the built-in gains tax. This tax applies when a former C corporation sells an asset that had built-in gains when the S election was made. Keep in mind that this is only an issue during the first ten years as an S corporation. Several rules and exceptions apply, so check with your CPA before moving forward.

Limited Liability Company (LLC)

LLCs offer liability protections similar to the corporations. However, LLCs are typically taxed as partnerships. Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. Unlike the S corporation, there is no maximum number of members in an LLC. Most states also permit "single member" LLCs - those having only one owner. All LLC income, losses, deductions and credits "flow through" to the owners. This means that earnings of an LLC are taxed only once. LLC members may agree to divide these items any way they see fit as long as the allocations have substantial economic effect. This gives the LLC members a considerable amount of tax planning flexibility.

LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Other features of LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation. A few types of businesses generally cannot be LLCs such as banks, insurance companies and nonprofit organizations. Check your state's requirements and the federal tax regulations for further information. There are also special rules for foreign LLCs.

There are advantages and disadvantages to all business structures and understanding the complexities in the tax laws relating to each can be challenging. Before making your decision, be sure to evaluate the pros and cons of each entity type with a business consultant or CPA to determine which structure makes the most sense for your business.

SIDEBAR: New S Corporations Rules

  • Beginning in 2005, the American Jobs Creation Act of 2004 (the Act) allows suspended losses to be transferred with transfers of S stock to a spouse or former spouse incident to divorce.
  • For distributions after 1997, the Act permits an S corporation to use distributions on stock held by its Employee Stock Option Plan (ESOP) to repay loans, provided the stock of at least equal value is allocated to participant accounts.
  • The Act allows an IRA to hold S corporation bank stock that the IRA held on the enactment date with the IRA owner treated as the shareholder and allows the stock to be sold to the beneficiary for fair market value upon the corporation making an S election.
  • Beginning in 2005, the Act disregards unexercised powers of appointment in determining potential current beneficiaries of a special type of trust for holding S stock known as electing small business trust (ESBT), and increases the period during which a trust can dispose of stock after an ineligible shareholder becomes a potential current beneficiary from 60 days to a year.

Michael Oates is a certified public accountant and tax principal with Rothstein Kass-Certified Public Accountants (, one of the top 20 largest international accounting and consulting firm based in the U.S. He regularly work with entrepreneurial companies in various industries.