Choosing the "right" entity type is a crucial decision for businesses that comes right at the beginning of the entity lifecycle.
Although taxes are a significant driver in determining which entity structure to select, they are far from the only factor to consider, according to Barbara Weltman, author of J.K. Lasser's Small Business Taxes and a contributing author to the Your Income Tax series. "Among the consequences to consider are tax rates, access to capital, liability, nature and number of owners, Social Security and Medicare taxes, restrictions on accounting methods, the owner's payment of company expenses, filing deadlines and extensions, multistate operations, and exit strategy," she said.
"If your business owes money, you might be at risk if you are a sole proprietor or a general partner in a partnership," Weltman indicated. "In all other cases, you do not have personal liability." She also noted that a C corporation may make it easier to raise money. "Equity crowdfunding, which allows businesses to raise small amounts from numerous investors, is effectively limited to C corporations," she explained. "S corporations cannot have more than 100 investors, while partnerships and LLCs would have difficulty in divvying up ownership among an ever-changing number of owners." A C corporation can also be a vehicle for rewarding employees with ownership through an employee stock ownership plan, she added. "You have to have a corporation for that."
HOW MANY OWNERS?
"There are factors to consider when choosing the proper business structure, which include evaluating the risk of significant liabilities resulting from the business and measuring tax consequences," agreed Theresa Racek, CPA, a senior manager at Top 100 Firm ParenteBeard LLC. Furthermore, near-term gains and losses, as well as personal wealth, should be assessed, along with identifying how much capital will be necessary.
One key factor of determining who will own the business may, by necessity, dictate some of the options. For instance, as it relates to S corporations, the number of shareholders impacts an individual's options and a person is required to be a U.S. citizen if they are considering a shareholder position.
Regarding sole proprietorships, there are various advantages as it relates to reporting and filing, Racek indicated. "However, the disadvantages of no liability protection and self-employment taxes are something to consider. Moreover, by definition, a sole proprietorship applies to one person - except in some cases involving a husband and wife. Otherwise, if there are two individuals, some type of partnership is required."
"You have to rank the factors in order of what's most important to you," suggested Roger Harris, president of Padgett Business Services. "There are different things to consider, including taxes, legal protection, and the complexity that an entity may put on you regarding how you pay yourself. In some cases, tax may be the driving reason, while in other cases, legal protection may be. If you talk to a lawyer, you may hear one suggestion, your tax advisor may have another suggestion, while a businessperson may give you a third recommendation."
If you're starting from scratch, you have to consider the nature of the start-up contributions, said Harris. "Does one provide better entity structure or tax benefits based on what you are contributing to start the business? How do you anticipate dividing future profits and losses? These all have to be discussed."
Harris cautioned that the most important thing is to get with someone who is knowledgeable before you do it and understand what it is you are doing.
Regardless of the entity, Harris said, it is vital that anytime you have more than one person, always negotiate a buy-sell agreement immediately and put it in writing. "This is the most optimistic you will ever be about this business. If you can't negotiate an agreement today when you're optimistic, based on the positive belief that all will work out perfectly, how do you think you can possibly negotiate when the business is not going well, or negotiate with a spouse because someone passes? No matter what entity, if two or more are in it, make sure you negotiate a buy-sell agreement while you're still friends."
"I ask new start-ups what type of business they are looking to create," said Salim Omar, president of the Cliffwood, N.J.-based Omar Group CPAs. "If it will be a small business run out of the home with no liability issues, then they don't really need liability. I'll advise them to run the business as a sole proprietorship to get started, since often you don't know if it will be viable. If it takes off, you can go with forming an LLC or an S corporation."
"A sole proprietorship is a very inexpensive way of getting started. And if you need to dissolve it, you can just walk away from it. With a corporation or an LLC, you need to go through a formal dissolution."
"With a partnership, there's no liability protection," he noted. "If it's small, it can be two owners with an operating agreement or a partnership agreement. ... It makes sense to have the operating agreement or partnership agreement down on paper, rather than have the members think or assume what their responsibilities are."
"If there are liability issues, go right into an LLC since you'll need legal protection," he said. "Where the choice is between an LLC and an S corporation, the benefit of the S corporation is some saving on self-employment tax. For example, let's say the business makes a $100,000 profit, and the owner takes a salary of $75,000, and a dividend of $25,000. He would save 15.3 percent times $25,000, or $3,825. Of course, the salary paid to the owner must be reasonable - he can't just underpay himself in order to escape the self-employment tax."
START WITH STRATEGY
"Don't let the tax tail wag the entity dog," advised Kathi Mettler, director at WTP Advisors. "It shouldn't be the tax structure that governs the business strategy."
"Often, tax planners get so caught up in saving taxes that they miss the overall scope of the business strategy. Entity selection and the 'check the box' [on Form 8832] election make it so much more flexible, but you still need to make sure you're looking at the big picture and not planning in a vacuum," she said. "Most businesses start out as a mom and pop or sole proprietorship. A sole proprietor might find some desire for products outside the U.S., and engage in export sales while still a sole proprietor. Eventually, as they grow, at some point they will consider incorporating."
"Things have evolved," observed Larry Gradzki, director of taxation at New York and New Jersey-based firm SaxBST. "The entity of choice in the 1980s was the S corporation, now it's the LLC. It gives the protection of a corporation, but the flexibility of a partnership."
In fact, single-owner LLCs are taxed as a sole proprietorship, and multiple-owner LLCs are taxed like partnerships, so there are no tax consequences per se. However, some states may impose added taxes on LLCs in the form of a franchise tax, in addition to the state income tax. "There is more flexibility with the LLC and the partnership than with an S corporation," Gradzki noted. "There's no cookie-cutter solution where one size fits all," he explained. "You go through a decision tree where you evaluate what the business goals are, who the owners are going to be, what kind of growth you foresee, where will you expand, and numerous other factors."
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