Choosing the Right Business Entity: Understanding Tax Implications

Choosing the Right Business Entity: Understanding Tax Implications

Selecting the appropriate business entity structure is arguably the most crucial decision a business owner will make for their venture. Affecting everything from taxation to succession planning, it is a rite of passage in every entrepreneur’s journey, and choosing the right entity is a critical step in setting the business up for financial success.

The three most common business structures—S Corporations (S Corps), C Corporations (C Corps), and Limited Liability Companies (LLCs)—each offer distinct advantages and disadvantages that vary based on the business’s unique needs and goals. While entity selection is a vastly complex process, understanding the fundamental tax implications of each entity structure can help entrepreneurs make informed decisions for their current and future well-being.

When deciding which business entity is best for their venture, there are several things to consider:

  • Tax implications: what are each entity’s potential tax advantages and disadvantages, including federal and state tax implications?
  • Legal and liability considerations: what is the desired level of liability protection, and what are the legal formalities associated with each entity type?
  • Business goals and growth plans: what are the long-term objectives of the business, including plans for growth, fundraising, and exit strategies?
  • Operational flexibility: what are the administrative burdens and level of flexibility required in managing the business?

Considering these factors, let’s explore the three most popular entity structures.

S Corporation (S Corp)

An S Corp is popular among small and medium-sized businesses due to sizeable potential tax benefits. S Corps pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes, meaning the corporation does not pay federal income taxes. Instead, shareholders report their share (percentage ownership) of the corporation’s income or losses on their individual tax returns and are taxed at individual income rates. In addition, shareholders can potentially reduce their self-employment tax liability by paying themselves “reasonable compensation” as employees and taking the remainder of their income as distributions, which are not subject to self-employment tax.

Although widely considered tax-friendly, S Corps are somewhat inflexible and carry several long-term disadvantages. Strict eligibility requirements, including restrictions on the number and types of shareholders (maximum 100), may significantly limit their suitability for certain businesses looking to reach growth goals.

C Corporation (C Corp)

C Corps are separate legal entities from their owners, offering limited liability protection to shareholders. On the bright side, C Corps can attract investors more easily by issuing multiple classes of stock, making them an ideal structure for businesses seeking significant growth and expansion. However, C Corps are subject to double taxation, meaning they pay the 21% federal corporate income tax on their profits and any applicable state income taxes, plus their shareholders pay taxes on dividends received.

Due to their complexity, compliance with corporate formalities and reporting requirements may also be more burdensome for C Corps than other entities, often resulting in undesirably higher administrative costs and fees.

Limited Liability Company (LLC)

As one of the more popular entities, multi-member LLCs offer a flexible business structure that combines elements of partnerships and corporations. While generally considered a partnership by default, LLCs may elect to be taxed as either a C Corp or S Corp by filing a Form 8832 with the IRS. Perhaps most attractive is the fact that LLCs avoid double taxation, as profits and losses are passed through to members and reported on their individual tax returns.

In terms of flexibility, LLCs may offer more options for management and ownership structures in comparison to corporations; however, that can often result in more complications and tax compliance requirements. Unlike S Corps, where only wages are subject to self-employment tax, LLC members may be subject to self-employment tax on the entire net income of the business. Also noteworthy is the fact that LLCs may be subject to varying regulations and taxes at the state level, adding complexity for companies operating in multiple states.

Ultimately, there is no one-size-fits-all answer when it comes to choosing the best business entity. While this article provides a brief overview and some basic considerations, consulting with your CPA or business advisor can provide valuable guidance tailored to your specific goals and vision. If you have questions or want to learn more about how your entity structure affects your business, please reach out.

Dan Doiron ARB Principal edited

Dan Doiron has been in public accounting since his college internship with ARB in 1986. He has been a Principal since 1996 and works extensively with all types of clients to solve their compliance and tax planning issues. Dan was the May 1987 State of Maine Gold Medalist for earning the highest scores on all four parts of the CPA Examination. He is the Practice Leader of both ARB’s Business Tax Services Team and ARB’s Private Client Advisory Services Team.

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