Choosing the Right Business Entity for Your Needs and That of Your Company
- Grey Bell | J.K. Boatwright & Company, P.C. 06/20/12
One of the most common questions tax practitioners are asked today is what form of legal entity should a business owner establish and operate their business under. This question is asked for not only start-up businesses but for preexisting businesses as well. The correct answer to this question is far from easy and can change over time depending on the facts and circumstances of the business owners and the financial climate with which they operate. While you have to consider the non-tax legal considerations for the entity that you choose such as liability protection, which is a key element to consider when entering into a new business, the central consideration should be the tax consequences of the type of entity that has been chosen and the effects the entity chosen will have on the business and the owners tax situation.
There are a number of business entities to choose from with the core of the entities being a corporation (C and S), a partnership, or a Limited Liability Company (LLC) (if recognized by your state). Before a decision can be made as to the type of entity the business and its owner(s) wish to operate they first have to decide the specific nature of the corporation, partnership, or LLC they desire based on the non-tax implications, as well as the tax implications they have decided are important.
For instance, a corporation can elect to be treated as a “C” or an “S” corporation both of which have totally different tax treatments. If you choose to be a partnership, you can select differing levels of control and liability such as general or limited partnerships offering general or limited control and financial exposure. And for LLC’s, you can elect to be treated as a partnership or a corporation, or you can choose to be a single member LLC if there is only one deemed owner and they wish to be disregarded for tax purposes. Remember also that once you have chosen to be a specific type of entity, you are not stuck with that entity permanently. There are provisions within the tax code that allow for flexibility between entities. But, always remember to look out for the tax traps when making a change and always consult your tax professional.
In general, each one of the business entities has its plusses and minuses and none of the entities are better than the other although each practitioner tends to have a favorite and one that they are more experienced and knowledgeable at handling than the others. As mentioned above, choosing the right business entity depends on the need of the business and its owner(s). In order to give you a better idea about the various entities and to help you best choose the entity that’s right for you the below listed summary has been compiled to show the main advantages and disadvantages of each.
C Corporation – This entity type is owned by the shareholder(s) of the corporation via stock and it pays tax at the entity level. These companies are typically your international businesses and publicly traded companies but some are operated as small tax paying entities to simplify the reporting for the individual owner(s). A single individual can own this type of entity.
- Entity is taxed as its own separate business entity
- No limitation as to the number of shareholders (one or more) or the types of shareholder (foreign shareholders and other business entities allowed).
- No restrictions on the classes of stock ownership (multiple classes can exist with preferential payouts)
- No personal liability of the shareholders to the creditors of the entity unless there is personal neglect or the corporate veil is pierced
Any taxable accounting year can be chosen (calendar or fiscal)
- Double Taxation (taxed at corporate filing level and on corporate distributions)
- If a loss corporation, losses held up at entity level even if money at risk
- Increased reporting and record keeping (required board meetings and minutes at least annually)
- Not ideal for real estate and investment holdings. No preferential capital gains tax
Reasonable compensation requirements must be met
“S” Corporation – These entities are typically small closely held businesses. They provide liability protection similar to that of a Corporation. The activity of this business is passed on to its owners who subsequently report it on their returns and thus there is no entity level tax. These entities can also be owned by a single individual.
- No personal liability of the shareholders to the creditors unless there is personal neglect, the corporate veil is pierced, or you personally guarantee debt.
- No corporate income tax. Instead, gains, losses, deductions, and credits are passed on to the shareholder and are claimed on the individual shareholders return and paid at the shareholders rate maintaining their classifications.
- If losses result from operations, they are passed thru and can be deducted on the individual’s return, if certain circumstances are met.
- Distributions, if certain circumstances are met, are typically not subject to a second level of tax (i.e. distributions can be tax free).
- FICA tax is not owed on regular business earning of the corporation, only on salaries paid out.
- S-corporations are not subject to accumulated earnings tax like C-corps on undistributed earnings. No personal holding company characterization risks.
Reasonable compensation must be paid to owner/operators. This could be an advantage due to the savings resulting on the payroll taxes for self-employed individuals.
- There are certain restrictions on the number and type of shareholders that can own an interest. For example, you cannot have more than 100 shareholders (husband and wife are considered one) and corporations, nonresident aliens and most estates and trusts cannot be a shareholder.
- S-corporations cannot own subsidiaries unless the subsidiaries are 100% owned S-corps (or QSubs).
- Only one class of stock is allowed.
- You cannot gain basis in your stock to deduct losses from personally guaranteed debt. Basis only comes from capital contributions into the S-corporation and personal loans.
- Limitations on the tax favored fringe benefits for greater than 2% owners.
- Generally you must operate on a calendar year unless certain circumstances are met
- If once a C-Corp, and profitable, there may be BIG tax implications (built in gains tax issues)
- Must pay reasonable compensation to owner/operators. But, this can also be an advantage depending on the determined reasonable comp which in turn helps to control payroll taxes.
Generally, S-corporations must recognize gain on the distribution of appreciated property
Partnership - This entity type is two or more people or businesses co-owning a business for a profit who then share in the activities of the business based on their agreed upon ownership structure as reflected in the partnership agreement. In general, there are two main types of partnerships. While there are other types, the main two types which will be discussed below are general and limited partnerships.
General Partnership (GP) – All partners are general partners:
- Easy formation as compared to corporations and simple structure with no limitations generally as to the number and type of partner.
- Partners can combine resources and share financial commitment.
- Pass-thru tax treatment meaning typically no entity level tax. Thus, the entity, depending on the ownership structure, is not subject to double taxation.
- Special allocations, if desired, are allowed as long as economic substance exists and they are agreed upon by the partners.
- Because the partnership is a general partnership they are able to get basis from the debts of the business in order to deduct losses, if incurred.
No unreasonable compensation exposure to owners because partnerships are not to pay W-2 wages to owners.
- If profitable, there can be unlimited self-employment tax issues on ordinary business income (no control over SE taxes).
- Personal liability. Generally, each partner is liable for the debts and obligations incurred by partnership and all of its general partners.
- In many cases, the partnership will dissolve automatically when a partner dies, files bankruptcy, retires, resigns or otherwise discontinues his interest in the partnership unless another means is agreed upon to continue business.
- Generally there is no central control unless agreed upon in that any partner can enter into obligations on behalf of the partnership.
Difficulty in attracting investors and raising money due to the personal liability issues that exist.
Limited Partnerships (LP) – consists of at least one general and one limited partner:
- Generally, limited partners are only responsible for company liabilities to the extent of their investments. No personal liability unless otherwise agreed to by the limited partner via personal guarantees with creditors. Thus, they can share in the profits without being totally at risk.
- Special allocations, if desired, are allowed as long as economic substance exists and they are agreed upon by the partners in the partnership agreement.
- Basis in debt if personally liable for debt (would apply to general partners and limited partners with personal guarantees).
- For the general partners, they maintain control over the day to day operations and future decisions of the company.
Typically, an LP is rather stable in that is does not dissolve by the insolvency, retirement, incapacity or death of a limited partner.
- Self-employment tax issues for the general partners.
- Lack of control for limited partners. Typically the business operations are run and decided upon by the general partner(s). Limited partners have no implied authority to represent or bind the partnership.
- General partners typically have unlimited liability.
More legal documentation and operating requirements than general partnerships.
- General Partnership (GP) – All partners are general partners:
Limited Liability Company (LLC) – This is a business entity created under state law which has characteristics of both a corporation and a partnership with typically none of the down sides. This entity type also has the choice to be taxed as a partnership, corporation (either C or S), or in the case of a single member LLC, elect to be taxed as a disregarded entity for tax purposes.
- Limited liability for both the limited (passive) members as well as the managing (general/active) members.
- If a member does decide to personally guarantee debts of the LLC, then personally liability could exists which would in turn provide them basis to deduct losses as long as the LLC did not elect corporation status.
- Ability to choose the type of tax entity the LLC wishes to operate under with the ability to change later if desired.
- Because an LLC is a hybrid entity, if partnership status is elected, the entity can act as a partnership using special allocations and other advantages but does not suffer the burden of personal liability unless intentionally entered into by members.
Depending on the type of entity type elected, could have any of the advantages of the above noted entities.
- Self-employment tax issues for member managers (general partners of the LLC) if they elected partnership status or are a single-member LLC disregarded.
Depending on the type of entity elected if other than partnership treatment, C or S Corp, they could have any of the disadvantages as outlined above.
As can be noted above and as mentioned, each entity has its plusses and minuses. But, don’t let the number of advantages or disadvantages listed or lack thereof deter you from deciding to be a specific type of entity. If you decide to go into business with a group of individuals or by yourself, make sure that you look at all of these entities as a whole. Make sure to consult your professional advisors to discuss all of your options as well as what it is you are looking to achieve and how you are going to achieve it. Certain entities are best suited for certain circumstances and in some instances, it is better to start out as one type of business entity and then switch to another type down the road as business picks up or the set of circumstances and facts change. At the end of the day, every entrepreneur wants to be successful with their endeavors so make sure you start off on the right foot with choosing the best entity for the needs of you and your business.
- C Corporation – This entity type is owned by the shareholder(s) of the corporation via stock and it pays tax at the entity level. These companies are typically your international businesses and publicly traded companies but some are operated as small tax paying entities to simplify the reporting for the individual owner(s). A single individual can own this type of entity.
About the author:
Grey Bell is a CPA that has been practicing for 9 years. He was trained in Atlanta before moving to LaGrange to start a family. His main area of expertise is closely held businesses and personal taxation for the individual owners. Grey is also experienced with audit, review, and compilation engagements as well as general business and tax consultations and planning.
J.K. Boatwright & Company, P.C.
15 North Lafayette Square
LaGrange, GA, 30241
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