Posts Tagged ‘entity choice’

Up to now, I’ve covered sole proprietorships, general partnerships, limited liability companies (LLC), and S-Corporations.  The last major entity option is a C-Corporation. 

As I mentioned in the piece on S-Corporations, in general, S-Corporations and C-Corporations have many of the same advantages and disadvantages. There are some very distinct differences you’ll need to consider.  Here are some advantages and disadvantages of a C-Corporation (yes, there is some duplication with the S-Corporation).

ADVANTAGES:

• Continuity of life – by operation of law the entity has an infinite life.  It is not dependent on its shareholders.
• Transferability – generally shareholders are free to sell or transfer their ownership interests at their own will.
• No liability – generally, shareholders do not have personal liability for the business’s obligations. Owners are only at risk for their investment.
• Bankruptcy – entity can file for bankruptcy.
• Publicly traded – most publicly traded companies are C-Corporations
• Ownership – There are no ownership restrictions like those of the S-Corporation
• Capital gain exclusion – original stockholders may be eligible for a capital gain exclusion on the sale of their stock up to $10 million if the stock is qualified small business stock and the stockholder holds the stock for five years.
• Tax rates – due to increasing personal tax rates, C corporation earnings may be taxed at a lower effective tax rate than individuals.
• Separation – complete separation from owners, tax-wise

DISADVANTAGES:

• Complexity – forming a corporation is nearly as complex and expensive as an LLC or LLP.
• Double taxation – The Corporation pays tax at the entity level.  Then distributions to its owners, aka dividends – are taxed again at the shareholder level.
• Formalities – once formed, there are certain formalities that should be followed
• Shareholders have no management rights – Shareholders elect the Board of Directors who elect the officers.  The officers manage the corporation.
• Dissolution – Unwinding generally involves a taxable transaction

See a professional when making these decisions. Every situation is unique and must be considered separately.

Up to now, I’ve covered sole proprietorships, general partnerships and limited liability companies (LLC).  Now let’s talk about S-Corporations.  The majority of our clients are S-Corporations.  I’d imagine that CPAs favor S-Corporations like lawyers favor LLCs.  It’s not the perfect entity, but we see advantages over the other entities for most privately held businesses.

In general, S-Corporations and C-Corporations have many of the same advantages and disadvantages. There are some very distinct differences you’ll need to consider.  We’ll focus on S-Corporations for today’s post and C-Corporations in part 5.

ADVANTAGES:

• Continuity of life – by operation of law the entity has an infinite life.  It is not dependent on its shareholders.
• Transferability – generally shareholders are free to sell or transfer their ownership interests at will as long as there is a willing buyer or transferee.
• No double taxation – an important difference from the C-Corporation; profits and losses flow through to the shareholders – and NO self employment tax! (Reader beware – Congress is trying to change the self employment tax part…)
• No liability – generally, shareholders do not have personal liability for the business’s obligations. Owners are only at risk for their investment.
• Bankruptcy – entity can file for bankruptcy.
• Distributions – shareholders can take distributions tax free, though they pay tax on their proportionate share of profits.

DISADVANTAGES:

• Complexity – forming a corporation is nearly as complex and expensive as an LLC or LLP.
• S-Corporation limitations –
  • No more than 100 shareholders allowed
  • Shareholders must be individuals, estates or certain trusts
  • Must be a domestic corporation
  • Generally only one class of stock allowed
  • All shareholders must be US residents or citizens
  • Formalities – once formed, there are certain formalities that should be followed.
  • Asset distributions – assets taken by shareholders must be removed at fair market value which can create a taxable transaction.
  • Shareholders have no management rights – Shareholders elect the Board of Directors who elect the officers.  The officers manage the corporation.
  • Dissolution – unwinding generally involves a taxable transaction

See a professional when making these decisions. Every situation is unique and must be considered separately.

I previously wrote blogs on sole proprietorships and general partnerships.  I know this can be a little boring but hopefully it’s useful.  It’s important to know and understand all options.  Assuming capitalism doesn’t go by the wayside, one day you might start a company.  Heck, if high unemployment persists, you may have to start a company!

Before I go into the advantages and disadvantages of a limited liability company (LLC), I want to give you a question to ponder.  If you do decide to form a business, and you were a good boy or girl and sought the advice of a professional, one very important question should be, “What is your exit strategy?” The answer to this question could outweigh your opinions on other factors, even those on taxation.  This most important question is critical when considering choice of entity!

On to LLCs!  A Limited liability company provides the asset protection of a corporation and some of the tax liability of a partnership or (in case of a single owner) a sole proprietorship.  Lawyers love them and frequently suggest converting a sole proprietor to an LLC.  You still need to weigh the pros and cons.

Here are some (NOT ALL) advantages and disadvantages of a Limited Liability Company.

ADVANTAGES:

• Limited personal liability to members – members (owners) enjoy the limited liability that shareholders of corporations enjoy, meaning, members are NOT personally liable for the entity’s obligations beyond their investment in the entity.
• Flexible tax options – LLCs can elect to be taxed as a partnership, corporation or S-corporation.
• Bankruptcy – the entity is eligible to file for bankruptcy protection under Bankruptcy Statutes.
• Lower audit profile – the IRS does not audit LLCs as frequently as sole proprietorships.
• You can form a single member LLC which is taxed like a sole proprietor.
• Dissolution – when the LLC elects to be taxed as a partnership, it is possible to “unwind” an LLC without tax consequences to the entity or the owners; same as partnerships.

DISADVANTAGES:

• Expensive – forming an LLC is one of the most expensive and complex entities to form
• Self-employment tax – usually income is subject to self employment tax
• LLC fees – in the state of California, there is an LLC fee assessed on gross revenues, not profits.  This means your company could be bleeding from every corner, struggling to make money and still have the pay the fee. 
• Transferability is limited – in most states, there must be consent from all members to sell or transfer ownership interest.
• Limitations on types of businesses – many licensed businesses cannot use this form due to the limited liability such as contractors and accountants.
• Single member LLC – the IRS does not recognize a single member LLC and requires it to be taxed as a sole proprietor, therefore subject to self employment tax (yet still subject to the LLC fee in California).

A few additional facts about LLCs you might want to know:

• LLCs are formed by filing certain documents with the state.
• Unless the operating agreement states otherwise, all members have the right to participate in management of the LLC.
• Voting strength is not equal between members, voting strength is determined by each members’ proportionate ownership interest in the entity or by the operating agreement.
• Unless stated otherwise in the operating agreement, profits and losses are allocated on the basis of the members’ contributions.
• There are no rights to distributions.
• Unlike a corporation, entity life is limited.

See a professional when making these decisions. Every situation is unique and must be considered separately.

I wrote about some advantages and disadvantages of a sole proprietorship.  The next easiest entity structure to form is a general partnership.   A general partnership is similar to a sole proprietorship except there are at least two owners.  

Below are some (again, NOT all) advantages and disadvantages of a general partnership:

ADVANTAGES

• Taxed once – all business profits and losses flow through to the partners (also disadvantages).
• Formality is limited – there is relatively very little formality to starting a business as a general partnership.  It can be as simple as an oral agreement.  I think we all know that “oral agreements” of any sort are very risky in today’s world.   I’d advise a written Partnership Agreement.
• Can report on the cash basis – for tax purposes.
• Can file for bankruptcy – for bankruptcy purposes, a general partnership is considered a separate entity – separate from its partners – and can file for bankruptcy under the Bankruptcy Code. (Note – insurance companies and savings institutions cannot file for bankruptcy regardless the entity structure)

DISADVANTAGES

• Liability – partners are liable for obligations of the partnership.  Partners can also be sued along with their partnership in the same action (but must be named separate from the partnership)
• Entity life – the partnership may dissolve after the death or dissociation of a partner unless the partners have agreed otherwise. 
• Transferability is limited – there must be unanimous consent of all partners to transfer one’s interest.
• Self employment tax – because all partners are considered general partners, usually all flow- through trade/business income is subject to self employment tax – Social Security and Medicare taxes.

All partnerships are considered general partnerships unless stated otherwise. Here are a few additional facts about general partnerships you should know:

• All partners are general partners (unless the agreement states otherwise).
• All partners share in management.
• New partners must be approved by all existing partners.
• All partners are personally liable for partnership obligations.
• If a partner is leaving the partnership, he/she must give notice to creditors prior to withdrawal; otherwise you are still on the gook for those obligations.
• All partners have the apparent authority to bind the partnership (and therefore the rest of the partners), thus, it is important when a partner leaves the partnership that appropriate public notice is given. 
• Unless the partnership states otherwise, profits and losses are shared equally among partners (even when capital contributions are not equal!!).
• No rights to distributions.
• When more than 50% of a partnership interest changes or withdraws, the partnership is liquidated for tax purposes.

See a professional when making these decisions! Every situation is unique and must be considered separately.

One of the first decisions you have to make when starting a new business is the type of entity structure to establish.  There are many thoughts and questions that may run through your head.  “I don’t want to pay taxes” might be the first one.  First off, come to terms that you are going to pay taxes.  You live in this wonderful country we like to call America and there is going to be a small price to pay for it.  Hopefully Congress doesn’t get in the way and raise taxes… but I digress.  While you will pay taxes, assuming you are profitable – and profitability is the goal in business right? – you shouldn’t pay more taxes than necessary. 

The second question might be “How do I reduce my liability, I don’t want to be on the line for this?” You have some options, each offering a different level of liability on the owners.

The third though might be regarding the simplicity or complexity of the business structure.  You can spend a good chunk of change in lawyer fees for a more complex structure, or you can be cheap and give the lawyers nothing. 

You have to weigh the importance of these factors to your business and make a choice, hopefully the right one.  What is the right one?  Only you can answer that question.

On our website, we have a chart that gives a list of factors to consider when choosing an entity type for your business.  There’s a lot to consider and the chart can’t cover all the issues, but it’s a start.

There are five main entity structures to choose from:

• Sole proprietorship (self employed)
• C-Corporation
• S-Corporation
• General partnership
• Limited liability company

This post will go through some (not all) advantages and disadvantages of the sole proprietorship structure.  Future blogs will go through the other structures.

ADVANTAGES:

• Taxed once – all business profits and losses flow through to the sole proprietor (also disadvantages).
• Formality is limited – there is relatively very little formality to starting a business as a sole proprietor.
• Free to transfer interest – generally, you can transfer your interest in the business to another entity without cost.
• Can use cash basis – for tax purposes (in most cases)

DISADVANTAGES:

• Personal liability – the sole proprietor is personally liable for all business obligations.  This means you are sued personally if the business is sued.
• Social security tax –profits are subject to Social Security and Medicare tax.
• Life of entity – the business does not exist past the life of the sole proprietor.
• Bankruptcy – there is no bankruptcy option for a sole proprietorship.  The owner must personally file for bankruptcy under Federal Bankruptcy Statutes.
• Higher IRS audit risk – the IRS typically audits more individuals with a Schedule C (how you report your income and expenses for a sole proprietorship) than other business structures.  These audits are consistently productive for the IRS.
• Only one owner – the minute you add another owner, you are forced to select a different entity structure.

 Always consult a professional when starting a business to consider all your options and the advantages and disadvantages of each.