One of the most important decisions you’ll make for your company is what form of business organization – or business entity– your organization will be.
What are the advantages and disadvantages of your business being a C corporation? An S corporation? A limited liability company? A partnership?
Today’s business owners have many options to choose from when it comes to corporate organizational structure. There isn’t one right answer for every business.
What factors influence entity choice?
Two major considerations in choosing what form of business entity you should use and whether you should incorporate your business are:
- Protection from legal liability
- Income tax savings
Most business owners see liability protection and tax reduction as the most important factors affecting entity choice. Liability protection may be obtained even if the selected entity is not a corporation, but state laws vary so it is imperative you consult with legal counsel regarding your state’s liability laws. However, contract terms with lenders, suppliers and other parties may trump liability protection of the entity.
Choosing which business entity is best for your company can be one of the most confusing decisions you have to make. It is also one of the most important ones.
The selection of your company’s entity is a decision that should not be entered into without considerable analysis and professional advice.
Corporations are legal entities that are owned by stockholders, and ownership shares may be easily transferred. The life of corporations can extend beyond the participation of their founders. One of the chief advantages of corporations is that the owners are limited in their personal liability to creditors and lawsuits.
- C Corporation There are no restrictions on the type of shareholder that can own a C corporation. C corporations are taxed as separate entities subject to a separate tax rate schedule.
An advantage of C corporations, unlike S corporations, is that there is no shareholder tax on undistributed earnings.
Another advantage is the tax benefit available for some small businesses organized as C corporations. Small business stock purchased after Sept. 27, 2010, and before Jan. 1, 2012, and held for more than five years, the owner’s entire gain is tax free upon sale. The company that issues the stock must meet technical qualification rules. Qualified small business stock purchased before Sept. 28, 2010, may qualify for partial exclusion of gain. Although this provision is not available for purchases of small business stock in 2012 and subsequent years under current law, it may be extended. Be sure to check with your tax adviser on the status of this important tax benefit.
C corporations are commonly used by entities planning to go public.
One of the primary disadvantages of a C corporation is double taxation, in which income tax is paid at the corporate rate before any profits can be paid to shareholders. Then shareholders’ dividends are subject to income tax again at the individual rate.
Tax strategies to withdraw earnings in a deductible manner, such as through salaries, rents and interest, may alleviate this double tax burden. Double taxation may also be a major disadvantage upon eventual dissolution. In addition, C corporations may be subject to the accumulated earnings or personal holding company tax.
- S Corporation An S corporation is a domestic corporation that can’t have more than 100 shareholders, has only one class of stock, and has only U.S. citizens and residents as shareholders. In addition, shareholders generally must be individuals, estates or some trusts.
Named because it is taxed under Subchapter S of the Internal Revenue Code, an S corporation is a U.S. corporation and is taxed as a pass-through entity in which taxable income is taxed to shareholders on their personal tax returns in proportion to their ownership percentage of the S corporation. For state corporate law purposes, S corporations are treated the same as C corporations regarding limited liability. S corporation status must be elected.
The primary advantage of this form of organization is that shareholders have the organizational benefits of a corporation but escape the double taxation of a C corporation. The overall tax burden is lower for profitable businesses when the owners collectively are in a lower marginal income tax bracket than the corporation. Since any profits are taxed to the shareholders in the year they are earned by the S corporation, they generally are not taxed again when they are distributed (as with C corporations). And owners may be able to deduct losses on their income tax returns to offset other income on their returns.
Close attention must be paid to maintaining the necessary basis (and other criteria) to deduct these losses, including correct structuring of corporate debt. Unlike partnerships, debt of the entity does not give S corporation owners basis. The only basis S corporation owners get from debt is any loan directly from the owner to the S corporation.
Another advantage to S corporations is that earnings taxed to the owners (other than actual salaries paid to the owners) are not subject to Social Security tax. State taxation of S corporations varies by state. Some states that do not have personal income tax, such as Florida, do not tax S corporations.
Disadvantages of the S corporation status include restrictions on ownership, limits regarding tax years, taxation of fringe benefits provided to owners, and a few other hurdles.
Because of provisions that apply to C corporations, it is generally recommended that entities holding property that will appreciate not elect S status. The reason for this recommendation is that any appreciation on properties distributed will be taxed upon distribution. Partnerships and LLCs are not subject to this provision.
Entities taxed as partnerships
Limited liability companies (LLCs) and partnerships, discussed below, are governed by state statute as to organization. Laws vary by state. Federal law governs their federal income taxation. Businesses taxed as partnerships are also pass-through entities, and their earnings or losses flow through to their owners’ personal tax returns.
As with S corporations, partners and members must have basis in order to deduct their losses. However, basis is more broadly defined with these entities since it can generally include debts of the business. Unlike S corporations, partnership rules do not restrict the number of owners, type of owners, etc.
In addition, the partnership agreement or LLC member agreement allows owners to allocate profit and losses in a much more flexible manner than they could under an S corporation election. Also in contrast to S corporations, all of the earnings of these entities can be subject to Social Security tax. As with S corporations, generally owners of entities taxed as a partnership are taxed on fringe benefits.
- Limited Liability Company (LLC) An LLC limits the liability of its owners (called members) to claims and lawsuits. This is the primary advantage of an LLC over limited partnerships or general partnerships. An LLC can choose to be taxed as a C corporation, an S corporation (assuming other requirements are met) or partnership.
- General Partnership A general partnership is an unincorporated business that has two or more partners. As a general partnership, partners have personal liability for any debts the partnership incurs, as well as for the negligent actions of their partners. This is called “vicarious” liability because partners may have negligent acts of another partner imputed to them in a suit for damages. General partnerships are much less common than in prior years because of this virtual unlimited liability and the availability of alternatives to operating as a general partnership.
- Limited Liability Partnership (LLP) A limited liability partnership generally combines the limited liability aspect of a corporation, protecting its owners from claims and lawsuits, with the aspects of a partnership. A partner’s liability is limited to the amount invested in the company unless a personal guarantee is given, and a partner usually can’t be held accountable for the wrongdoings of other partners.
- Limited Partnership A limited partnership has at least one general partner in addition to limited partners, and in other respects is generally the same as an LLP. Limited partners should not take an active role in the business to avoid compromising limited liability.
- Sole Proprietorship – A sole proprietorship is an unincorporated business owned by a single owner and is not considered a separate entity. The business activity is reported on a Schedule C, which is filed with the owner’s personal tax return.
The sole owner of a domestic LLC is not a sole proprietor because the business is legally an LLC. However, unless an election is made to be taxed as a corporation, a single-member LLC is a disregarded entity for tax purposes and files a Schedule C with the owner’s personal income tax return.
What other factors influence the choice of business entity?
Federal tax law applies uniformly across the United States, although its application may depend upon the nature of relationships established by local law. State law can affect many other entity choice factors, including which choices are available and the liability protections offered by each.
The dynamics that affect your choice of business entity may change as your company enters new life cycles. The entity choice should take into consideration the survival of the business when it is passed down to the next generation. Some entity choices are permanent, while some can change with a tax election. In any event, it is in your best interest to regularly consult with your CPA and attorney to ensure that your entity choice produces maximum benefits for you and your company.
Linda Harding is the Director of Tax Services at CPAmerica International. She has more than 30 years of Big 4 tax experience and was a tax shareholder with a large local firm. Harding manages the technical resources, tax practice matters and reviews tax publications for CPAmerica. Follow her on Twitter @LHardingLin.