Entity Choice, Taxes and Liability Protection

 Today, if you are starting a new business, a new division of your business or a joint venture with another business, you have many different options for the entity structure.  This is good news because you have the flexibility to choose the entity that will best address your legal, tax, management and financial planning concerns.  On the other hand, all those choices can make the decision overwhelming, especially when the business or new store is just opening, and its future direction and performance are difficult to predict.

Your Options

Your options fall into three categories, based on the tax status and liability protection the entity offers:

            Pass-through taxation to the individual owners without liability protection (sole proprietorships or general partnerships);

            Pass-through taxation with liability protection, with limited partnerships (LP), limited liability companies (LLC), limited liability partnerships (LLP) and S corporations; and

            Separate entity taxation (C corporations).

Which is Best for You?

Which entity form is best for your business?  The answer will depend on a number of factors.  The following are some general guidelines to consider:

Tax rates.  C corporations enjoy a federal tax rate advantage, particularly on the first $75,000 of net income, which is taxed at rates of 15% (first $50,000) and 25% (next $25,000).   Compare this to the top tax rate of 35% for individuals in 2008.  This advantage can be reduced somewhat in states with high tax rates on corporations.  The graduated rates for corporations do not apply to personal service corporations; they are taxed at a flat rate of 35% of taxable income.

Use of tax losses.  If a new business will have tax losses for a period of time, the C corporation can only carry them forward to offset against future income.  By contrast, the pass-through forms of ownership can allow losses to offset the owners' other income.  S corporations generally have more restrictive rules for deducting losses than partnerships or LLCs, but still may present opportunities to use losses currently.

Sale of the business.  While a C corporation owner's tax basis consists solely of his or her investment in the stock, the pass-through forms of ownership allow an owner to build up tax basis for undistributed income allocable to that owner.  For example, Joe and Jack each started a business in 1990.  Jack was the sole owner of an S corporation, and Joe owned a C corporation.  Both Joe and Jack made an original investment of $100,000.  Each business had retained earnings of $500,000 over the years, increasing Jack's tax basis to $600,000, but not Joe's.  In 2008, the stock of each company was sold for $1 million.  Jack's taxable gain on the sale was $400,000.  By contrast, Joe's taxable gain was $900,000.

            2nd level of tax.  Whether on its sale or during its life, distributions from a C corporation are subject to double tax.  After the corporation pays its tax on income or on the sale of assets, the shareholders must also pay taxes on the distributions.  Thus, Joe would be subject to double tax in the above example if his company sold its assets and liquidated.

            Fringe benefits.  The cost of providing many fringe benefits is deductible, regardless of business structure.  But if your business is an S corporation, LLC, partnership or sole proprietorship, the cost of certain benefits provided to the owners is taxable to them, although owners can receive a full deduction for health insurance premiums.

            Compensation and payroll taxes.  Sole proprietorships, general partners or LLC members who are actively involved in a business must treat their entire net income share as self-employment income.  S corporation shareholders must receive only a "reasonable" salary.  The owner may receive additional money from the business as distributions.  FICA/Medicare tax poses a problem for high-income C corporation shareholders.  Those who prefer to take money out as salary to avoid double taxation must pay an additional 2.9% charge in Medicare tax to do so.  Thus the S corporation is generally the ideal structure for payroll tax purposes.

            Flexibility.  The partnership and LLC forms are clearly the more flexible vehicles.  They allow different ownership classes and disproportionate distributions while an S corporation does not.  Furthermore, you generally can convert from a partnership or LLC to an S or C corporation without a tax cost, while the reverse is generally not possible.  Until recently, many sole proprietors rejected the LLC structure because it required including a second LLC member and preparing an additional income tax return.  But now an increasing number of states allow single member LLCs, which provide liability protection while being taxed as a sole proprietorship.

            Estate planning.  Accomplishing your estate planning strategies is often easier if your business is a partnership or LLC because you can use multitiered entities or different classes of ownership. S corporations still have a number of restrictions on shareholders, structure and operations, but Congress has liberalized the rules.  S corporations may now have as many as 100 shareholders, may own any portion of a C corporation and 100% (but not less) of another S corporation.  In addition, certain trusts are eligible shareholders, including trusts treated as being owned by an individual and trusts that elect to be treated as S corporation shareholders.

Making the Best Choice

Choosing the right entity type for your new ventures is a big decision.  While it is possible to change entity type, this often causes a substantial tax burden.  For this reason, you want to be sure to consider entity choice carefully from the outset.  Please feel free to call us if you have any questions about the different options.  We can help you determine which structure will best help you meet your planning goals.