WEIGHING YOUR ENTITY OPTIONS

By Joseph G. Grillo, CPA

The Review

Published: Winter 2005

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One of the most important decisions a new business owner will make is under what form of legal entity their business will be conducted. The term “Choice of Entity” is what a lawyer refers to when deciding on the legal form of a new business. Most new business owners are aware of corporations (C-corporations) and partnerships as the two most traditional legal entities. However, over the years, the list has grown longer to include limited partnerships, limited liability companies and Subchapter-S corporations.

With the exception of a regular (or general) partnership, all of the mentioned entity choices share a common goal: to help the owner limit personal liability exposure. Why is this so important?  ….because, depending on the choice of entity, an owner can be liable for tortious (think slip and fall) injuries caused by the business. Keep in mind that no type of liability-limiting entity can protect an owner’s personal assets from liabilities related to his or her own professional errors and omissions or tortious acts.

In addition to liability issues, business owners want to minimize their taxes. The differences among the entities can yield significantly different tax results. This article will deal with some of the more significant considerations in choosing the type of entity in which to conduct one’s business.

C-Corporation
A C-corporation is an independent legal entity, existing apart from its shareholders, officers and directors. With a C-corporation, you do not get the “flow-through" tax benefits that all other small business entities enjoy. What this means is that the profits and losses of the company are taxed at the entity level, not at the shareholder’s level. The C-corporation will have to file a tax return and pay taxes on the income it receives. Then, if there are any dividends to be paid to the owners, those owners will have to pay taxes again on the money received as dividends. This is the double taxation of corporations that so many shareholders grumble about. There are ways, however, for small corporations to avoid the double taxation of income. Often, a small corporation will pay its owners salaries rather than pay dividends, so the corporation gets a deduction for the amount paid to shareholders. But the IRS watches such salary payments very closely and considers unreasonable compensation as nondeductible dividends. Not surprisingly, startup businesses rarely adopt the traditional corporate format.

S-Corporation
An S-corporation is a hybrid between partnerships and C-corporations. S-corps are formed exactly like a C-corp and have a very similar structure. There are shareholders, bylaws, articles, stock, etc., just like a C-corp. But the tax treatment of the S-corp is markedly different from that of the C-corp. Unlike a C-corp, income and losses of an S-Corp are generally attributed pro rata to the owners. This means that there is no “double taxation" of corporate income like there is with a C-corp. Another advantage to an S-corp is the lower tax rates. That is, when an S-corp's income is distributed, it will be taxed at the rate of the individual owners, rather than the higher rate applicable to C-corps.

General & Limited Partnerships
Partnerships consist of two or more partners. Each partner in a general partnership carries unlimited personal liability for the obligations of the partnership. Each partner has complete and equal managerial control over partnership affairs unless there is a partnership agreement stating otherwise. Partnerships are often cheaper to maintain than corporations. Partnerships do not have to take minutes detailing their actions like corporations, nor do partnerships pay taxes (the partners pay taxes individually on the income they receive from the partnership). There are no directors, officers, etc., just the partners. That’s the good news. The bad news---each general partner in a general partnership has personal liability for all of the partnership debts. In addition, general partners are jointly and severally liable for the tortious acts of co-partners who are acting within the scope of the partnership business.

A special type of partnership is the limited partnership. Limited partnerships have one very large advantage over the general partnership: limited partners do not take on personal liability for the obligations of the partnerships; they are only liable to the extent of the money contributed to the partnerships. The general partner in the limited partnership, however, retains all of the personal liability for partnership debts that one finds in the general partnership entity.

Why use it? The limited liability partnership is often attractive to entrepreneurs because they can retain control of the business by acting as the general partner, while still being able to offer limited partner investors the tax benefits of a tax flow-through entity. But with Limited Liability Companies offering the same benefits without requiring a general partner, limited partnerships are becoming less common.

LLC
The main advantages of Limited Liability Companies (“LLC”) are the protection the LLC owners receive from business creditors and the fact that, unlike a limited partnership, the owners (referred to as members) can still participate in the management of the business. The LLC has one very large advantage over the general partnership: members of an LLC do not take on any personal liability for the obligations of the LLC and they are only liable for debts of the LLC to the extent of their investment in the LLC. Additionally, there is no requirement that there be a general partner who retains personal liability for the LLC debts that one finds in limited partnership entities.

The LLC enjoys the same “flow-through” tax treatment that partnerships and S-corporations do. The rules concerning capital accounts, contributions and other basic partnership taxation principles apply to LLCs as well. In short, this means that although LLCs (other than single member LLCs) must file a tax return, the LLC owners report income and pay the taxes owed on such income using their personal tax rates. A downside is that, unlike a C-corporation, an LLC (like partnerships and S-corps) cannot retain earnings without the owners of the business having to pay income taxes on those earnings.

State Taxes
You should also be aware that some states impose a tax and/or fees on each of the above types of entities. You should check with your tax advisor to make sure you minimize your company’s overall tax liabilities.

Summary
This general information just scratches the surface regarding this topic. It is important to coordinate these matters with your accountant and attorney when deciding your business entity type. Have your professional team compare each entity form’s pluses and minuses, paying special attention to different industries, which may also affect the choice. Doing a careful “choice of entity” analysis and taking the appropriate steps at the outset will help avoid costly problems later. Many factors influence these decisions including both federal and state tax considerations.