A taxing decision

One of the most important decisions a
new business will make is selecting
an appropriate tax entity. The form of tax entity that is chosen will have a major
impact on future outlays to Uncle Sam.

Because all types of tax entities contain
business-related flexibilities and restrictions it pays off in the long run to seek help
from qualified advisers upfront.

“It is paramount to seek professional advice from competent advisers in structuring
a business,” says David Thaw, vice president of Gumbiner Savett. “The cost of these
services is often insignificant compared to
the benefits and savings that can be derived
from choosing the right entity form.”

Smart Business spoke with Thaw about
the importance of properly structuring
one’s business, how tax structures of various entities differ and the dangers of operating under the wrong tax entity.

What factors should be considered when
choosing a tax entity?

One of the first decisions a start-up
needs to make is the form of the business
— whether or not to incorporate, organize
as a Limited Liability Company (LLC) or a
partnership. The selection of the proper
form of business requires balancing tax
and business considerations. From a business perspective, ownership and management structure and liability protection are
key factors in choosing the type of entity
for doing business. Additionally, consideration must be given to each stage of the
entity life cycle: formation, operation and
exit. From a tax perspective, an important
factor is whether business profits or losses will be taxed directly at the entity or
owner level. Another salient factor is
whether the economic arrangement
between owners allows for the efficient
sharing of profits and losses. Other issues
include exit and/or succession strategy,
state and local taxation, movement of
assets, and compensation and benefits.

What are the advantages and disadvantages
of incorporation as a C corporation?

From a tax perspective, an advantage of
the C corporation form is that the corporation can issue various classes of stock
conferring different ownership and economic rights onto its owners, and there
are no restrictions on the number and
type of shareholders. The financial flexibility and well-understood legal body of
law surrounding the corporation may
result in a broader array of investors compared to other entities when the company
seeks capital.

Another advantage is that the corporation and its owners can participate in tax-free reorganizations with other corporations and/or owners. A possible disadvantage of being taxed as a C corporation is
‘double taxation.’ That is, profits are subject to a corporate-level tax and subject
to an additional level of tax at the owner
level when the corporate profits are
distributed.

How do the tax structures of C corporations,
S corporations and partnerships (LLCs) differ?

As mentioned previously, a C corporation is subject to double taxation and
allows for multiple ownership classes.
Since the C corporation is a taxpayer,
however, losses can be trapped at the corporate level and are therefore unavailable
to reduce the owner’s current tax liability.
Also, a C corporation allows for different
types of owners (i.e., exempt organizations and foreign taxpayers).

An S corporation generally does not pay
federal taxes at the entity level, rather, its
profits and losses are reported on the
shareholder’s tax returns. An S corporation, however, may be subject to corporate-level state and local franchise or
income taxes, typically imposed at
reduced rates. The ability to pass through
profits and losses may be quite attractive
compared to the C corporation. The S
corporation, in contrast to the C corporation, is faced with restrictions upon the
number and type of shareholders.
Additionally, the S corporation can only
have one class of stock outstanding,
which may limit profit and loss sharing
arrangements.

A partnership or LLC taxed as a partnership does not pay federal income tax.
Some states do impose taxes upon partnerships or LLCs. Like the S corporation,
partnership profits and losses are reported on the partners’ tax returns. Similar to
the C corporation, there is no limit or
restriction on the number or type of partners. Furthermore, a partnership offers
flexibility in the allocation of profits and
losses.

What type of entity is most effective when
transferring a business to family members or
key employees?

One way to transfer a business interest
to a family member or a key employee is
through the use of a Family Limited
Partnership. The formation of such entities can provide significant advantages
and planning opportunities in reducing
estate taxes, facilitating family succession and protecting assets.

DAVID THAW is vice president of Gumbiner Savett Inc. Reach him at (310) 828-9798 or [email protected].