Forming a business entity is fairly easy, but each type of entity has its strengths and weaknesses. There is no question that operating as a sole proprietorship is not a good idea. It is important to form an entity that is separate from the owners for legal, tax and other considerations.

A corporation is by far the most common form of business entity for installing security companies, but limited liability companies (LLCs) are increasingly receiving attention from business owners. The following is a brief definition of each entity and some advantages and disadvantages for each.

 Please keep in mind that the information is from a tax and accounting standpoint only and does not consider legal ramifications. For legal advice be sure to consult with an attorney. Every situation is unique. It is also important to consult with a competent tax professional before deciding upon a particular type of entity.

Considering Incorporation

Corporations are distinct legal entities. They have shareholders and report their income and expense as a separate entity. Corporations that do not elect to become Small Business Corporations (S corporations) are referred to as C corporations, and generally pay tax on their income at the corporate level. This can cause what is referred to as double taxation.

A C corporation pays tax on its income. When the residual profits (retained earnings) are distributed to the shareholders, they are taxed to the shareholders as dividends. Consider the following example: The C corporation has earnings of $100,000 and pays tax of $16,750. This leaves $83,250 to be distributed to the shareholders. The shareholders would then pay tax on the dividends. With the maximum individual tax rate at 35%, this could mean an additional $29,000 or more in taxes. Such a scenario can result in total tax rates approaching 60% for corporations earning more than $300,000.

Many C corporations avoid taxation at the corporate level by paying a “bonus” to the stockholder(s) at year end roughly equivalent to the corporate earnings. The bonus is treated as salary expense, thereby reducing the corporate earnings to zero and the stockholder(s) report the amount as wages.

This approach is only a short-term solution for a security company. As alarm company owners know — and, unfortunately, few tax practitioners understand — the recurring monthly revenue (RMR) of a security company may be its greatest asset. When an alarm company sells these assets, the proceeds of the sale are income to the C corporation.

For a company with RMR totaling $83,000, the proceeds would probably be around $3 million. The corporate tax on $3 million is approximately $1.02 million. This would leave nearly $1.98 million to be distributed to the owner(s) (shareholders). The tax on dividends of $1.98 million could be as much as $670,000 for a total of $1.69 million or 56% of the proceeds. 

One way to avoid the double taxation is for the C corporation to elect S corporation status. By virtue of its S corporation status, a small business corporation is typically not considered a taxable entity. There are some restrictions on S corporations. For example, S corporation stockholders must typically be individuals (no corporations or certain other entities), must have one class of stock (with some exceptions) and may not have more than 100 shareholders (with some exceptions).

Since an S corporation is typically not a taxable entity, its taxable income is “passed through” to its shareholders, who report the income on their personal tax returns. Not only does this eliminate the end of year bonus issues discussed above, it presents a huge advantage if RMR is sold.

Assuming the same RMR sale discussed above, the S corporation would pay no tax and pass the proceeds to its shareholder(s). The RMR would be considered a capital asset and the gain on its sale would be substantially a long-term capital gain. Currently, long-term capital gains are taxed at 15%, so the tax bill could be as low as $450,000. 

Another advantage of S corporations is that its net income is not considered “employment income” to shareholders. This means it is not subject to “self-employment” tax (Social Security and Medicare), which is substantial at 15.3%.

It is important to remember that an employee/shareholder cannot manipulate this situation by taking a nominal salary so as to avoid any employment taxes. The Internal Revenue Service reviews the wages paid to owners of S Corporations to determine if the salary is reasonable by industry standards. Shareholder(s)/employees must take a reasonable salary to avoid scrutiny by the IRS. 

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