284 ENTREPRENEURSHIP
yond his or her proportionate capital contributions except for “insiders” in cases of se-
curities fraud or violations of the tax code.
A corporation is taxed as a separate entity according to the corporate tax code and
rates. Dividends declared by the corporation are “after-tax” from the firm’s point of
view, and are then taxed again at the shareholder level. This is known as the “double tax-
ation” problem. To get around this, entrepreneurs often resort to tactics regulated by the
Internal Revenue Service under the Federal Tax Code. These tactics usually revolve
around issues of salary and interest expense.
Interest expense is deductible from a corporation’s pretax profits and, therefore, re-
duces its tax liability. This may tempt an entrepreneur to lend the new venture money
for start-up and expansion capital instead of taking an equity position. This practice is
legitimate—up to a point. Under section 385 of the Federal Tax Code, a thinly capital-
ized company (one with a debt/equity ratio over 10:1) can have its debt reclassified as
equity. Also, if the debt does not look like debt because, for example, it has conditional
payment schedules instead of fixed coupon rates, it may be reclassified as equity. This
means that what were tax-deductible interest payments are now double-taxed dividends.
The losses of regular corporations accumulate and can be used as tax shields in future
years. The losses of proprietorships and partnerships are passed along to the principals
in the year they are incurred. One exception to this involves “section 1244 stock.” If this
type of stock is selected in the firm’s initial legal and tax organization, the owners of the
firm can deduct their losses from their regular income if the business goes bankrupt. If
they selected a regular corporation, their losses are treated as capital losses at tax time.S Corporation. An S corporation is a special vehicle for new small businesses that
enables them to avoid the double taxation of regular corporations. To qualify for S cor-
poration status, the firm must:- Offer only one class of stock (although differences in voting rights are allowable)
- Be wholly owned by U.S. citizens and derive no more than 80 percent of its income
from non–U.S. sources - Have 35 or fewer stockholders, all of whom agree to the S corporation status
- Obtain no more than 25 percent of its revenue through passive (investment) sources
Although S corporations are incorporated under state law, for federal tax purposes
they resemble partnerships. Usually, stockholders receive the profits or losses of the firm
proportionally. This percentage is deemed a dividend. The monies paid to shareholders
are considered self-employment income but are not subject to self-employment tax.
Limited Liability Company (LLC). The limited liability company is a relatively new
type of business organization that shares characteristics with both corporations and part-
nerships. Like a corporation, an LLC is legally a separate entity that provides liability
protection for its owners. However, when it comes to taxes, LLCs are treated like part-
nerships: The LLC does not pay taxes itself and all profits and losses flow through
directly to LLC owners and are reported on their tax returns.
Although a corporation is characterized by four basic characteristics (limited liability,
continuity of life, centralized management, and free transferability of interests), an LLC