The decision as to which type of business organization to use when starting a business is a major one. And, it's a decision to be revisited periodically as your business develops. While professional advice is critical in making this decision, it's also important to have a general understanding of the options available. This Financial Guide provides just such an overview.
Businesses fall under one of two federal tax systems:
Double Taxation
Taxation of both the entity itself (on the income it earns) and the owners (on dividends or other profit participation the owners receive from the business). This system applies to the business S-corporation-called the "C-corporation" (C-corp) for reasons we'll see shortly and the system of taxing first the corporation and then its owners is called the "corporate double tax."
Pass-through Taxation
This type of entity is in itself not taxed; however, each owner is each taxed on their proportionate shares of the entity's income. The leading forms of pass-through entity are partnerships, S-corporations, LLCs, and sole proprietorships.
Types of Business Entities
C and S-Corps
The S-Corp (so named from a chapter of the tax code) is a tax device created by federal law in 1958. It is a regular corporation with regular limited liability under state law, whose owners elect pass through status for federal tax purposes. That status requires compliance with a number of often constricting rules but, with some exceptions, complying corporations escape federal corporate tax.
Corporations whose owners don't choose to make the federal S-corp election are called C-corps (after another chapter of the tax code).
Partnerships
General Partnerships
Ordinary partnerships, called "general partnerships," do not have limited liability under state law.
Limited Partnerships
Limited partnerships limit liability for some partners but not others. A limited partnership has both general partners (who manage the business) and limited partners (who, in essence, are passive investors). The liability of limited partners is generally limited to their investments.
Limited Liability Partnerships (LLPs)
A still more recent development, not yet adopted everywhere, is the limited liability partnership which was designed for professional practices.
Limited Liability Companies (LLCs)
LLCs have become the most popular business form for new entities, and many existing entities have converted to this form. They exist in some form in every state. They embody limited liability features of corporations and pass-through characteristics of partnerships and S-corps, but are more flexible than S-corps.
For business law purposes, LLC members may be either passive investors or active investor-managers. Unlike with limited partnerships, active management won't affect limitation of liability. For federal tax purposes, LLCs are treated as partnerships (unless they elect otherwise).
Choosing the Tax Treatment
Since 1997, the IRS has allowed business owners a previously unheard-of measure of choice as to how the entity will be federally taxed. It allows you to choose between C-corp and pass through treatment (universally called "check-the-box").
Important Considerations
- If the entity is incorporated, it must be treated as a corporation
- Publicly traded partnerships and publicly traded LLCs must be treated as C-corps
- An LLC with two or more members may choose to be taxed as a C-corp, a partnership or an S-corp
- An LLC with a single member may choose either to be taxed as a C-corp or an S-corp or to have the entity disregarded
Choosing the Pass-through Entity
S-Corporation
Advantages
- Limited liability protection
- Simple to operate
- Pass-through taxation
Restrictions
- All owners must agree to S-corp status
- Only one class of stock allowed
- Limited to 100 owners
- Restrictions on who can be owners
- Limited types of business allowed
LLCs vs. S-Corporations
LLC Advantages
- More flexible allocation of tax attributes
- Easier to add co-owners
- Tax-free transfers of appreciated property
- Complex tax adjustments available
- No tax on distribution of appreciated property
S-Corp Advantages
- Better understood by business community
- Tax-free exit via corporate reorganization
- Simpler tax structure
Professional Practice Entities
Professional practices (such as doctors and lawyers) have a number of options as to their form of business entity.
Professional Corporations (P.C.s)
- Limited liability for general business debts
- No limited liability for own malpractice
- May be C-corps or S-corps
- Can use cash method of accounting
Limited Liability Partnerships (LLPs)
- Designed for professional practices
- Partner liable for own malpractice only
- Required to maintain malpractice insurance
- Not subject to entity-level tax
Other Pros and Cons of C-Corps
Advantages
- Better fringe benefits for owner-employees
- Health insurance can be wholly tax-free
- Less likely to be subject to passive loss limitations
- Can build up funds at relatively low tax rates
Disadvantages
- Double taxation on income
- Limited ability to use cash method of accounting
- Distribution of appreciated assets creates double tax
- IRS may limit "unreasonable" compensation deductions
Further Insights on S-Corps
Potential Tax Issues
A qualifying S-corp, generally nontaxable, can be subjected to C-corp taxation on certain items without losing S status for other items. This happens when:
- A C-corp converts to an S-corp and carries over appreciated property later sold at a gain
- The S-corp has "excessive" passive investment-type income (interest, dividends, etc.) in excess of 25% of gross receipts
Employment Tax Considerations
Some see S-corps as a way to reduce employment taxes by taking a portion of income as wages and the rest as dividends. However, the IRS may treat dividends as wages subject to employment taxes in abuse situations where little or no wages were paid.
Changing To Another Entity
The many advantages of LLCs, for both business and tax reasons, have encouraged many business owners to convert, or consider converting, to the LLC form. Here's what happens for federal tax purposes when entity status is changed:
C-corp converts to S-corp or vice versa
No tax on the conversion. Pass through treatment applies while it is an S-corp.
C-corp or S-corp converts to LLC, partnership or sole proprietorship
Generally, a tax on the liquidation of the corporation, with pass through treatment for the new entity.
Partnership converts to LLC or vice versa; sole proprietorship converts to single member LLC or vice versa
No tax on conversion - pass through treatment continues.
LLC, partnership or sole proprietorship converts to C or S-corp
Generally, no tax on conversion. Pass through treatment (in modified form) for S-corp income.
Government and Non-Profit Agencies
Small Business Administration (SBA)
The Small Business Administration (SBA) has offices located throughout the United States. Contact SBA through their website for additional resources and guidance on business formation and management.
Disclaimer: This Content is for informational purposes only. Nothing contained herein constitutes accounting, tax, financial, investment, legal or other professional advice, and, accordingly, the author and the distributor assume no liability whatsoever in connection with its use. This Content is not an exhaustive explanation of any topic, practice or process. You should seek the advice of a licensed professional before making any accounting, tax, financial, investment or legal decision.
