The First Decision in Forming a Business: What Type of Entity? By: Corey Moore

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Choosing the appropriate entity for a new business is not as easy as one might think. Most people tend to gravitate towards a limited liability company, or LLC, for its relative ease of formation and asset protection, however there are various other entities that can be beneficial for an emerging business.  The various entity types, including C and S corporations, LLCs, and partnerships all have aspects that can be useful to a new business and should be examined before selecting an entity.

Businesses with Multiple Owners

If the new business entity will have multiple owners with different rights and interests when it comes to control, income, business losses, or assets upon liquidation, ownership rights may need to be structured differently for each owner.

If the new entity is a C or S corporation, ownership is limited to company issued stock and those owning the majority of outstanding stock control the business, whereas partnerships and LLCs are flexible and can customize and define control and interests through the entity’s operating agreement. The ability to customize LLCs and partnerships can allow the owners to set up a business structure that can take into account the differences each owner may bring to the business.

Earnings Bailout Potential

Further, it is important for the new business owners to fully understand the earnings bailout potential of various entities. With S corporations, LLCs, and partnerships, it is fairly easy to remove earnings from the business and pass them on to the owners.  In this case the profits generated by the business are taxed directly to the owners, so the distribution of profits in the form of dividends or partnership distributions will not carry tax consequences for the entity.  However, when a C corporation distributes earning to owners, or shareholders, in the form of dividends, the dividend distribution is not deductible to the corporation. Instead, it is double taxed, once to the entity and once to the owner, which can be a huge hit against company profits.  This tax trap can be avoided if the shareholders are employed by the corporation and receive earnings in the form of taxable compensation.  The compensation would then be deductible to the corporation, which results in a tax at shareholder level only.

Business Losses

A new entity can also benefit from utilizing losses generated by the business. The threshold issue is whether the losses should be retained by the entity or passed through to the owners. Losses generated by C corporations are retained in the business and can be carried backwards or forwards to be deducted against earned income.  This can be a valuable tool in lowering the business’s tax liability once the business makes a profit, but the shareholders never benefit from the losses of the business.  In an S corporation, LLC, and partnership, losses can be passed through to the owners.  For example, when losses are anticipated in the first year of the business, passing the losses on to the owners may generate tax advantages if the owners have other taxable income against which those losses can be offset. 

Ability to Restructure

Additionally, the ability of an existing organization to restructure without being penalized can be a helpful tool for a business down the road. For a C corporation looking to restructure, the options are limited.  If it converts to a partnership or LLC, the corporation will recognize gain on all its assets, and the shareholders will recognize gain on the liquidation of their stock, leading to tax liability.  An S corporation and other pass through entities, on the other hand, can convert without triggering the type of gain and tax consequences you would see with a C corporation.

Estate Plan Integration

Although most people do not consider it when starting a business, it is also important to integrate a new business entity with the owners’ estate plan. Owners may want to shift income to a lower tax bracket, freeze or slow down the growth of an estate, or utilize the annual gift tax exclusion.  To make use of these options, LLCs and partnerships provide the best options and flexibility.

Potential of Sale

Finally, although most people will not think about it when beginning a business, it is important to consider the possibility of selling the business or going public. If the business is an S corporation, partnership, or LLC when the assets are sold, the gains realized on the sale of the assets are taxed to the owners in proportion to their interests in the business.  In a C corporation there will be taxes levied on the proceeds at the corporate level and then upon distribution to the shareholders.  The shareholders will pay capital gains tax on the difference between the amount they received in distribution and their individual basis in the corporation’s stock.  While there are ways for C corporations to mitigate their tax liability, it would be easier to sell a business if it was not a C corporation.  However, if the company is funded with outside capital, as many emerging companies are these days, and the plan is to eventually go public, then a C corporation is the only option.  The interests of outside investors and potential gain that can be found on the public market may trump any of the other concerns discussed above.

Deciding which type of entity to use for a new business venture may not be a difficult decision for some, but it is important to look at all the factors before creating the entity. The above discussion does not address every factor to consider nor is it a thorough discussion of the factors mentioned.  The point is to make sure to fully analyze and understand how the choice of entity decision can help or hinder the goals of the business.

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