Choosing a business entity is a big decision. The choice affects how owners are required to conduct business on a day-to-day basis, how financial statements are presented, and what income is taxable and the rate at which the income is taxed. The structure affects the manner in which owners can take cash out of the business and if the cash received from the business is taxable. And it will have long-term effects if or when the time comes to make changes in the ownership structure or sell the business.
Smart Business spoke with Kirk Trowbridge, director at Clarus Partners, about the factors to consider when determining the structure that’s best for a business.
What choices are available to those setting up their business entity and how are they differentiated?
Among the factors that narrow the possibilities are the number and types of owners involved. Ownership structures will dictate whether a company is registered as a single member limited liability company (LLC), partnership, S corporation or C corporation.
It’s important to recognize that just because a person chooses a type of legal entity, it does not necessarily mean the entity will be taxed in the manner that follows that choice. For example, a single member LLC by default would report its income on a Schedule C attached to the owner’s Form 1040. However, that person can make an election with the IRS for the single member LLC to be classified as a corporation and then make an additional election to have it report as an S-corp. with the IRS.
Another limit could be that the ownership structure doesn’t fit the entity. A business cannot be set up as a partnership if there is no partner. S-corps are limited by the number of owners who can be involved in the business and the tax structure of the owners. For example, an S-corp. cannot have a partnership as an owner, but a partnership can have an S-corp. as an owner.
How does someone determine what is the best business structure for their venture?
Many people, when setting up a business, want to know what structure will require them to pay the least amount of tax or put the most money in their pocket. While this can be an important factor, it should not be the primary factor. Rather, first consider what state and federal laws allow. Some business ventures may not be able to conduct business in a manner that is most tax-advantageous because of the makeup of the owners.
Also consider what type of flexibility that’s desired in the operations of the business. Partnerships generally allow the most flexibility while corporations offer the least.
A person should also think about why they are putting the business venture together in the first place. Is the plan to own the entity for five to seven years and then sell it, or is the plan to own the business for a long time?
Choosing the wrong structure can result in paying higher taxes and not having the flexibility that’s desired when conducting business on a day-to-day basis. Long-term, it can also affect how easily change in ownership can take place and how the sale of the business must be structured.
Who should someone work with as they consider which structure is best for their venture?
Work with an attorney and CPA when considering which structure is best for a business. An attorney will make sure the business is set up following state laws, and that all documents and proper registrations with the state have been filed. A CPA can advise the business as to the different options that are available when it comes to structuring the business under current tax law, along with advising on the best structure for income tax purposes.
There are multiple options available when it comes to setting up the structure of a business. Understand all of the choices that are available and the consequence of each before picking one.
Insights Accounting is brought to you by Clarus Partners