Choice of Business Entity

Entity choice is one of my favorite topics. It reminds me of a chess game. The choice of your business entity is the cornerstone of your tax and legal foundations. Not all entities are taxed in the same fashion, others treat the taxation of a sale of its assets differently, and still others will have varying types of owner’s compensation just to mention a few of the different entity attributes. Other entity choices make switching from one entity to another very expensive. For example, switching a C corporation to an LLC may be a very expensive proposition. But, going the other direction by switching an LLC to a C corporation is usually painless. Nellie Akalp in the following article does an excellent job of discussing more of the pros and cons of entity choice.
                                                                    -Mark Bradstreet

A lot is riding on the business entity type you choose. The business structure you decide on affects your legal liability as an owner, tax obligations, growth potential, and compliance requirements you'll need to satisfy on an ongoing basis. To make matters more complex, the entity type that's right at the beginning of a business's existence may not continue to be the ideal choice as the company grows and evolves.

So, what's an entrepreneur to do? First and foremost, I encourage business owners to consult with a licensed attorney and accountant or tax advisor to get professional guidance. Every situation is unique, so it's critical to have expert advice before making the crucial decisions of choosing a business entity and assessing when it's time for a change.

To help you prepare for your all-important discussions with your legal and financial advisors, the following is food for thought about some of the most popular business entity types.

Business entity basics

1. Sole proprietorship and general partnership

Many small businesses start as either a sole proprietorship (one owner or a married couple) or general partnership (multiple owners). When business owners don’t formally register their companies with the state, they are, by default, considered either a sole proprietorship or general partnership. There is no legal or financial separation between the business and its owners.

Pros of sole proprietorships and general partnerships:

• Inexpensive and straightforward to set up and maintain administratively—Usually, there's no legal formation paperwork required to operate as a sole proprietorship or general partnership. Aside from filing a DBA (fictitious name registration), if someone wants to advertise the business under a name that doesn't include their first and last name, state paperwork is minimal. Compared to other business structures, sole proprietorships and general partnerships have fewer ongoing compliance formalities to fulfill. 
• Pass-through tax simplicity—Business profits and losses flow through to the business owners' individual tax returns, keeping tax filing simple, too.  

Cons of sole proprietorships and general partnerships:

• Personal liability risks—If someone sues the business or the business can't pay its bills, the owners are directly responsible. That means your personal assets (home, retirement savings, etc.) might be taken to satisfy debts or lawsuits. 
• Potentially excessive self-employment tax burden—All taxable business income earned by sole proprietorships and general partnerships is subject to Social Security and Medicare taxes. That 15.3% on all profits can add up to a lofty tax bill.
• Limited opportunities for growth—Sole proprietorships and general partnerships may not sell stock to raise capital. Also, outside investors typically will not fund businesses that haven’t formally registered as a statutory business entity (e.g., LLC or corporation).
• Inability to sell the company—Sole proprietors and general partners may sell their business's assets. However, they may not sell the business entity itself. Also, if a sole proprietorship or general partnership has outstanding debt upon closing, the business owners will be responsible for what's owed, even though they are no longer running the business.  

2. Limited liability company (LLC)

The LLC business structure may be described as a bit of a cross between a sole proprietorship or partnership and a corporation. By default, an LLC is considered the same tax-paying entity as its owners ("members"). However, the LLC is regarded as a separate legal entity from its members. Articles of Organization must be filed with the state to form an LLC. 

Pros of limited liability companies

• Limited liability for owners—The legal separation between the business and LLC members helps protect the business owners' personal assets in the event of legal or financial debts. 
• Tax flexibility—Normally, LLCs receive pass-through taxation, with business income and losses reported on their personal tax returns. However, eligible LLCs may instead elect to be taxed as an S Corporation (more on that later!). 
• Management flexibility—Multimember LLCs can choose to be member-managed or manager-managed. That allows them to decide if the business’s owners will handle the day-to-day management responsibilities or if they will designate a person (or persons) as a manager(s). Most states consider an LLC “member-managed” unless otherwise specified in its formation documents.

Cons of LLCs

• Potentially excessive self-employment tax burden—By default, LLCs are treated as a pass-through tax entity. This means that, like sole proprietors and general partnerships, self-employment taxes apply to all business profits.
• Limited opportunities for growth—While an LLC can add members (unless limited by its operating agreement) to bring additional funds into the business, it cannot raise capital by issuing stock. 
• Limited lifespan—Unless an LLC’s operating agreement states otherwise, an LLC is considered to cease to exist if a member departs from the LLC.

3. C Corporation

A C Corporation is regarded as a separate taxpayer and legal entity from its owners. Business income and expenses are tied to the business, and the corporate entity reports and pays taxes. Ownership of a C Corp is through purchasing shares of stock.

Incorporating as a C Corp involves filing Articles of Incorporation (sometimes called Certificate of Incorporation) with the state. Other state requirements must also be met to start a corporation.

Pros of C Corporations

Most legal protection for owners—The C Corp structure provides the highest degree of liability protection for business owners. Under most circumstances, shareholders, directors, and employees have protection from lawsuits and debts of the corporation. 

Growth potential—C Corporations can have an unlimited number of shareholders and may issue multiple classes of stock. Typically, investors will be more interested in funding companies organized as corporations rather than those operating as other entity types.  

Tax flexibility—Eligible corporations may choose to be taxed as an S Corporation (see more about that in the next section). Often, corporations are eligible for more tax deductions than businesses operating as other business structures. 

Perpetual life—Ownership interests in a corporation may be transferred to others. Shareholders can sell, gift, or bequeath their shares of company stock, and the corporation continues to exist. Only when a C Corp is formally dissolved is its life ended. 

Cons of C Corporations

More compliance complexity and costs—In most states, it costs more to incorporate a business than to form an LLC. There are more internal and external rules to start and operate a C Corp, such as appointing a board of directors, drafting bylaws, filing an initial report, filing annual reports, etc.

Double taxation—A C Corporation's profits get taxed at the federal corporate income tax rate. Then they are again taxed to shareholders when the corporation distributes those profits as dividends. This creates a double tax because the dividends paid do not qualify as tax deductions for the corporation. Another potential disadvantage from a shareholder's individual tax perspective, is that they may not deduct any loss of the corporation on their personal tax returns.  

Overview of the S Corporation election for LLCs and corporations

The S Corporation is a tax election that qualifying LLCs and corporations can choose.

The benefit for LLCs is that S Corp election can reduce the amount of self-employment tax business owners must pay. An LLC taxed as an S Corp still gets pass-through tax treatment (tax obligations pass-through to the owners' returns), but only the wages and salaries of business owners on the company's payroll are subject to Social Security and Medicare taxes. Any profit distributions paid to owners do not have those taxes levied on them.

To request S Corporation election, an LLC must file IRS Form 8832 (to be taxed as a corporation) and IRS Form 2553 (to choose S Corporation election).

S Corp tax treatment allows corporations to avoid the sting of double taxation. As an S Corporation, a corporation's profits and losses flow through to shareholders' personal tax returns. The corporate entity does not pay income tax. Shareholders who are employed by the corporation pay Social Security and Medicare taxes on their wages or salaries from the company, but the dividend income paid to shareholders is not subject to those taxes.

Note that S Corporations may not exceed 100 shareholders. Therefore, corporations with more than that are not eligible for S Corp election.

Is your business entity type still the right one for you?

Business owners operating as a sole proprietor, general partnership, or LLC may find that their business is outgrowing the limitations of their entity type. A few things that might drive entrepreneurs to consider changing their business structure include:

• Wanting to add employees
• Desiring to bring on a new partner or co-owner
• Seeking funding from investors
• Wanting to reduce self-employment tax payments
• Planning to sell the business
• Planning to retire

The process to switch from one business entity type to another will vary by business structure and in which state the business is operating. An attorney and accountant can help determine whether a change may be beneficial. Also, a lawyer can advise on the correct steps to take to change business entities. Details are often available on states’ Secretary of State websites, as well. 

Ideally, when starting your business, it’s helpful to think both short-term and long-term about what structure will best serve your needs and vision. With some research, reaching out to the right resources for guidance, you will be empowered to make an informed decision. 

Credit Given to:  Nellie Akalp is a passionate entrepreneur, business expert, professional speaker, author, and mother of four. She is the Founder and CEO of CorpNet.com, a trusted resource and service provider for business incorporation, LLC filings, and corporate compliance services in all 50 states. Nellie and her team recently launched a partner program for legal, tax and business professionals to help them streamline the business incorporation and compliance process for their clients.

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.

This Week’s Author, Mark Bradstreet, CPA

–until next week.