Which Entity Is Best For Your Company

When starting a new business, an owner is faced with a very important decision.  What form of entity should my business operate under?  The answer is not always clear and will require some careful thought.  Let’s start with the basic question...

What are my choices?

The general choices are:

  • A regular or C corporation
  • An S corporation
  • A limited liability company (LLC)
  • A limited liability partnership (LLP)
  • A general partnership
  • A limited partnership
  • A sole proprietorship

All states now recognize LLPs.  Some states allow one-member LLCs or have special entity types for professional, such as the professional corporation or a similar professional-oriented variation of the LLC or LLP.

What factors are most important?

First, consider how the choice will affect your relationship with co-owners, creditors, other contracting parties and various tax authorities.

Most business owners see liability protection and tax reduction as the most important factors affecting entity choice.  Liability protection may be obtained even if the selected entity is not a corporation.  However, contract terms with lenders, suppliers and other parties may limit liability protection.

Tax reduction strategies must consider the specific nature of the business operations, the desired relationship between the owners, business success plans and other factors that can affect the entity choice.

Federal tax law applies uniformly across the United States, although its application may depend upon the nature of relationships established by local law.  State law can affect many other entity choice factors, including which choices are available and the liability protections offered by each.

Which entity is best for a professional service firm?

Liability protection is important to providers of professional services.  Using an entity to protect against acts of professional negligence is often limited by state law, but certain entities can protect against negligent acts committed by a co-owner of the business.

Pros and Cons of Each Entity Type

Advantages: Disadvantages:
Regular Corporation Liability shield, may offer more fringe benefits Possible double tax, state law requirements
S Corporation
Liability shield, generally only one level of tax
Less tax flexibility, state law requirements
LLC or LLP Liability shield to all owners even if they participate in management, tax flexibility
New – certain unanswered questions remain
General Partnership Tax flexibility, easy to establish No liability shield
Limited Partnership Tax flexibility, liability shield to limited partners No general partner liability shield, limited partners cannot participate in management
Sole Proprietorship Easy to establish, simple tax reporting, tax rates decreasing Not available if more than one owner, no liability shield

General partners have joint-and-several liability for negligent acts.  This is called “vicarious” liability because partners may have negligent acts of another partner imputed to them in a suit for damages.  Most state professional corporation, LLC and LLP statutes limit professionals’ liability to their actions and the actions of those directly under the control of the professional, avoiding this vicarious liability.

States differ with respect to which entities professionals may use for their practices.  Thus, a professional service provider may find the choices to be fewer than are available to other businesses.

How will the entity I choose affect my taxes?

Your entity choice will significantly affect how much you pay in state and local taxes, federal taxes and, perhaps, international taxes.

  • Regular corporations may subject earnings to two levels of tax.  Tax strategies to withdraw earnings in a deductible manner, such as through salaries, rents and interest, may alleviate this double tax burden.
  • Partnerships, which for federal tax law include LLPs and include LLCs with at least two owners, generally offer the most flexibility for federal income tax purposes.  Property can often be withdrawn tax-free from a partnership.
  • S corporations do not generally allow for an adjustment to the basis of assets when stock is purchased and never allow for such an adjustment when stock is acquired by inheritance.  Distributions of appreciated property from an S corporation will accelerate taxation of the inherent gain in the property.
  • One-member LLCs and “qualified Subchapter S subsidiaries” provide a liability shield under local law, but may report all operations on the tax filings of their owners.  This liability protection with simplified tax reporting is becoming increasingly popular.
  • A sole proprietorship will include its operations on your personal tax return.

With personal income tax rates dropping as a result of tax legislation, more businesses may consider operating as sole proprietorships, partnerships or S corporations rather than regular corporations.

Certain entities may be disregarded for federal and, perhaps, state tax purposes.  Many businesses pay more taxes to state and local jurisdictions.

What else needs to be considered?

You need to give some thought not only where your business is right now but to where you may be headed in the future.  The entity choice should take into consideration the survival of the business when it is passed down to the next generation.

Feeling alone with your decision?

Don’t . . . we can help.

Choosing whether your company should be a corporation, a partnership, an S corporation or one of several other options can be confusing for the business owner.

There are so many choices and so many factors that weigh into the decision – taxes, liability, estate planning and your relationship with co-owners.  The selection of your company’s entity is a decision that should not be entered into without considerable analysis and professional advice.

The dynamics affecting your choice of entity may change as your business enters new life cycles.  It is in your best interest to regularly consult with your CPA to ensure that your entity choice produces maximum benefits for you and your company.  If you ever have any questions surrounding this issue, or any issue related to your business for that matter, please do not hesitate to call us.  We love hearing from our clients!

Jim Chakires

 
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