Discussion on Entity Selection and Walkthrough of Entity Lifecycle

You’re starting a venture, or you already have a business? Getting informed is the first step, but very often an important second step is missed: Getting expert help. Ask yourself this: Do you navigate a new country alone? Extract your own teeth? File your own business tax returns? Build your own website? Some of these may have a “yes” answer. Some a “no”. It really depends on your personal abilities and desire to learn these abilities. Getting informed without hiring an expert to guide you through the maze that exists in business entity selection never allows you to have that critical dialogue about the pros and cons of each entity with a trusted attorney, CPA, or other advisor – that’s essentially the service you are paying for: guidance. We’ll give you a brief primer on entity selection in this article to help you in your self-education journey and we’ll leave hiring an expert to you.

‍Introduction:

There are multiple options to choose from when it comes to business entity types (or structures), each with their unique benefits and disadvantages. As a business owner your task is to analyze these advantages and disadvantages to determine the ideal business structure for your present and future needs or retain an informed and experienced attorney or CPA to guide you through the maze of entity selection and formation.

It is necessary to periodically assess your financial and legal needs and consider alignment with your business entity structure (es) as it relates to liability protection, ownership interest transferability, tax law, succession planning, business insurance, debt and equity financing, and many other aspects as various life and business events arise. The key is to understand that entity planning is dynamic and must evolve with your business, unless your business is static, which is a problem of its own.

The subsequent section offers a brief rundown of the commonly available business structures. Acquainting yourself with these choices will facilitate more meaningful conversations with your legal advisor, accountant, and business associates.

‍Sole Proprietorship:

A sole proprietorship refers to a business managed by a single person; incorporating another owner disqualifies it from being a sole proprietorship. For small and nascent ventures, particularly those providing services such as contractors, plumbers, bookkeepers, and freelancers, this business entity often proves to be the most appropriate – in fact, it’s not even an entity; it’s just how we differentiate between someone employed by an employer and someone that is self-employed.

Setting up a sole proprietorship doesn't necessitate any formal steps, but the proprietor can opt to register their trade name, secure an EIN (Employer Identification Number), purchase business insurance, or create a business bank account. In terms of taxation, a sole proprietorship submits taxes through Schedule C attached to the proprietor's individual 1040 tax return, and taxes are levied solely on net income (revenue exceeding expenses).

While a sole proprietorship could persist for the duration of the proprietor's lifetime, the inclusion of more owners or employees frequently leads to a transition to a different business entity due to the attractive provision of limited liability.

‍Limited Liability Companies (LLCs):

Limited Liability Companies, or LLCs, have been very popular since the late 1990s and early 2000s when many states created them. From a legal standpoint, LLCs have members, not partners, not shareholders, not owners – they own membership units in the LLC. LLCs offer members limited liability, which insulates each member from legal liability that may arise from business activity. It is very important to set up and operate the LLC in accordance with state law for liability protection to function as intended because in a courtroom, settlement meeting, arbitration arrangement, or other legal mechanism used to resolve legal disputes, all of that will be peeled back by opposing legal counsel.

LLCs with more than one member can be taxed like a partnership, S Corporation, or C Corporation, except when there is only one member, in which case they can be taxed as a “disregarded entity” (or sole proprietorship), S Corporation, or C Corporation.

Those choosing an LLC often seek the partnership taxation attributes that are inaccessible to S-Corps and C-Corps. Though LLCs are often linked with commercial real estate, they're gaining traction in sectors such as technology, construction, manufacturing, and professional services.

LLCs are created by filing organizational documents and a fee with the Secretary of State and demand annual filings and fees for maintenance. Some businesses might start as LLCs and subsequently transform into S-Corps or C-Corps, but the reverse is relatively rare due to possible tax penalties.

‍S-Corporation:

An "S-Corporation" is a distinct type of corporation acknowledged in the federal tax code. The “S” refers to Subchapter S of Chapter 1 of the Internal Revenue Code (IRC).

S Corporations can pose challenges for businesses seeking investors as they cannot exceed 100 shareholders, all of whom must be US individuals. To get an entity to be treated as an S-Corporation either an LLC or corporation needs to be registered in your desired state by filing organizational documents and submitting the required fee with the Secretary of State, you will also need a Federal EIN, and a formal election request on Form 2553 with the IRS.

There are countless creative and advanced tax planning strategies available to S Corporations and shareholder-employees. To discuss all combinations of these strategies would be futile; it is best to get a hold of us at Cruncher Accounting, PC to review your needs and opportunities before creating a tailored tax plan that meets your specific needs.

‍C-Corporation:

A C-Corporation is the default tax treatment of a corporation. Although it provides limited liability to its shareholders, it doesn't enjoy flow-through tax treatment, like a S Corporation or Partnership. Instead, it's a separate taxable entity subject to double taxation at both the corporate and shareholder levels. Similar to the S Corporation, there are disadvantages and some very creative and advanced tax planning and tax reduction strategies afforded to C Corporations; your needs simply need to align.

C-Corps are commonly publicly traded companies or large private companies with hundreds of investors or with foreign investors. Use among private businesses are done strategically for estate planning, tax planning, or some other business planning reason. A C-Corporation is established by filing organizational documents and a fee with the Secretary of State and each state has its own specific process.

Consistent with S Corporations (or any entity for that matter) it is best to get a hold of us at Cruncher Accounting, PC to review your needs and opportunities before creating a tailored tax plan that meets your specific needs.

‍Limited Partnership:

This business entity bears resemblance to an LLC, featuring partnership taxation and limited liability for limited partners. However, the General Partners who manage a Limited Partnership aren't afforded limited liability. This absence of protection is a major reason why LLCs have gained in popularity.

The formation of new Limited Partnerships is now rare and typically limited to specific business activities like Private Equity; Venture Capital; Hedge Fund; Oil and Gas; Film Production/Entertainment, Real Estate Investment Funds; or Offshore Entities where for various reasons there must be a General Partner that assumes the risks and liabilities of the partnership. The establishment of a Limited Partnership involves filing organizational documents and a fee with the Secretary of State, followed by annual filings and fees for upkeep.

‍Recap:

Existing businesses should also evaluate their choice of entity—especially now, in light of President Biden’s proposals to increase the tax burden on corporations and high-wealth individuals. Depending on the circumstances, it may make sense to consider converting an existing entity to a different type of tax entity or structure in order for businesses and their owners to better manage their overall tax obligations. An analysis should be performed to determine the amount of any immediate tax cost that would be incurred upon changing entity classification compared to the future tax benefits of conversion.

Choice of entity decisions need to take into account many tax and legal considerations based on the taxpayer’s specific facts and circumstances, as well as business and investment goals. Taxpayers should keep in mind that current tax proposals would raise tax rates and make other changes to the federal income tax system for corporations and high-wealth individuals. These proposals should be monitored, and their potential effects should be considered when evaluating the short and long-term benefits of a particular entity choice.

‍Tax Considerations When Choosing An Entity:

There are many tax considerations that play into the choice of entity decision, some of which are discussed below. All of the considerations should be analyzed together with other important factors, such as whether investors intend to distribute or reinvest available cash, income projections including whether the business anticipates upfront losses, the expected rate of return on investment, the time horizon for exit and available exit strategies.

‍Effective Tax Rate on Earnings:

The rate at which businesses pay tax on their earnings impacts after-tax cash flow and return on investment. Further, whether the business distributes or reinvests its available cash affects enterprise value.

C corporations pay tax on their earnings at the corporate level at a 21% rate, and earnings distributed as dividends are subject to tax again at the shareholder level. This double taxation amounts to an overall effective tax rate on distributed earnings of around 40%, as opposed to a single 21% rate on earnings that are reinvested in the business. President Biden’s tax proposals would increase the corporate tax rate to 28%, which would increase the overall rate on distributed earnings to 45%—or even higher for individuals that would, under his tax plan, be subject to ordinary income tax rates on dividends.

Passthrough entities (S corporations and partnerships), on the other hand, do not pay entity level tax. Instead, their earnings are reported by and taxed at the rates of their owners, regardless of whether the earnings are distributed. For individual owners, this means a top marginal tax rate of 37% on passthrough earnings, or 29.6% if the qualified business income deduction applies. President Biden’s plan would increase an individual owner’s top rate to 39.6% and phase out the qualified business income deduction at income levels exceeding $400,000.

Although, based on the difference in tax rates, C corporations that reinvest their earnings may be able to generate greater after-tax cash flow than a passthrough entity, the analysis should not end there. A C corporation shareholder may pay more tax upon disposing of its investment than a passthrough owner, especially in cases where no viable tax planning strategy exists (see “Exit Strategies,” below). In addition, C corporations that do not pay dividends may be subject to the accumulated earnings tax and the personal holding company tax.

‍Exit Strategies:

The amount of tax owed on exit plays a very important role in the choice of entity decision. Due to the difference in the build-up of tax basis in investments in C corporations versus investments in passthrough entities, C corporation shareholders will generally have a larger gain on the disposition of their investment than passthrough entity owners. The tax on disposition will depend on the owners’ tax rates and the amount of ordinary income recapture, among other factors.

There are certain exit strategies that may be used to defer the tax on gains from dispositions of investments. These strategies include:

▪ Reinvesting the gains in qualified opportunity zones or qualified opportunity funds;

▪ Selling the shares of a C corporation to an employee stock ownership plan; and

▪ Transferring the investment through estate planning. Note that under President Biden’s tax proposals, the tax basis step-up of property at death would be limited.

In addition, non-corporate shareholders may be permitted to exclude part or all of the gain from the sale or exchange of “qualified small business stock” (QSBS) of C corporations that has been held for at least five years. The overall gain exclusion per issuer is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the disposed shares. Each partner in a partnership and each shareholder in an S corporation is entitled to their own $10 million limitation on dispositions of QSBS by the partnership or the S corporation.

‍Changes to Entity Classification:

Converting from one type of entity to another requires thoughtful consideration, analysis, and planning, and certain entity types may provide more flexibility than others for changing entity status. Converting to a different type of entity may trigger immediate tax consequences, which must be measured relative to any potential future tax benefits. Examples of possible tax consequences include taxable liquidations, tax on built-in gains, gain on liabilities in excess of tax basis, deferred revenue recognition, and changes in accounting methods.

‍Other Tax Considerations:

▪ The following are among the many other tax issues to consider when choosing an entity, the tax treatment for which can vary by entity type:

▪ International tax rules, such as taxation of controlled foreign corporations, foreign tax credit limitations, and consequences of repatriation tax deferral;

▪ Deductibility of upfront net operating losses;

▪ Self-employment taxes (note that the social security base would increase under President Biden’s tax proposals);

▪ State income taxes, which vary by state;

▪ Estate and inheritance tax consequences for individual owners and their families; and

▪ Tax reporting requirements, which in certain cases can be less onerous for C corporations as opposed to passthrough entities.

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Disclaimer: The information presented on this website or any Cruncher Accounting, PC online platform is for general information and illustrative purposes only. It should not be considered tax, legal, financial, or other professional advice. The content is not intended to provide definitive answers or solutions to specific business situations and is not a substitute for careful research or the advice of a licensed professional that knows your unique circumstances.

Readers are advised not to rely solely on Cruncher Accounting materials or use them as the basis for any business, legal, tax, or accounting decision without first seeking independent subject matter expertise and counsel. All case studies shown are hypothetical and intended for demonstration purposes only; results shown are not guarantees of performance or outcomes.

Please contact a Cruncher Accounting professional directly to discuss your specific questions or business situation. Our team would be happy to speak with you about a tailored consultation to your needs. We also encourage all readers to seek counsel from licensed attorneys, financial advisors, CPAs, Enrolled Agents, or other qualified professionals prior to making decisions related to their finances or enterprises.