Helping your clients determine their form of ownership

Selecting a business structure—sole proprietor, partnership, limited liability company (LLC), or corporation—can be daunting to business owners. There is not a one-size-fits-all approach. Depending on the business owner’s circumstances with regard to industry, net income, capital raising requirements, growth projections, U.S. residency status, appetite for fringe benefits, and other factors, specific business structures may be more appropriate than others. There is no substitute for careful planning before forming an entity, and even afterward for potential restructuring.

Since the passage of the Small Business Job Protection Act of 1996 and the check-the-box entity classification regulations that were created, in part, to increase the competitiveness of small businesses by providing tax relief, LLC and S corporation elections appear to have become the preferred formation and tax classification combination for many small business owners. The number of S corporation returns filed has consistently increased yearly, while C corporation returns have decreased.

The check-the-box entity classification regulations were created to simplify the entity classification process by allowing unincorporated entities to elect how they want to be treated for federal income tax purposes. Before these entity regulations, unincorporated business entities (except sole proprietors) were generally considered a partnership or corporation for federal income tax purposes, based on whether they met a preponderance of pre-defined corporate characteristics.

The Internal Revenue Code has since established default entity classification rules for Domestic Eligible Entities (DEs), a business entity not organized under a federal or state statute as a corporation or joint-stock company—for example, an LLC or partnership.

If a DE has at least two members, it will, by default, be classified as a partnership for federal income tax purposes and would be required to file Form 1065, U.S. Return of Partnership Return. If a DE has only one member, it is considered, by default, a “disregarded entity”—it is disregarded as an entity separate from its owner. Accordingly, the entity’s net income/loss is reported on Schedule C (Self-Employed), Schedule E (Rental), or Schedule F (Farming) of the business owner’s tax return.

With the options of business structure and the flexibility to elect how to be taxed, decisions come about that require careful planning and consideration, since there are unique benefits and disadvantages to each business structure and tax classification. Here are some general factors to consider with your client when choosing a business structure.

Liability protection

Unless they’re structured as a limited partnership, sole proprietors and partnerships generally lack liability protection because they don’t have any entity liability shield.

Corporations, LLCs, and limited partnerships provide certain personal liability protection to help ensure that a loss or incident occurring in a business doesn’t expose personal finances and assets. This protection, however, can be pierced based on actions of the owners, such as the Alter Ego Theory (lacking separateness between the owner and company because of commingling funds, poor governance, and other factors), committing fraud, and conducting illegal activities.

There is no substitute for implementing strong company policies, proper training, and consistently assessing and monitoring operation risks to avoid potential risks. However, since there is no invincible protection against liability, consideration should be given to purchasing business insurance, including commercial general liability insurance, as well as errors & omission insurance for professionals, such as lawyers, engineers, accountants, and others. It’s essential to obtain legal consultation when determining the best form of legal protection.       

Tax rates

C corporations pay a flat 21% tax on their profits at the federal level. Dividends paid to shareholders from those same profits are generally taxed at the shareholders’ long-term capital gains tax rate, creating double taxation. At first glance, this may appear as a disadvantage, but depending on the shareholder’s overall taxable income and strategic timing of dividend payments, capital gains taxes on dividend payments can be minimized or eliminated.

For example, a married couple that owns a C corporation and has no other income may receive dividend payments from the corporation up to $83,350, plus their standard or itemized deduction, without paying capital gain taxes because of the flat 0%, 15%, or 20% long-term capital gains tax rates. Moreover, to defer or reduce capital gain taxes on dividend income, the corporation doesn’t have to make a distribution. It can hold on to cash for expansion, working capital, and future benefit payments without consequences, if the accumulated earnings tax rules aren’t tripped.

S corporations generally avoid double taxation because net income flows through the corporation without paying taxes until it is reported by the shareholders, who are taxed at their individual tax rate. However, certain local and state taxing authorities do not recognize the S corporation status, and therefore can treat the entity as a C corporation by taxing it at that entity level. For example, in New York City, S corporations pay an 8.85% corporation tax on the net business income at the entity level. This creates double taxation for S corporations operating within the five boroughs of New York City, since the business’ net income is passed through to the shareholders and taxed on the shareholders’ federal and state (where applicable) tax returns. Special consideration and analyses are essential in such a situation, since the purpose of electing the S corporation tax classification may be defeated.

S corporation shareholders don’t pay Social Security and Medicare (self-employment) taxes on the entire profit of the business like a sole proprietor or partner would pay. Instead, Social Security and Medicare taxes are paid on the owner’s/employee’s reasonable compensation.

Owners of pass-through entities, including partnerships, S corporations, and sole proprietorships, pay income taxes at their individual income tax rates. They also may deduct up to 20% of their qualified business income on their tax return because of the Qualified Business Income (QBI) deduction. The Tax Cut and Jobs Act provided this gift for pass-through entities to level the playing field for small business owners, since it reduced the corporate tax rate to 21%. The QBI deduction’s tax savings should be considered in determining an entity’s tax classification.

Intuit® has an excellent tool for calculating and comparing the total taxes under different entity-type scenarios, based on a hypothetical business net income and other assumptions that you can input into the analysis. 

Allocating profits and losses

Partnerships are allowed flexibility in allocating the income and losses of a partnership each year to benefit the tax position of specific partners. However, the income and losses of S corporations must be allocated based on the ownership split.

Exit strategy

Sole proprietors can generally exit their business without formal paperwork, while other business structures, such as a corporation, require a formal dissolution.

Moreover, the business structure selected can determine how much is paid in capital gain taxes when the business interest is sold. For example, Section 1202, the Small Stock Gains Exclusion, allows owners of certain small businesses to exclude from income up to 100% of capital gains from selling their qualified small business stock held for more than five years. However, this exclusion is only afforded to C corporations.

Employing children

If your client has children, there is an opportunity to shift income to a lower tax bracket by paying the children a salary from the business. However, the selected entity type makes a difference when it comes to Social Security and Medicare tax treatment.

Children employed through a C corporation or S corporation are subjected to Social Security and Medicare taxes. However, children employed by a parent who owns a sole proprietorship, or by both parents who own a partnership, do not pay Social Security or Medicare taxes until they are 18. Accordingly, children can be paid up to the maximum standard deduction amount without paying taxes, while the business recognizes a deduction.

Fringe benefits

C corporations are generally allowed more fringe benefits that are deductible by the corporation and tax-free to the employees, which includes an owner-employee. For example, whereas an owner-employee of a corporation can participate in a Health Reimbursement Arrangement (HRA) and get reimbursed for qualified medical expenses, owners of 2% or more of an S corporation and other pass-through entities, including sole proprietors, are generally not eligible to participate in their company’s plan on a tax-favored basis.

Accountable plans are generally only available to employees. Therefore, owner-employees of S corporations and C corporations can personally benefit from these plans, while sole proprietors cannot since they are not considered employees.

Non-resident business owners

While there are no citizenship or residence requirements for owning a C corporation or an LLC, S corporation regulations do not permit non-resident aliens to be shareholders. In certain instances, it may be necessary for a non-resident alien to partner with a U.S. citizen to effectively operate an LLC in the United States.

Customized entity structures

It may be beneficial to form multiple business structures to take advantage of the unique benefits afforded to particular entities.

For example, a family-owned business classified as an S corporation may create a disregarded LLC that provides services to the S corporation and pay their children through the disregarded LLC to avoid paying Social Security and Medicare taxes. Similarly, an S corporation owner can form a C corporation that provides services to the S corporation, so that the owner can receive health care reimbursements under an HRA, which are not afforded to more than 2% of owners of S corporations and other pass-through entities. There are endless possibilities that are dependent on your creativity.

Raising capital

Generally, operating as a C corporation may be easier to raise capital, since the business can issue stock or sell bonds.

Limitations

Certain states limit licensed professionals to a particular business structure. For example, in New York State, licensed professionals generally register their business as a Professional Limited Liability Company or Professional Corporation.

Audit rates

Overall, there has been a downward trend in the number of audits conducted by the IRS since 2011. Based on the audit data in the most recently published IRS Data Book, the entity types with the greatest audit risk, in order of most audits to least, are:

• Large corporations with more than $20 million in total assets: 50% audit rate.
• Large corporations with $10 million to $20 million in total assets: 6% audit rate.
• Schedule C filers (disregarded entities): .75% audit rate.
• Small corporations with under $10 million in total assets: .5% audit rate.
• S corporations: .2% audit rate.
• Partnerships: .18% audit rate.

The audit rates, however, are expected to increase with the recent passing of the Inflation Reduction Act, which provides $80 billion of increased funding to the IRS.

The bottom line

Choosing the proper business structure can be challenging and somewhat complex. Careful consideration of multiple factors is required, which should not be rushed or taken lightly. Legal consultation is highly recommended when considering the legal aspects of business structures.