The most common legal entity structures are sole proprietorships, C corporations, S corporations, partnerships and limited liability entities, such as
limited liability companies (LLC) and limited partnerships (LP). Understanding the
advantages and disadvantages of each is
imperative when deciding on the best entity structure for your business.
“Choosing the correct entity is an important decision for every business,” says
Jason Sanders, CPA, a tax manager with
Briggs & Veselka Co.
Smart Business spoke with Sanders
about corporate entity structures, the various intricacies of them and how to know
which one is right for your business.
How do you know what corporate entity
structure is right for your business?
Unfortunately, the best choice of entity is
not always clear. Many factors must be
evaluated before making an ultimate decision. You really need to look long and hard
at each option, comparing the major advantages and disadvantages of each. This is not
a decision that should be taken lightly.
How do different entities offer different
benefits?
A sole proprietorship consists of one individual and is the easiest form of business to
organize. There are few legal restrictions
associated with the formation and operation of the business.
C corporations offer three distinct advantages. First, they afford business owners limited liability protection. Second,
they’re advantageous when you’re looking
to raise outside capital. The flexibility of
ownership allows for creativity through
the use of different classes of stock with
different ownership rights. Finally, owner-employees can take advantage of corporate-provided, tax-free fringe benefits,
which are deductible to the corporation
for federal income tax purposes but are
not taxable to the owner-employees.
S corporations also enjoy limited liability
protection but are not faced with the double-taxation dilemma that plagues C corporations. S corporations are often referred
to as ‘flow-through’ entities because the
corporate-level profits and losses are
passed through to the corporate shareholders. As such, S corporations avoid double taxation as profits are taxed at the
shareholder level. Losses are passed
through to the owners and are deductible
at the shareholder level to the extent of the
shareholder’s stock and loan basis.
General partnerships also provide freedom from double taxation of earnings.
Generally speaking, general partnerships
are easier to establish than other forms of
entities and offer greater flexibility in ownership and capital structure. Partnerships
also allow partner-level basis for partnership debt, the ability to specially allocate
tax benefits among partners, and the ability to step up the basis of partnership assets
upon the sale or exchange of partnership
interest.
LLCs and LPs are often referred to as
‘hybrid’ entities. These entities are generally structured to ensure limited liability of
the owners but also offer greater flexibility
and tax benefits. This combination of corporate-like protection and tax benefits has
greatly increased the popularity of these
types of entities over the last few years.
What problems or issues can arise from the
various entities?
The major disadvantage to operating as a
sole proprietorship is unlimited liability of
the owner. This disadvantage may be alleviated, however, by forming a single-member limited liability company (SMLLC).
SMLLCs provide limited liability protection
without interrupting the ease of operation
of the business.
C corporations are taxed as separate entities from the principal owners, which gives
rise to the potential for double taxation of
the company’s earnings. The earnings are
taxed at the corporate level and again upon
distribution to the owners. In addition, corporate-level losses are trapped at the corporate level and cannot be deducted by the
owners. This is often a problem for start-up
entities that experience losses early in the
corporations’ life span.
S corporations allow for only one class of
stock, are limited in the number of owners
and types of ownership interests, and do
not allow for special allocations of tax benefits. Also, fringe benefits are generally
included in income for those who own
more than 2 percent.
General partnerships do not offer limited
liability protection. All partners are liable
for the debts of the partnership and claims
based on the actions of all other general
partners as well as employees of the partnership. Another disadvantage is that
fringe benefits are included in the partner’s
income as guaranteed payments.
What’s involved when a company decides
on an entity and begins to implement it?
Every aspect of the business should be
carefully considered before a decision is
made. Besides the various advantages and
disadvantages, factors such as business
type, profit and loss expectations, estate
planning and ownership transfers should
be weighed carefully during the decision-making process.
JASON SANDERS, CPA, is a tax manager with Briggs & Veselka Co. Reach him at (713) 667-9147 or [email protected].
