Does your legal structure meet your needs? Are you still unsure what business entity to go with?
After deciding that a business venture is going to be profitable, an important step in the strategic planning for the business is what type of legal entity is going to be used. At the outset, there are two major options: an unincorporated entity, usually a sole proprietorship, that does not provide any liability protections; and an incorporated entity, such as a corporation or LLC, that shields the owners of the business from the liability of the business.
Let's take a look at the following questions business owners need to ask themselves when making the decision on what type of business entity works best for their situation:
If you don’t need liability protection, go with a sole-proprietorship. If you need liability protection, go to the next question.
The biggest question in deciding between an unincorporated entity and an incorporated entity is whether or not the business owner needs liability protection. When a person operates as a sole-proprietorship, if the business incurs a liability (e.g., a customer getting injured at the business), the owner is liable. This is because there is no separation between the business and the owner. Operating as an unincorporated entity is not limited to sole-proprietorships. When multiple people operate a business together without forming a business entity with the secretary of state, those people are operating as a general partnership, which results in all the business owners having liability for the operations of the business.
For some businesses, operating as a sole-proprietorship or as a general partnership may be a necessary first step because of limited resources in starting the business. These businesses may recognize a need for liability protection, but decide to put the business capital to other uses to get the business started and make a calculated decision to take on some risk early on. For other businesses, such as an individual that makes a small amount of jewelry and sells it through eBay or Etsy, the amount of risk may not be sufficient to warrant the need to incorporate.
Operating a sole-proprietorship is easy in the sense that no separate tax return is required, and the person reports business income and expenses on IRS Form 1040 Schedule C of his or her tax return.
If a business decides that no liability protection is needed, then the entity selection stops with the first question. But, if the business needs liability protection, then the business owner needs to decide which type of entity works best.
If your business is holding real estate, go with a pass-through entity, such as a limited liability company. If not holding real estate, go to the next question.
If your business is going to hold real estate, there are some big advantages in selecting an entity that passes the profits and losses of the business to the owners. And, if your business is going to purchase real estate to house the operations or store goods, another planning consideration is using a separate entity to own the real estate. Using a separate entity to hold the real estate protects the real estate from the liabilities of the operating business and vice-versa. If the operating business incurred a liability that wiped out all the equity in the business, and the real estate is owned in a separate entity and certain formalities are observed, then the equity in the real estate entity can probably be saved.
There are five reasons to use a pass-through entity for holding real estate:
1. Depreciation cost recovery deductions. One of the biggest fictions in the Internal Revenue Code is that real estate improvements (everything but the land) lose all of their value over time, which allows for depreciation cost recovery deductions. This allows business owners to fully depreciate the cost of everything but the land. This is done over 27.5 years for residential real property and 39 years for nonresidential real property.
2. Nonrecourse debt. Being able to depreciate the value of the building is only as good as the ability of the business owner to have that deduction offset other income. Normally, this is limited by the business owner’s “basis” in the property, which is the actual amount of money that they put into the business. However, with real estate entities, a business owner can include the debt used to purchase the building as part of their basis. One way around this basis challenge is to have the debt secured by a personal promise of the business owner, which means if the business can’t pay the debt, then the business owner will – this is known as “recourse debt.” This personal promise of the business owner defeats one of the liability protections of incorporating. However, nonrecourse debt allows the business owner to not be on the hook for the debt and still include the debt in his or her basis to take a deduction.
3. Real estate shouldn’t be subject to C corporation double tax. In general, there is no reason to subject appreciating real estate to the double taxation of C corporations. As such, it should be kept out of C corporations.
4. Avoid self-employment tax. Income from real estate activities that passes through to the owners is generally not subject to self-employment tax. The exception to this rule is people that receive rental income as part of a trade or business as a real estate dealer.
5. Step-up in basis. When a person dies, the value of their assets steps-up (hopefully) in basis to each asset’s fair market value. With a pass-through entity, through an election under Internal Revenue Code §754, so does the basis in the property inside the entity. Basically, this allows a person to fully depreciate the value of everything but the land over time, then have the basis in the value stepped-up to fair market value when they die, allowing the people who inherit the property to avoid income tax on the gain.
For these five reasons, an entity that provides for pass-through taxation is appropriate for real estate. And, real estate is normally worth putting in a separate entity from the other part of the business. The typical pass through entity for taxation is a limited liability company or a partnership.
If you are at question 3, then your business needs liability protection and at least one part of the business will not be holding real estate. You are down to three main candidates for your business entity: a limited liability company, an S corporation, or a C corporation. There are lots of factors that impact the decision in deciding between these entities.
In looking at the different factors between a limited liability company, S corporation, and C corporation, it's more than a matter of adding up the score between them of pluses and minuses. For some businesses, one factor may trump all the others (such as wanting outside investors that require a C corporation) and for other businesses it may be less clear with one or more factors favoring different entities.
Below are factors that favor each aforementioned entity:
Factors Favoring a Limited Liability Company
Different ownership interests. Limited liability companies allow the business owners a great deal of flexibility in how the ownership interests are structured. This can provide for certain owners to get deductions when the company is running at a loss, and then providing all the owners part of the appreciation once profitable. In addition, the business can also provide a key employee a profits-only interest, which would allow the business to provide the key employee an incentive in growing the business without having to buy into the capital of the business.
Control rights. Limited liability companies also allow the business owners an almost infinite opportunity to structure how the business is controlled. This is much more than deciding if the LLC is member-managed or manager-managed (do all owners of LLC make decisions or just a person selected by members). Certain owners can be given decision making rights for some decisions while other owners can be given other decision making rights. For example, a certain group of owners may have the right to decide if the headquarters for the business can be relocated while a different group (which may or may not include some of the other owners) would have the right to decide when profit distributions are made. However, this ability to vary the control rights in an LLC may actually favor going with a different entity that does not allow for as much negotiation in control.
Loss utilization. When a business operates at a loss, if taxed as a pass-through entity, the business owners can utilize the business losses as deductions against their other income. This is not an option with a C corporation where the losses are trapped inside the corporation. While most businesses plan to turn a profit eventually, the ability to deduct the losses early on may favor the ability to utilize the losses as deductions against other income of the business owners (also available with S corporations).
Single level tax. With a limited liability company, the actual business doesn’t pay any income tax. Instead, the income tax of the business passes through to the business owners in accordance with their ownership interest. This results in a single level of tax for the business profits (also available to S corporations). In contrast, a C corporation pays a corporate income tax and the owners pay a tax on the dividends they receive from the corporation, which is why C corporations are referred to as having a double tax structure.
Less formalities. Limited liability companies do not require annual meetings of the owners or people running the business. While it is advisable to have these periodic meetings each year, not having them with an LLC does not jeopardize the business being respected as a separate entity from the owners. As such, many business owners favor the LLC because of less onerous formalities.
Factors Favoring an S Corporation
Self-employment taxes. By structuring a business as an S corporation, a business owner can split the earnings of the business between a salary received for working for the business and a dividend for owning the capital of the business. The money received as a dividend for owning the business is not subject to Medicare and Social Security (self-employment taxes). This can save 13.2 percent of the money that is classified as a dividend. However, a business owner must still receive a “reasonable salary” for their service to the business, and so a business owner couldn’t classify all of the earnings of the business as a dividend.
Control rights. As discussed under LLCs, one advantage of LLCs is the ability to structure the control of the company however the owners want. While this may be an advantage sometimes, it's not always. By using a traditional corporate structure, the control rights are with those who own the majority of the company. An S corporation dictates this traditional set of control rights even more because an S corporation is by definition only allowed to have voting and non-voting stock (a C corporation might have different classes of stock that allow some stock super voting rights, such as 10 votes per share). When the majority owner wants control, an S corporation or C corporation is going to be the preferred entity, as it can help avoid the control issue as a negotiation point.
Single level of tax. See the discussion under LLCs.
Loss utilization. See the discussion under LLCs.
Factors Favoring a C-Corporation
Control rights. See the discussion under s-corporation and LLCs.
Not my income tax return. By using a C corporation, the finances of the business do not impact the individual tax returns of the business owners. This is an important consideration for some business owners that do not want to expose themselves to a potential audit because of what happens with the taxes of the business.
Outside investment. Many outside investors require that businesses are structured as C corporations. Part of this is the “not my income tax return” factor discussed above, and the other part is that it's what many outside investors are used to dealing with. If a business wants outside investors, then structuring the business as a C corporation may be the only option.
Going public. If the eventual exit plan for the business owners is to have the business go public, then the business should be structured as a C corporation because it's the type of entity traded on public exchanges. In addition, an audited track record of a company in the form of C corporation best shows the market how the company is performing and usually allows for the highest valuation when going public.
Fringe benefits. There are certain fringe benefits available to shareholder/employees of a C corporation unavailable to owner/employees of pass-through entities (LLCs and S corporations). These fringe benefits are able to be deducted from the profits of the corporation without being taxed as compensation to the shareholder/employees. These fringe benefits can be a significant consideration for owners. These fringe benefits include group-term life insurance, medical-dental reimbursement plans, cafeteria plans, and dependent care assistant programs. Health insurance premiums are a neutral factor because they can be deducted by an LLC owner or S corporation owner.
Respect Business Formalities for Liability Protection
If the answer to the first question of whether liability protection is needed is yes, then the business owners must make sure to respect the separate identity of the business to ensure the liability protection. Respecting this separateness means that separate bank accounts must be maintained for the business, major transactions between the business and the owners should be tracked in minutes or resolutions of the business, and the business owners should not portray themselves as being the business, which means a business owner should sign in their capacity as an operator or owner of the business (for example, an owner of a corporation should sign for the business as “John G. Millionaire, President, Millionaire, Inc.” rather than just “John G. Millionaire”).
From the needs of your business to the risk tolerance of the owners, the entity choice for your business is no small decision. The questions and discussion above is a good starting point. After thinking about these questions and examining the factors outlined above, you will either be ready to pick an entity yourself or consult with a business planning attorney to help you make the entity decision and form an entity.