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How To Choose The Right Tax Entity For Your Company
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The How-To Business Book
11/20/2000
By: Mitchell Young
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One of the important decisions to be made by every company is choosing and maintaining which tax entity form the company will assume.
The purpose of this article is to provide readers food for thought to begin your evaluation or re-evaluation of your corporate status.
As with many business choices, the right decision is based on balancing a number of variables. With choosing or changing your company's corporate status, ownership, tax consequences of a sale of the company and how profits are to be divided among shareholders are of paramount concern.
The most common business entities are listed below with some relevant information to consider:
Sole proprietor: As a sole proprietor, the owner assumes all responsibility for the business, including assets and liabilities. All business receipts are taxed as personal income. Costs are low in setting up and maintaining this business form.
Partnership: A partnership allows two or more people to share in the profits and liabilities. Each partner is responsible for debts and liabilities the other partner or partners assumes.
In limited partnerships, certain liabilities can be limited to partners, but that is at the expense of control in the partnership. Net profit and loss is reported as personal income, depending on the share each partner owns.
'S' Corporation: An “S” corporation does not pay federal corporate income taxes. Its shareholders pay taxes on their share of the income as personal income tax. That income is taxable to shareholders whether they distribute it to the shareholders or retain it in the company. Profits (and taxes) are allocated based on ownership share. Shareholders are not individually liable for corporate debt. Because stockholders are taxed personally on gains of the company, upon sale the corporation is not taxed only the individuals - avoiding double taxation. “S” corporations are restricted to U.S. citizens.
Limited Liability Corporation (LLC): A relatively new form of business organization, the LLC combines the features of a corporation and a partnership. LLC owners are not personally liable for the corporation's debts. Losses by members are limited to their investment.
Income from an LLC is reported as personal income and the LLC has the added flexibility of being able to assign profits to owners according to a formula unrelated to equity.
In a partnership of attorneys, for example, profits can be distributed by hours, seniority or agreement.
This is in contrast to a partnership or “S” corporation, where profits need to be assigned by percentage of ownership. LLC owners can be other corporations, venture capitalists or other entities that might not qualify for “S” corporation status.
'C' Corporations: An incorporation category owned by multiple shareholders whose losses will be restricted to their respective investments. Shareholders are not personally liable for the corporation's debts. A “C” corporation pays federal and state income taxes on earnings.
Many state tax incentives for computer or manufacturing equipment or for research and development are available only to “C” corporations.
Tax Consequences at Sale
One of the most important factors for small and mid-sized companies involves the eventual sale of the company. In the sales of most small and mid-sized companies, assets (not stock) are sold so the buyer may avoid the assumption of potential liabilities.
When this occurs in a “C” tax-entity corporation, it is taxed on the sale of its assets. When proceeds are then distributed to shareholders they are taxed as well, effectively creating double-taxation.
There are tax preferences for original stockholders meeting a holding period that may reduce these taxes but these sales are subject to the alternative minimum tax of 28 percent, assuring a significant tax bite.
The tax-liability-on-sale factor severely limits which companies use “C” status, with the vast majority of Connecticut companies opting for alternate tax entity status.
Changing Status
At any time a “C” corporation can change its status to an “S” corporation by election. At that point, however, the company must make an evaluation to determine its gains from its start-up point as a “C.”
Once that value is fixed it will be taxable to the company and then again when it is distributed back to shareholders. Future appreciation will be taxable only once to the shareholders.
While the flexibility of an LLC may cause you to jump in that direction, keep in mind that corporate laws regarding “S” and “C” corporations are more frequently litigated, and settled, than those pertaining to the newer LLCs.
Another major factor is that the profits allocated to shareholders in an “S” corporation are not subject to the self-employment tax. In an LLC, profits - whether they are distributed to shareholders or not - are subject to that tax, a hefty 15 percent.
Businesses paying taxes in multiple states also need to consider filing requirements. With an LLC, all members must file taxes in every state in which they are taxable. An “S” corporation can elect to file as a corporation and save a great deal of paperwork.
The company, however, will be paying at the corporate, not personal, level for that state, which in most states is lower than the corporate rate.
Both LLC and “S” corporations are also restricted in defining their fiscal years, which must end after the first eight months of the calendar year
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