Small Business

Incorporating to Reduce Liability


While it's a good idea to protect your assets by forming an LLC or corporation, finding the right format to avoid extra taxes is critical

Q: I'm a licensed realtor and my wife is a loan officer. We formed a limited liability company (LLC) to protect our assets and reduce taxes when we bought our first home recently. However, now we're wondering whether we'd be better off if we each formed separate corporations. Can you give us some advice? —F.R., Las Vegas

A: While an LLC or corporation (BusinessWeek, Aug./Sept, 2007) is valuable to protect your personal assets from potential business liability, you'd probably be better off if each of your businesses were operated through separate entities, experts say. "With both your real estate business and your wife's business as a loan officer operated in a single entity, each of your creditors can access the assets of the other's business. If each business were operated by a separate entity, the creditors of one business would not have access to the assets of the other business, so long as the entities are adequately capitalized, corporate formalities are properly observed, and you don't make the choice to grant the creditor access to additional assets by granting a guarantee in your individual name or your spouse granting a guarantee in her name or from her business," says Julia Stift, an attorney at Nossaman, Guthner, Knox & Elliott in Los Angeles.

Limited liability companies and corporations provide similar liability protection. Traditional corporations, called C corporations, are taxed separately from their owners, creating what is commonly called "two levels of taxation," Stift explains. Simply put, if the corporation earns $100,000, it is subject to tax on its income, leaving a lesser amount for distribution, say $70,000. Upon distribution of money to the corporation's owners, the owners must now pay income tax on the distributed amounts. That leaves less expendable income than if the business had been conducted directly by the business owners.

Choosing the Right Corporate Structure

Businesses with 75 or less shareholders may elect to be treated as S corporations. An S-corp is known as a "pass-through" entity, which means it's not subject to corporate tax as is a C corporation. Instead, the S-corp's income is reported and taxed on its owners' personal income tax returns, so the income "passes through" the corporation to the individual for tax purposes. Thus, S-corps provide liability protection while eliminating the two levels of taxation problem inherent with C-corps.

Limited liability companies are similar to S corporations in that they are pass-through entities whose income is taxed on the personal income tax returns of their owners rather than at an entity level, Stift says.

There are other considerations you should take into account when you think about which business entity to choose, however. Which entity is most desirable for your businesses will depend in large part upon state income tax laws. While neither an S-corp nor an LLC is subject to federal income taxation, states differ in how they treat these entities for state income taxation purposes. They sometimes impose taxes on one form of business and not another. "The appropriate form of entity may also depend on your cash flows, as sometimes the state fees and taxes imposed on one form of business are measured by the entity's income and those imposed on the other are measured by the entity's gross receipts," Stift notes.

You'd be smart to speak with a local attorney or CPA about the particular tax consequences of the various business entities in your state. Look for someone who works with small business startups and gets good recommendations from your or your spouse's colleagues.

Karen E. Klein is a business journalist who covers small-business issues for several national publications. She writes her Smart Answers column twice a week.

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