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 firstname.lastname@example.org.
Gumbiner Savett Inc.