With changing tax rates and pending legislation, choosing the right type of entity for your business is becoming increasingly more difficult.
“It is much less clear now in what form you should operate your business from a tax standpoint,” says Mark Klimek, chair of the Tax Practice Group at McDonald Hopkins LLC. “With the changes in tax rates, does it still make sense to set up your business as a limited liability company? The analysis used to be pretty straightforward, but it has become much more difficult.”
Smart Business spoke with Klimek about how to determine which type of entity will work best for your business and how having an exit strategy can simplify that decision.
How can a business owner begin to determine which type of entity to select?
The ideal option is one that allows you to maintain flexibility and operate your business in a form that would allow a change in the future, if needed. For example, if you operate as an S corporation and it turns out that a C corporation would be more advantageous, you can generally terminate the S corporation election without tax consequences. If the business is an LLC or a partnership, you can usually convert the business to a corporation on a tax-free basis. You normally cannot convert a C corporation to an LLC or partnership without it being a fully taxable transaction.
It is also important to accurately forecast and plan for what is likely to happen with the business in the future. If you know you will keep the business during your lifetime and simply draw a salary, that is one analysis. But it is a different analysis if you plan to build the business up to its maximum value and then sell it in five years. For the exact same business, those different exit strategies might dictate a different type of entity.
Should you plan your exit strategy before you start your business?
If possible, yes. If a business owner could predict with certainty what was going to happen with the business from start to finish, it would be very simple to determine which entity type would best suit it. And although predicting with certainty is impossible, a business owner should engage in the process of planning for the life cycle of the business and keep the end in mind. You do not have to determine an exit strategy to make a choice on entity type, but it does help.
How have recent changes in the tax law impacted the choice of entity?
First, the individual income tax rate will be going up in 2011; 2010 is the last year of the Bush tax cuts. Without any legislation and none is expected these rates will increase. So for businesses that are LLCs or S corporations, which pass through income to their owners, the owners’ tax bill will be higher next year.
Another factor is that dividend rates are potentially more than doubling in 2011 for some taxpayers, because without further legislation, dividends will be taxed as ordinary income, increasing from 15 percent to nearly 40 percent for higher income individuals. If the business is a corporation that puts all of its profits back into the company to stimulate growth, then increased dividend rates will not have as much of an impact. For a corporation that does not have cash needs and instead distributes its profits as dividends, the increased dividend tax rates will have a significant impact.
With the increase in the tax rate, should owners shy away from choosing an LLC as an entity type?
For the last 15 years, the best advice has been to set up a new business as an LLC, and that is still good advice. Yes, you are looking at potentially higher tax rates, but if higher rates turn out to be problematic, the business could likely convert to a corporation and take advantage of lower corporate tax rates.
Now may actually be a good time to convert an existing corporation to an LLC, even though it is a fully taxable transaction. The tax rates are currently lower than we will likely ever see in the future, and the economy is still struggling. If your corporation was worth $10 million five years ago, you may now be able to take a position that it is worth significantly less today. Sales are down, profits are down and the future is uncertain.
The tax on the conversion is based on the value of the business, and if you can justify a really low value, and are taxed at a historically low tax rate, now may be the time to convert to an LLC. Many corporations have also sustained net operating losses for the past couple of years, which can be used to offset a portion of the gain on the conversion.
What does a business owner need to think about regarding entity type before selling a company?
Business owners often get hit with huge tax bills for having the wrong type of entity when they sell the business. Before deciding to sell, a business owner needs to think about the tax consequences as early as possible in the process. If the business is a C corporation and is sold in a transaction structured as an asset sale, the aggregate tax rate between the C corporation and the shareholder could be more than 50 percent of the sales price. There are some planning techniques that can be used, but these require advance planning, so the earlier the better.
Whether you are thinking about selling soon or far into the future, now is a great time to be thinking about this. People tend to wait until they are ready to sell, and then say, ‘Why didn’t I do something about this before?’ You really must look at the facts and circumstances, forecast what is likely to happen with the business in the midterm horizon and then make your decisions based on that.
Mark Klimek is chair of the Tax Practice Group at McDonald Hopkins LLC. Reach him at email@example.com or (216) 348-5453.