Consider the Basics
When Choosing an Entity
Universal Advisor, 2004 Issue No. 3
When starting a business, the decision concerning the type of entity to form is often an afterthought. A great deal of effort is exerted in determining the location, size, and even the name of a new business. However, the decision concerning entity structure is equally important. Business owners need to determine the most advantageous tax and legal structure in order to facilitate their overall business objectives.
A number of income tax planning objectives to consider may include the following:
• Can assets move into and out of the business entity without incurring a tax liability?
• How will the profits from the business be taxed, and are there opportunities to reduce and/or defer the tax?
• If the business generates a loss, can the loss be used to offset income from other sources?
• Can the owners of the business participate in the risks and rewards of the enterprise in different ways?
• How can income and estate tax associated with increased equity value of the business be avoided or minimized?
• How will employment taxes and various employee benefits differ based on the form of business entity selected?
Some non-tax business objectives may include:
• How can owners of the business limit their personal liability with respect to obligations incurred by the business entity?
• Which form of entity will provide the most favorable equity and capital financing structure?
• Will the form of business entity facilitate future transfers of equity ownership?
• What type of entity structure will provide the most effective platform for management of the business?
• Will the financial and administrative costs of organizing and maintaining the form of business entity outweigh its benefits?
Going It Alone — Sole Proprietorships
For many businesses, sole proprietorship is the default solution to the question of which form of business entity to choose. A sole proprietorship is perhaps the simplest way to organize a business venture, since it’s conducted in the owner’s individual capacity without the organization of a separate legal entity.
Since no separate entity exists for income tax purposes, no separate income tax return is required. Instead, the owner reports the results of the business activity separately on his own individual income tax return. Although the business is the alter ego of the business owner, a separate identity may be created by registering an assumed name or “doing business as” (DBA). Unless the business has employees, there’s no need to obtain a tax identification number (EIN). Income from the business is generally subject to self-employment tax. The sole proprietor can transfer appreciated assets to and from the business activity without incurring a tax liability. Since no separate entity exists, a sale of the business will be treated as a sale of each of the individual assets of the proprietorship. As a result, the amount and character of any gain or loss will be determined separately for each of the specific assets being sold.
While a sole proprietorship can be a simple solution, it may not be the right solution if liability risk is a concern. The sole proprietor has unlimited personal liability for the obligations of the business. If the assets of the business are insufficient to satisfy the claims of its creditors, the creditors can collect against the owner’s other non-business assets.
Transferability of an interest in the business is not an option for a sole proprietorship. If the owner’s objective is to transfer a portion of his interest in the business or sell ownership to raise capital, the sole proprietorship form of entity structure is not appropriate.
Partnerships
General Partnership
The Uniform Partnership Act defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit.” “Persons” in this context can include individuals, other partnerships, corporations, trusts, or estates. The Internal Revenue Code describes a partnership as a “syndicate, group, pool, joint venture, or unincorporated organization through, or by means of which, any business, financial operation, or venture is carried on, and which is not, for federal income tax purposes, a corporation, trust, or estate.”
For federal tax purposes, a partnership is treated as an aggregate of the separate partners, rather than a single distinct taxable entity. A partnership is not required to pay federal income tax, but instead files an information return that includes the name of each partner and the amount of income or loss allocated to each partner. The individual partner includes his share of the partnership income or loss in his individual tax return. The individual partner is taxed on his allocated share of partnership income regardless of whether the income is actually distributed to him. Partnership taxation rules provide a tax-efficient means for the formation of the business entity, since the contribution of appreciated property to the partnership results in no tax liability to the contributing partner. In some instances, the partnership may distribute appreciated property to a partner with no tax liability associated with the distribution. A partnership can be extremely flexible from the standpoint of profit- and loss-sharing allocations among the partners. A partnership’s equity structure can be comprised of multiple classes of equity investment which can accommodate the varied interests of a diverse group of owners and investors. There are, in fact, so many favorable tax characteristics associated with the partnership form of business entity that it should at least be considered for every business venture formed. These extremely favorable tax benefits, however, do not come without a price.
First, the tax rules for partnership taxation are said to be the most complicated in the Internal Revenue Code. In fact, a judge who was ruling in a partnership tax case stated that “the distressingly complex and confusing nature of the provisions for partnership taxation present a formidable obstacle…surely, a statute has not achieved simplicity when its complex provisions may confidently be dealt with by, at most, only a comparatively small number of specialists who have been initiated into its mysteries.” Second and, more importantly, is the concern about unlimited liability.
From a liability standpoint, a general partnership is no better than a sole proprietorship, since a general partner has unlimited liability for the obligations of the partnership. To potentially make matters worse, every general partner is an agent of the partnership, and the act of every general partner in carrying on the partnership business generally binds the partnership. This means that an individual partner could have his personal assets placed at risk because of the actions of one of his partners.
Limited Partnership
A limited partnership is a partnership formed by two or more persons under the limited partnership laws of a state. The partnership must have one or more general partners and one or more limited partners. A limited partnership possesses the same favorable taxation characteristics as a general partnership. The biggest distinction is that in a limited partnership, only the general partner bears the risk of unlimited liability. The limited partners are only at risk for the amounts they have invested in the partnership.
Family Limited Partnership
The family limited partnership (FLP) is a limited partnership used for a special purpose, often estate planning. The objective of the FLP is to transfer limited partnership interests to children or younger generation family members. In determining the value of the transferred limited partnership interest for gift tax purposes, discounts for lack of marketability and lack of control will often be applied. The reduced value of the gift affords the person making the gift the ability to transfer more inherent value away from his estate. Often property with high appreciation potential, such as family-owned businesses or real estate, is used to fund the FLP.
Incorporation
A corporation is a permanent legal entity that has an independent existence separate and distinct from its owners. In order to maintain that separate status, however, the corporation must adhere to “corporate formalities” such as obtaining and maintaining state registration, selecting officers, and holding shareholder meetings and keeping minutes to record what was discussed. Organizing as a corporation will insulate an owner’s personal holdings from legal liability.
Unlike a partnership, the corporation is subject to federal income tax separate from its owners. The profits that have accumulated after payment of the corporate-level tax are subject to tax once again when those profits are distributed to the owners as dividends. This is referred to as “double taxation.” Double taxation will also occur if a corporation sells its assets and then liquidates. The first level of tax is assessed to the corporation on the gain from the sale of its assets. The second level of tax occurs when the corporation’s after-tax proceeds from the sale are distributed to the shareholders upon liquidation of the corporation. This double tax regime can be very costly and can result in an effective tax rate well in excess of 50% when taking into consideration both federal and state income taxes.
Owners of a corporation who are also employed by the corporation can help offset the impact of the double tax by increasing the salary and benefits that they pay to themselves. Although this is an effective tool to potentially reduce the double tax, it’s not a guarantee. The IRS will challenge unreasonably high shareholder compensation and can reclassify the portion they consider unreasonable as a dividend. Years ago, Congress provided a means for many corporations to escape this burdensome double-tax regime. The provisions for relief from corporate double taxation are found in Subchapter S of the Internal Revenue Code and are discussed below in more detail.
Since start-up businesses often incur losses in their initial years, planning for the utilization of those losses is an important consideration. Owners of sole proprietorships and partnerships can use start-up losses to offset other income, whereas corporate losses can only be used against corporate profits.
Similar to a partnership, a corporation’s equity structure can be comprised of multiple classes of equity investment (stock). Stock may be common or preferred, and either kind may be issued in various classes with different rights and priorities as to voting, dividends, and liquidation preferences. Some venture capital participants will insist on the corporate entity format and, of course, if the intent of the organizers is to “take the company public,” then a corporation is the appropriate form of entity structure.
S Corporations
If a corporation qualifies, it may make an election under Subchapter S of the Internal Revenue Code and will be afforded a special tax status: “S Corporation.” S Corporation status provides a company with some of the favorable tax characteristics of a partnership, namely one level of taxation. The S Corporations will have no tax consequences at the entity level. All corporate level income will be treated as received directly by the shareholders without regard to whether the income is actually distributed to the shareholders. Generally, losses incurred by an S Corporation can be used by its shareholders to offset other individual income.
Since an S Corporation is a corporate entity, the shareholders of an S Corporation have limited liability such that their personal assets are not subject to the claims of corporate creditors.
Not every corporation has the ability to elect S Corporation status. Only individuals, estates, and certain trusts and charities can be shareholders, and shareholders must be U.S. residents. The corporation must have 100 or fewer shareholders (recently expanded from 75 shareholders by the 2004 Tax Act), must be a domestic corporation, and can only have one class of stock.
Shareholders that are also employed by an S Corporation receive wages that are subject to employment tax. Additionally, the shareholder’s allocable share of corporate profits (whether distributed or not) represents taxable income to the shareholder for income tax purposes but is not subject to employment or self-employment tax. However, a shareholder may receive a cash distribution of the profits of the company free from income and employment tax.
Limited Liability Company
An important development in the choice of entity arena is the increased availability of the limited liability company (LLC). An LLC is formed and operated in accordance with state statutes and provides insulation from liability to the same extent as a corporation. Typically, the LLC is treated as a partnership for federal tax purposes and provides its owners (members) with the option of participating directly in the management of the business or designating certain members as managers. LLCs are allowed to have multiple classifications of equity ownership interests, in contrast to S corporations, which are permitted only one class of stock. Consequently, members of an LLC enjoy tax-planning opportunities not available to S Corporation stockholders. The primary advantage of an LLC over a partnership is the lack of personal liability of any owner of the business. Unlike partnerships, a severance of management from ownership is possible with an LLC.
In short, an LLC offers all owners the benefits of limited liability (similar to a corporation); the favorable single level of tax afforded to partnerships and S Corporations; and the flexible equity structuring possibilities enjoyed by partnerships. The LLC format of business entity should clearly be a consideration in every new business venture.
So Which Entity Is the “Right Entity”?
The issues surrounding choice of entity are numerous and complex. While tax benefits or detriments of a particular entity should always be considered, issues such as asset protection, employees, investors, creditors, employment, self-employment taxes, and state taxes should also be reviewed. Your Plante & Moran tax advisors can assist you in formulating the right entity to fit your business model.
