When going into business, one of the first questions you will want to answer is "what sort of entity should I be." Inherent in this question are two sub-questions: What sort of "legal" entity should I be and what sort of "tax" entity should I be. These questions overlap but are not the same.
The choice of entity, from a legal perspective, has more to do with the basic structure of your business— whether you choose to create a separate legal entity under state law. For example, you might decide to incorporate your business or to form a Limited Liability Company (LLC) by filing the appropriate application with your state. The state will vet your application and either grant your charter, or not. Alternatively, assuming you have acquired all necessary permits or licenses, you may simply decide to start conducting business and acquire your legal identity that way. However, up to this point, you have not necessarily made a clear decision about your classification for tax purposes.
For tax purposes, possible formats include sole proprietorships, partnerships and corporations. Corporations can be further broken down into "C" (regular) and "S" corporations.
Clearly, the legal and tax identities of your business affect each other and need to be considered together. For example, if you choose to incorporate your business, then by definition, you will not be able to use the sole-proprietorship or partnership tax rules for your business. With the LLC legal format, you can likely choose to be taxed under any of the tax classifications mentioned above, depending on your circumstances.
The ability to choose among the possible tax classifications is also limited by certain common sense conditions, as well as by many technical limitations under the tax code. For example, if your business will have more than one owner, then, by definition, you will not be a sole proprietorship. "S" corporation status is not available if, for instance, the business has more than 100 shareholders, or if any of the shareholders are non-resident alien individuals. So sometimes, your choices are narrowed down from the beginning.
The goal when choosing a tax classification seems clear—which entity type will provide the most effective tax status for your business operations. Small business owners have several options that allow both the income and losses of their business to flow through directly to their personal tax returns. This avoids any income being taxed, or losses being trapped, in the tax entity. This pass-through treatment avoids the proverbial "double-taxation" problem that "C" corporations are prone, and is the reason why many small business owners decide not to choose "C" corporation status for tax purposes. However, that being said, since the corporate tax rates were lowered last year from a high of 35% down to 21%, even "C" corporation status is getting a closer look in the small business arena. Most likely, a pass-through treatment is a better option, tax wise, if it is available. The most common pass-through options for small businesses are "S" corporations and partnerships, or if it fits, the sole proprietorship.
Partnerships and “S” corporations
While "S" corporations and partnerships are similar in that they are both "pass-through" entities, there are important differences to consider. First, as we stated, "S" corporations have some well-defined limitations on their use. For example, there is the 100-shareholder limit as noted above, as well as other shareholder restrictions. If you are planning to raise future capital by issuing shares of stock, then "S" corporation status could be a serious impediment. Partnerships tend to be less restrictive in this manner.
Another trait that differentiates the two is flexibility. Partnerships are generally considered more flexible than “S” corporations when it comes to designing an operating agreement and establishing the rights and responsibilities among the owners. For example, you can customize, within reason, the partnership agreement in terms of allocating profits and losses among the partners. "S" corporations tend to be less flexible in this area. The trade-off for this flexibility can be complexity. A partnership may be more complex in terms of maintenance and tax compliance than an “S”corporation, but not always.
Partnerships are also a little more robust relative to “S” corporations in terms of how debt of the entity is allocated among owners. Should your business incur early losses, this distinction could result in greater tax deductions compared to an "S" corporation. These two differences, flexibility and debt allocation, lead some to believe that the partnership format is better than "S" corporation status. I wouldn't go that far. After all, it depends on your specific circumstances.
Another issue that plays in to your choice of tax entity has to do with the type and nature of assets that you bring to the business. The issue is, in a nutshell, once you put the asset in the entity, what happens when you want to take it out? How does the choice of entity affect this? This problem can be illustrated with real estate, an asset that often appreciates. The general rule is not to put real estate in a "C" corporation. Since real estate can often appreciate, it could be subject to double-taxation. In general, the better choice would be to place the real estate in some sort of pass-through type of entity, including an LLC/sole-proprietorship, and avoid the specter of double-taxation on the appreciation.
As alluded to above, the LLC (or any variation thereof) is attractive as a legal entity choice because it is designed to provide the owners with the liability protection of a corporation, but preserves the ability to choose a pass-through type of tax regime, whether it is an "S" corporation, partnership or even sole proprietorship. If you are a one-person shop, you can match sole proprietorship tax treatment with your LLC - single layer of tax there too.
I hope that this brief walk through of the decision process for choosing a type of entity gives you a flavor of what you will encounter. This list is by no means exhaustive and, certainly, there is no cookie-cutter approach to making this choice. It depends on your specific facts and circumstances. However, by taking a thoughtful approach and engaging the right advisers as needed, you can make the best legal and tax entity choice for your business.
Arthur Caccamo is a manager based out of our Albany, NY office.