November 7, 2020

Choosing the Right Entity Classification for Your Business

Has Sheltering-In-Place given you the time to brainstorm some new business ideas? Entity selection and the resulting tax consequences are hot topics, and we can help!

The best entity choice is one that satisfies your nontax objectives, while maximizing any current and future tax benefits. Below listed are some definitions and considerations to make when choosing the right entity for your business ventures.

While most business can be structured successfully as one of the several options available, the pros and cons of each taxpayer’s specific situation can indicate meaningful differences between the various options. We are happy to consult with your further regarding your specific business endeavors and any other tax related matters.

C CORPORATION

Characteristics: A C Corporation can protect its shareholders from the debts of the business, while also enabling them to control day-to-day operations. Corporations offer the strongest protection to its owners from personal liability, but the cost to form a corporation is higher than for other structures. Corporations also require more extensive record-keeping, operational processes, and reporting.

Taxation: A C Corporation is taxed on its income at the entity level, regardless of any distributions to shareholders. The corporate tax rate is 21% for Federal purposes and 8.84% for California tax purposes.

Benefits: Corporations have a completely independent life separate from their shareholders. If a shareholder leaves the company or sells their shares, the C Corporation can continue to conduct business relatively undisturbed. Corporations have an advantage when it comes to raising capital because they can raise funds through the sale of stock, which can also be a benefit in attracting employees. Corporation classification can be a good choice for medium- or higher-risk businesses, businesses that need to raise money, and businesses that plan to “go public” or eventually be sold. It is also important to consider whether your business might qualify as a “qualified small business” which might make classification as a C Corporation attractive to investors.

Disadvantages: There is potential for double taxation of a corporation’s earnings: once through the corporation and again when distributed to shareholders as dividends.

S CORPORATION

Characteristics: An S Corporation is a small business corporation that satisfies certain statutory requirements. For tax purposes, the income, losses, deductions, and other tax attributes of the S Corporation flow through to the shareholders rather than being taxed at the corporate level.

Taxation: An S Corporation generally does not pay Federal tax at the entity level; rather, the income or loss is allocated among the shareholders, who report the income and pay the tax at the shareholder level. In California, an S Corporation is required to pay a 1.5% franchise tax on income with a minimum tax of $800.

Benefits: S Corporations also have an independent life, just like C Corporations. If a shareholder leaves the company or sells their shares, the S Corporation can continue to conduct business relatively undisturbed. S Corporation classification can be a good choice for a business that would otherwise be a C Corporation, but that meets the criteria to file as an S Corporation.

Disadvantages: There are stringent requirements in order to qualify for S corporation status. Certain types of businesses such as financial institutions or insurance companies are not allowed to choose an S Corporation structure. Shareholders of S Corporations are restricted to individuals, certain trusts and estates. Partnerships, corporations and non-resident aliens are not allowed to be shareholders of an S Corporation. In addition, the total number of shareholders in an S Corporation is restricted to 100 shareholders. Finally, an S Corporation may only issue one class of stock.

LLC – LIMITED LIABILITY CORPORATION

Characteristics: An LLC is a combination of limited liability for all investors with the income flow through attributes of an S corporation. LLC classification allows business operators to take advantage of the benefits of both the corporation and partnership business structures. The following are requirements for filing as an LLC:

  • Must be domestic
  • Must have 100 or fewer shareholders
  • All shareholders must be individuals, estates, or qualified trusts
  • Only one class of stock
  • The corporation cannot have a shareholder who is a nonresident alien

Taxation: An LLC does not pay tax at the Federal entity level; rather, the income or loss is allocated among the members, who report the income and pay the tax at the shareholder level. Losses may only be deducted by the partners to the extent of the shareholder’s basis in the stock and debt of the S corporation. Members of an LLC are considered self-employed and must pay self-employment tax contributions toward Medicare and Social Security. California levies a gross receipts tax on LLC’s “doing business” in California. While income and deductions are generally taxable at only the shareholder level, LLC’s “doing business” in California will pay an additional LLC tax of anywhere between $800 – $11,790.

Benefits: The owners are not liable for debts of the entity. LLC designation can be a good choice for medium- or higher-risk businesses, owners with significant personal assets they want to be protected, and owners who want to pay a lower tax rate than they would for a corporation.

Disadvantages: An LLC “doing business” in California will be required to pay at least a minimum annual tax of $800.

PARTNERSHIP

Characteristics: A partnership is formed when two or more people or entities join together to carry out a business or other venture and split the profits from it. There must be two or more participants for a partnership to exist. It is not necessary, but recommended for the participants to have a formal written agreement in order to operate a partnership for tax purposes.

Taxation: A partnership is a pass-through entity that does not pay tax on its income. Instead, the partnership passes along its income or loss, gains, deductions, and credits to the partners. Each partner reports a percentage of the partnership income and other items on each partner’s own tax return.

Benefits: Partnership designation can be a good choice for businesses with multiple owners, professional groups (like attorneys), and groups who want to test their business idea before considering incorporating their business.

Disadvantages: Partnership operation and tax law can be complicated. In general, a partnership agreement will need to lay out important factors such as how profits will be allocated, how distributions will be determined and who has authority to make decisions on behalf of the partnership.

SOLE PROPRIETORSHIP

Characteristics: A sole proprietorship is easy to form and gives the owner compete control of business operations. It is an unincorporated business owned by one person and has little legal significance separate from its owner.

Taxation: Single level of tax at individual’s tax rate. Sole proprietors are considered self-employed and must pay self-employment tax contributions toward Medicare and Social Security.

Benefits: A sole proprietorship can be a good choice for low-risk businesses and owners who want to test their business idea before forming a more formal business such as a partnership or corporation. This type of entity is the least expensive to organize.

Disadvantages: Very simply, no separate legal entity but the owner is legally liable for all business obligations.

WHICH ENTITY CLASSIFICATION SHOULD I CHOOSE?

If you are unsure of how to build your businesses to best suit your needs, we are happy to provide in-depth business advisory services. Contact us today to schedule a consultation.

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