By Zach Mattingly, CPA, Manager at Blue & Co.
You’ve got a new idea for a business – you’ve discussed strategy, the business plan, and the key players that will help you achieve your business goals. Now it’s time to decide which business entity type works best for you. While it may sound simple on paper, it’s important to identify your business goals and ensure the type of entity you choose aligns with them.
Do you want to keep the business in the family for generations? Do you want partners? Do you want to grow the business and set it up for a future sale? All of these are important things to know when making this key decision for you & your business.
The most common business entity types that we see are the LLC taxed as a partnership, the S-Corporation, the C-Corporation, and the sole proprietorship. We will go through the key characteristics of each entity and define what goals may align best with each structure.
LLC Taxed as a Partnership
The LLC taxed as a partnership (which we’ll simply refer to as a partnership) is perfect for those seeking flexibility. With a properly drafted operating agreement, partners can decide how to allocate operating profits/losses, how the business will be liquidated, how distributions will be handled, etc. It’s also considered a flow-through entity, meaning the entity itself does not pay federal taxes; the income “flows-through” to the partners.
This allows them to avoid double taxation, which we will cover when we discuss C-Corporations.
Other key advantages include that the partners can receive up to a 20 percent deduction on income from the entity under IRC Section 199A. Partners can generally enter and leave the partnership without creating a taxable event. Partners also receive a basis for any liabilities that they personally guarantee.
One disadvantage is that when partners are active in the business, their share of income is subject to self-employment taxes. Also, since this is a flow-through entity, the income will be subject to individual tax rates, which are often higher than the corporate rates.
Best for those seeking flexible allocations, planning to take cash out of the business, and not intending to sell the business in the near future.
S-Corporation
The S-Corporation will operate as a flow-through entity and has many similarities to a partnership, with a few key differences. The first key difference is that income allocated to shareholders will not be subject to self-employment tax. Instead, the IRS requires shareholders who participate in the business to be paid via a W-2, and the wages must be reasonable.
Shareholders are also eligible to take up to a 20 percent deduction via IRC Section 199A.
The biggest difference between partnerships and S-Corporations is that you lose a lot of flexibility in the S-Corporation structure. All allocations must be pro rata, and nothing can be allocated specifically to a single shareholder. For example, if one shareholder wants to take a distribution, all other shareholders would also need to take a pro rata distribution.
Other key items are that you are capped at 100 shareholders and limited to having individual, certain trusts, and estates as partners (non-resident aliens are prohibited). Certain actions can also revoke the entity’s status as an S-Corporation and force the entity to be taxed as a C-Corporation. Shareholders do not receive any debt basis for their share of liabilities.
Unlike partnerships, transfers and dissolutions may create unintended tax consequences (i.e., property distributed out comes out at fair market value, potentially creating income for the recipients).
Best for those who want to maintain flow-through status and mitigate self-employment taxes for the owners.
C-Corporation
A C-Corporation is a tax-paying entity that operates independently of its shareholders – the business will continue after their deaths, and the owners are not personally liable for any business debts or obligations. The C-Corp pays federal taxes at a flat 21 percent rate, which is generally lower than the federal rate for individuals.
The biggest disadvantages include potential double taxation, rigid allocations, and more regulatory requirements. When dividends are issued, they go out pro rata to all shareholders, and shareholders pay taxes on those payments on their own tax returns. Because the entity itself pays taxes, this creates a second layer of taxation.
There are also certain regulatory requirements for a C-Corporation, including shareholder/director meetings, along with notice and minutes of the meetings.
The most enticing advantage of a C-Corporation is the provisions of IRC Section 1202. Under these rules, shareholders can realize tax-free gains of up to $15 million on the sale of the business, provided certain requirements are met.
Best for those who don’t intend to take cash out of the business and plan to sell it in the future.
Sole Proprietorship (Single-Member LLC)
The last entity structure we will cover is the sole proprietorship. This is what we call a disregarded entity for tax purposes, as all the business’s activity is included on the owner’s individual tax return. There are no separate federal tax filings for the business.
This can only be used when you have no other equity partners in the business. A Sole Proprietorship is considered a flow-through entity and can participate in the benefits of Section 199A that we’ve discussed previously.
This entity is more commonly set up for legal reasons than for tax optimization. The LLC can protect the owner from personal liability and separates assets into an entity rather than being held by the owner.
Best for those without partners who desire simplicity.
As you can see, many factors come into play when deciding which business entity type to choose. If you already have a business and think that a different structure would be more beneficial, don’t fret, as there are ways to convert your business entity. Whether you’re thinking of setting up a business or already have one, we’d love to help you. Please contact Zach Mattingly or your local Blue & Co. advisor to discuss it further.
