Whether you’re starting a new business or spinning off an existing division into a standalone entity, there can be seemingly endless decisions to make. Every decision seems important––but some are especially so. One particularly crucial decision?
An entity structure refers to the way a business is organized. This decision is usually one of the first decisions business owners make when forming a new company. In the US, there are several options available, ranging from sole proprietorship to C-Corporation. Selecting the most appropriate entity structure for a business is a complex decision, with a wide variety of variables to be considered.
However, choosing the optimal entity structure is crucial to the success of the business. It can have major implications in the short, medium, and long term, and can affect many areas of the business: from tax strategy to operations.
Of course, it is possible to change entity type later in a business’s journey, sometimes without adverse tax consequences. However, in certain scenarios, switching a business’s corporate structure proves costly and disruptive, underscoring the importance of weighing all the options on the front end.
In this guide, we share why it’s important to make a well-informed decision on the best-suited entity structure for any business. We outline the factors business owners should consider and explore how the characteristics of different entity structures should be weighed in these decisions.
Before selecting an entity, there are several important considerations that business owners should think through. Often, these require thought on both the immediate plans and longer-term goals for the business.
The choice of entity can have impacts across a variety of areas. These include:
Let’s examine each of these concerns in more detail and explore the role they play in driving a business’s choice of entity.
Perhaps the most obvious consideration when assessing entity structure is the impact the entity choice will have on tax strategy. Each type of entity structure receives a different tax treatment.
Here is an overview of the tax treatment for the most common entity structures:
These entities are taxed separately from their owners. The corporation itself pays a 21% federal corporate income tax plus the applicable state income tax rate. When the corporation then pays dividends to its owners out of those profits, the corporation does not receive a deduction for those dividends. However, the individual owners who receive the dividends or distributions from the corporation will pay a federal income tax of 20% plus 3.8% Net Investment Income Tax (NITT) and the applicable state income tax rate.
This essentially means the corporation’s profits are taxed twice to the extent of the dividends paid. This is a potential total tax rate of 44.8% federal tax plus state tax when combining the rates of the corporation and individual owners.
These corporations do not pay the corporate level income taxes described in C-Corporation above. Alternatively, all of the profits are taxed only at the individual shareholder level. The tax rate of the profits will be based on the individual graduated rates based on income level and filing status.
S-Corporation income is not subject to the NITT additional 3.8% tax rate if the owner is an active participant in the business operations. Additionally, S-Corporation income is generally not subject to self-employment tax. Distributions paid to the owners out of company profits are not taxable to the owners.
One other benefit available to S-Corporation owners is an additional deduction that reduces the taxable income to the owner equal to 20% of the S-Corporation’s Qualified Business Income (QBI). This provision has exceptions as to who may take the deduction but many businesses in a wide variety of industries qualify. The type of taxpayer that can own an S-Corporation may only include individuals who are not US non-resident aliens. In addition, some estates and trusts will qualify. The number of S-corporation shareholders is limited to 100.
An entity legally formed as an LLC that has more than one owner is taxed as a partnership. A partnership is similar to an S-Corporation, in that partnerships are treated as pass-through entities for tax purposes, meaning tax is paid at the individual level, rather than the entity level.
However, unlike S-Corporations, the profits from a partnership are generally subject to self-employment taxes, in addition to ordinary rates. Like S-Corporations, LLCs also avoid the NITT additional 3.8% tax rate with active participation and no tax is paid on cash distributions paid out of the LLC profits.
LLCs can also benefit from the QBI 20% deduction mentioned in the S-Corporation description. In an LLC being taxed as a partnership, it’s easier to distribute appreciated property to owners with less tax exposure than in an LLC. An LLC taxed as a partnership generally does not restrict the number of owners and may consist of US or foreign individuals or businesses, estates and trusts. An LLC, while generally a partnership by default rules, may elect to be taxed as a C-Corporation or S-Corporation by filing a proper Entity Classification Election Form 8832 with the IRS.
Business owners should not only consider the near-term tax implications of selecting a particular entity structure; they should also think through long-term considerations.
Opting to structure a business as a C-Corporation may deliver millions of dollars of capital gains tax savings to shareholders in the event of a sale through the Qualified Small Business Stock Exclusion for shareholders that invest in corporations that meet the requirements. These benefits are not available to S-Corporations or LLCs and can represent a major tax benefit for shareholders in C-Corporations.
Each of the entity structures available to business owners results in varying degrees of flexibility and administrative requirements.
A C-Corporation is the least flexible entity structure, operationally. C-Corps have a variety of administrative requirements: the legal set up and maintenance of corporate records can be expensive and regular records, including minutes from regular board meetings, records of votes by the board of directors, corporate bylaws, etc. must be kept to maintain the corporate veil and liability protection as discussed below.
At the other end of the spectrum, LLCs typically offer the most flexible entity structure from an operational standpoint. To establish an LLC, business owners only need an Operating Agreement, which does not have to be updated or amended on an annual basis.
In determining the optimal entity structure for their business, business owners must also consider the long-term implications of their choice. If the business intends to expand to international markets, there are additional operational and tax concerns that should be taken into account.
Most entity structures afford shareholders a layer of liability protection. This protection shields individual shareholders against the business’s debts and known and unknown creditors of the business.
Corporations offer shareholders the highest level of liability protection as long as all requirements are met that maintain the corporate veil. They are considered fully-independent legal entities and are a good choice for businesses that are considered to be higher risk.
The owners of LLCs also enjoy liability protections, although they must be careful not to pierce the corporate veil that separates their personal assets from the business’s assets.
Not all entities offer this level of liability protection. A sole proprietorship offers no liability protection. Partnerships, unless they are structured as limited partnerships, also provide minimal legal liability protections to their owners.
Business owners should also consider their financing plans––both present and future––before finalizing their entity selection. Each of the different entity structures has its own characteristics in this regard:
Often, there is no one right answer when it comes to selecting the most appropriate entity structure for a business. There are so many different factors to consider, and each may weigh differently depending on the short and long-term goals of the business owners.
At Smith + Howard, we adopt a comprehensive approach to helping our clients determine the optimal entity structure for their business goals. Our experienced accountants model out every scenario, highlighting the different trade-offs business owners must consider when choosing to adopt one entity structure over another.
By providing business owners with a comprehensive overview of the implications of each entity structure, our team helps entrepreneurs make the best possible choice for the future of their business.
If you need guidance to determine which entity structure is optimal for your business, contact an advisor today.
If you have any questions and would like to connect with a team member please call 404-874-6244 or contact an advisor below.CONTACT AN ADVISOR