Choice of Entity Structure in Forming a Business
A critical step in starting a new operating trade or business is choosing the legal framework. Generally the choices are: Sole-proprietorship, partnership, Limited Liability Company (LLC), or a corporation. There are other possibilities such as a trust or co-operative, those are less common and are not addressed here.
Legal counsel and tax advisors should be consulted, ideally in the same meeting, when considering the pros and cons of the various options. Legal issues range from asset protection and isolation of liabilities to documents required to properly establish the desired business form. Tax aspects involved with the choice of business type are numerous and may be quite complex. There are choices in addition to business type that should be thoughtfully considered at the onset of establishing a business as well. Subsequent changes often prove to be much more costly than engaging qualified professionals at the onset.
Sole-proprietorships and partnerships are basic business types that have been around a long time. Both have a common disadvantage in that they don’t afford legal separation from the owners. In other words, claims against the business extend all the way to the business owners’ personal assets.
LLCs were established in Washington State under the Washington Limited Liability Company Act that became effective October 1994. LLCs have operating agreements as governing instrument and owners are referred to as members; members receive distributions.
LLCs are attractive as they offer liability protection and flexibility for taxation. LLCs are similar to sole-proprietorships (individual or married couple) as tax reporting of business operations is on IRS 1040 Schedule C (or F for a farmer) or a partnership 1065. Members of an LLC may also opt to have their LLC treated as a C or S Corporation for tax purposes.
A separate tax return is not required for LLCs owned by an individual or married couple. This is a common misunderstanding among financial professionals. The IRS considers single member LLCs to be disregarded entities. That means the IRS does not recognize the existence of the LLC for income tax purposes and the member simply uses his or her social security number as the Tax Identification Number and reports tax activity directly in their 1040. An Employer Identification Number is obtained only if the operation has employees.
Businesses still operating as a sole-proprietorship or general partnership are advised to consider converting to an LLC as there are no ill tax consequences for these forms of businesses converting.
Using a corporation has the legal benefit of asset and liability segregation from the shareholder with a longstanding case history to withstand legal challenges. Corporations are taxed as stand-alone entities and file IRS form 1120 unless an election is made to be taxed as an S corporation in which case an 1120S is filed. The S election is made by filing IRS form 2553 (this critical step is often missed, marking ‘S corporation’ on IRS from SS-4 when applying for a TIN is not adequate).
LLCs filing a 1065 partnership return and S corporations do not pay federal income taxes, instead tax attributes of the LLC or corporation pass-through to the members/shareholders on a schedule K-1. Rather than all activity being condensed into one net amount, transactions maintain their tax characteristics and are reported on each owner’s tax return just as if transacted by that individual. For example, a member’s (shareholder’s) share of security sales are reported on Schedule D in their personal 1040 just as if they sold the security personally, his or her share of charitable contributions are reported on Schedule A just as if he or she had made the contribution personally, and section 179 depreciation is reported separately on the owner’s 1040 as well.
A common mistake made by individuals receiving a K-1 is to associate taxable income allocated with cash distributed during the year. Often there is little if any correlation between the cash distributed and taxable income or loss allocated to recipients of K-1s.
There are some important tax considerations in each form of entity. Here are a few:
- LLCs that are disregarded entities for IRS purposes do not need to prepare and file a separate tax return
- Business income reported on 1040 schedules C or F (single member LLCs) or passing through on a K-1 from LLCs filing IRS form 1065 may be fully subject to self-employment tax
- While income from an S corporation flows through to the shareholders, it is not subject to self-employment taxes, only wages paid to the shareholders are subject to social security and Medicare taxes
- Pass through income on a K-1 is generally only taxed once
- C Corporations pay tax at a maximum rate of 35% and dividends to shareholders are taxed again
- C Corporations do not enjoy lower capital gains tax rates that apply to individuals
- Corporate dividends must be paid strictly based on shares owned; LLCs filing a 1065 have flexibility in allocating profits and losses
- Underlying assets of corporations cannot be stepped up on the death of an owner (or spouse in a community property state such as Washington); it can be with property held directly by the owner or a member of an LLC filing a 1065
- This can be really significant in a business or farm operation with depreciated property
- This is why most shareholders in closely-held corporations form a separate LLC to hold real property
- Owners fringe benefits are taxed differently in the various forms of entity
A carefully crafted business plan addresses choice of entity structure, it may even include a plan to transition to another form when beneficial. Established businesses should review their structure to ensure it is the best available. A move to a different entity structure should be made only after careful consideration of tax and other consequences of the change.