When starting a business, the form
of entity should be part of a well-thought-out business plan that considers the needs and desires of both the
business and the owner(s). As much as
possible, the decision should take into
account where the business is headed in
the future.
“The LLC has become a very popular
option, but it may or may not be the right
form for a particular business,” says John
T. Alfonsi, CPA/ABV, CVA, CFE, partner,
Cendrowski Selecky PC, Bloomfield Hills.
Smart Business spoke with Alfonsi
about the various forms of business entities.
What options are available for a business
entity?
Primarily, a business can be structured as
a C corporation, an S corporation or a
Limited Liability company (LLC). With an S
corporation or an LLC, there is a single
level of tax at the owner level. With a C corporation, there are two levels of tax: one at
the entity level and one at the owner level
when earnings are distributed. Many times,
a particular legal structure or strategy
should be considered when forming a business.
What are the major differences between the
choices?
From a tax savings perspective, there is
an advantage to being an S corporation or
an LLC if you experience losses in the first
few years, which can ‘flow through’ to the
owner. With a C corporation, losses cannot
be used by the entity until the company
starts achieving a profit.
The LLC is a state law concept. LLCs are
formed under state laws, not federal guidelines. For federal tax purposes, when there
is one owner, the entity is disregarded and
the owner is considered a sole proprietor.
If there is more than one owner, the entity
is taxed as a partnership. The owners can
elect to be taxed as a corporation but most
do not.
The S corporation is a convention of federal tax law. An S corporation elects to
have only one level of tax. The shareholders elect to pay tax on income whether or
not it is distributed.
With both an S corporation and an LLC, if
there is a profit, the owners have to pay tax
on it whether or not they receive any
money. The LLC tends to be the most flexible in terms of how income and cash is distributed.
How do S corporations and LLCs differ?
The biggest difference is that the allocation schemes are limited with an S corporation. With the S corporation, there can
only be one class of stock. Everything must
be shared pro rata among the owners: the
income earned, distributions. Many businesses want flexibility, however, in how to
allocate income and cash between the
owners so, if that desire exists, the better
option may be the LLC. But the disadvantage compared to the S corporation is the
self-employment tax. In an LLC, if you’re
acting like a general partner, you are subject to the self-employment tax on 100 percent of your share of the earnings whether or not they are distributed.
An S corporation is a separate entity for
tax purposes. So the distributed share of
income is not subject to the self-employment tax. A portion of the income is taken
as a salary, subject to normal payroll taxes.
For instance, if $100,000 in revenue is generated and the owner takes a salary of
$20,000, the entity and the owner pays payroll taxes on the $20,000. The remaining
$80,000 is not subject to self-employment
tax, only income tax, and it can be withdrawn generally without any further tax
consequences.
What are the advantages of each form of
ownership?
The single level of tax is an advantage for
both the LLC and the S corporation. The S
corporation offers the potential to mitigate
the self-employment tax, but you are limited to 100 shareholders. You are also limited with what types of entities or persons
can be shareholders. With an LLC or a C
corporation, the number and type of owners is unlimited.
If equity-based compensation will be
offered, it is advantageous to form as a C
corporation, where the compensation will
be easier to comprehend. It is also prudent
to form as a C corporation if there are
future plans to go public. The C corporation is also the only corporate option that
allows you to offer preferred stock.
In many cases, the LLC is recommended
for a start-up because of its flexibility. If the
self-employment tax is a concern, there are
ways to mitigate it, such as becoming third-party managed or by having a managing
member receive guaranteed payments for
his or her services.
JOHN T. ALFONSI, CPA/ABV, CVA, CFE, is a partner at
Cendrowksi Selecky PC, Bloomfield Hills, Mich. Reach him at
(248) 540-5760 or [email protected].
