Entity selection is an important decision when starting a new business. It’s a decision that requires more thought than many new business owners may anticipate. Regardless of your entity type selection, it will have legal and financial implications and impact tax compliance, access to capital, and company management. In most cases, there isn’t a rule of thumb or one-size-fits-all solution. The right choice will depend on the facts, circumstances, and goals of each situation. The most common entity types are sole proprietorships, S corporations, limited liability companies (LLCs), partnerships, and C corporations. It comes down to finding an optimal balance between your objectives and potential tax consequences. Here are some of the key considerations.
Structure, Capital & Management
Sole proprietorships are the simplest type of entity and are suitable in a one-owner situation. Many small businesses start out as sole proprietorships. S corporations can have from one to 100 owners, but there are restrictions on who those owners can be. In general, owners of an S corporation must be U.S. citizens, estates, or qualified trusts. S corporations may only have one outstanding class of stock, and the rules regarding an S corporation’s capital structure are rigid and inflexible. C Corporations may have unlimited shareholders of any type and have more flexibility in terms of designing a capital structure. LLCs can have unlimited members of any type, and an LLC can be designated as either member-managed or manager-managed. Partnerships require two or more partners, which may be any type of entity or individual. Both LLCs and partnerships offer the greatest amount of flexibility in terms of designing a capital structure to achieve the entity’s goals.
Legal Status & Owner Liability
Sole proprietorships offer no liability protection for the owner. It generally makes sense for a sole proprietorship to consider becoming a single member LLC, which can provide at least some liability protection to the owner. C and S corporations, as well as limited liability companies, are designed to provide liability protection to their owners. General partnerships offer no liability protection to partners, and limited partnerships can provide limited liability to its limited partners, but not its general partners.
Federal, State & Local Taxation
Sole proprietorships and single member LLCs report their income, gains, deductions, and losses on the income tax return of the owner. These types of entities are considered “disregarded entities” for income tax purposes. All other types of entities are not disregarded for income tax purposes, and are required to file their own income tax return.
S corporations, multi-member LLCs, and partnerships are all referred to as pass-through entities. Income, gains, deductions, and losses are passed through to the owners of the entity. The owners of the entity report the items on their income tax return and pay income tax at whatever tax rate might apply to their personal situation. Pass-through taxation is generally a good thing in the long-run, as it tends to result in a single level of taxation for the business income.
For an S corporation, rigid rules exist regarding how the entity’s income, gains, deductions, and losses are allocated to the owners. An owner of an S corporation can also receive a salary as an employee for services provided. There are special rules regarding the taxation of fringe benefits for S corporation shareholder-employees. In certain cases where an S corporation was previously a C corporation, certain taxes might be imposed at the S corporation level. The S corporation income, gains, deductions, and losses are reported on the owners’ income tax returns, whether or not income has been distributed to the owners.
For a multi-member LLC and a partnership, there is a great deal of flexibility regarding how the entity’s income, gains, deductions, and losses are allocated to the owners. An owner of a multi-member LLC or partnership can also receive a guaranteed payment for services provided to the LLC or partnership, and certain special rules also exist regarding the taxation of fringe benefits to LLC members and partners. Members in an LLC and partners may also be subject to the federal self-employment tax, depending on the circumstances. A multi-member LLC reports its income on a return of partnership income, unless it has made an election to be treated as some other type of entity for income tax purposes. The LLC or partnership income, gains, deductions, and losses are reported on the owners’ income tax returns, whether or not income has been distributed to the owners.
A C corporation is a separate taxable entity, so income is not flowed through to the owners. A C corporation pays federal corporate income tax on its taxable income at a rate of 21%. State income taxes will also apply, depending on where the entity is doing business. C corporations have a significant downside, as the entity and owner can be subjected to double taxation: once at the entity level and again at the shareholder level when dividends are distributed or the entity is liquidated. For that reason, C corporations are generally not utilized in most small business situations, particularly when appreciated assets are to be held by the entity.
Entity selection involves a myriad of factors. What I’ve discussed thus far only scratches the surface. There are additional considerations, such as transferability of interests, deductibility of losses, the distribution of appreciated assets if the company is liquidated, and more.
ARB’s Business Tax and Closely-Held Business teams provide companies with savvy, sensible tax, assurance, and advisory solutions tailored to their needs. If you’d like assistance determining the best entity type selection based on your circumstances, contact me today.
by Dan Doiron, CPA, CVA
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 ARB’s Business Tax Services Team and ARB’s Private Client Advisory Services Team.