The question that is often asked is as to what type of structure should a business be set-up as one starts a new business or diversifies or experiences growth. Ones choices have legal and tax implications. Here are some of the company formation choices:
- Sole Proprietorship
- General Partnership
- Limited Partnership
- Limited Liability Partnership
- Limited Liability Corporation
- C – Corporation or PC
- S – Corporation
One incorporates an entity at the state level (department of state) where the state laws govern the legality of the company. Such laws vary from state to state. However, formation of the company alone does not determine its tax status. At times, one has to make tax elections to determine tax status of the company in accordance with Internal Revenue Code. Let us shift through a few pages to understand key features of each of these structures.
Sole Proprietorship: There is no formal charter required for this type of business. One has to report all income and expenses on form 1040 schedule C to report net income from the personal business. It is generally good and easy way of operating a business where size of a business is small. However, this type of business reporting assumes personal liability and debt of the business. There is no differentiation between the personal and business assets and liabilities.
Partnerships: In most states there is no statutory requirement to form a partnership. A partnership is a business endeavor between two or more persons to carry out its profitable objectives. Partnerships can be a General or a Limited Partnership. Having formal terms of the partnership agreement is advisable for smooth understanding among its partners. A partnership files a federal income tax form 1065 but it is not taxed at the partnership level. It is treated as a flow through entity where its partners get an individualized K-1 statement that reports partners’ proportionate interest in line items of income and expense. The partners in turn report the income and expenses on their personal tax return (Schedule E).
In a General Partnership, all partners are jointly and severally liable for the business obligations. Profit sharing among the partners can be determined through implicit actions or explicit agreements among the partners.
In a Limited Partnership, there are General Partner(s) or Limited Partner(s). General partners control the day-to-day activity and decisions of the partnership. They are jointly and severally liable for the obligations of the partnership. Limited partners are passive participants and have limited liability to the extent of their interest or commitment to the partnership. Their participation and liability are determined by state statute and the partnership agreement.
Limited Liability Partnership (LLP): An LLP requires state registration. It is like a General Partnership in its characteristics and behavior. LLP as an entity along with its partners are jointly and severally liable for the contractual and debt obligations of the partnership. However, it separates individual partner(s) from the bad behavior of other partners. An LLP for tax purposes is treated like a pass-through General Partnership where it files a federal form 1065 and its partners get their proportionate interest reported on an individualized K-1.
Limited Liability Company (LLC): As the name suggests an LLC has the corporate veil of limiting the liability of its owners/members. It is an entity incorporated at the state level. However, it is also taxed as a pass-through entity for tax purposes. For an LLC to maintain its legal and tax status certain formalities are required to be met. An LLC is treated as a partnership for tax purposes where its income and expense line item characteristics are passed-through to its owners. An LLC files a federal form 1065 and provides a proportionate interest K-1 statement to its owners. An LLC can also be a single member LLC or be elected as a C-Corp. The advantage of a C-Corp is that it can have foreign nationals as shareholder(s).
Single Member LLC (SMLLC): SMLLC can also be elected as a disregarded entity by filing federal form 8832i which means that the SMLLC does not file its own federal tax return but instead its income and expense line items are reported directly on its owner’s tax return on form 1040 schedule C.
C-Corporation (C-Corp): A C-Corp is a corporation in the traditional sense. Its business is owned by its shareholders who have voting rights. However, its operations are executed by the board of directors and its Chief Executive Officer (CEO). A C-Corp has limited liability and its shareholders are not responsible for the company’s obligations and actions. A C-Corp is taxed as a stand-alone entity and files its federal tax return on form 1120. Currently, in 2022 it pays a flat tax rate of 21% on its net income. A C-Corp can retain its after-tax income and reinvest to continue to pay its flat income tax rate. However, if it distributes qualified dividend to its shareholders, its shareholders are taxed at the capital gains tax rate. This is often called Double Taxation.
Professional Corporation (PC): A PC is formed as a corporation for certain licensed professionals like CPAs, Doctors, Lawyers, Architects, etc. A PC’s operations must stick to its chartered line of profession. Thus, an active medical PC cannot have passive real estate activity. Employees and shareholders who are not licensed in the chartered profession of a PC cannot be its shareholder. Related and unrelated investors and family members are no exception to the rule. A PC may elect to file its taxes as a C-Corp or an S-Corp.
S-Corporation (S-Corp): An S-Corp is not an incorporated or registered entity by itself. It is a small business election that a C-Corp, LLC or a PC can use by filing federal form 2553. An S-Corp, has limited liability for its shareholders similar to a C-Corp. Once elected as an S-Corp a company can be treated as a flow-through entity like a partnership for income tax purposes. It files its income taxes using a federal form 1120S. S-Corps operate like a partnership except for the fact that it can pay a reasonable amount of W-2 salary to its owner(s) and the remainder can be treated as a pass-through income which retains S-Corp’s line-item characteristics. While the W-2 compensation is processed as a routine employer and employee compensation and payroll taxes, the flow through income is not subject to self-employment taxes (social security and medicare). An S-Corp can only have one class of shareholders (all domestic) not to exceed 100 and must follow statutory compliance requirements like a C-Corp.
It is a commonly asked question as to what entity structure is right for my business. As you can see from the discussion above there are several decision pivot points. One must understand their current and future business needs to determine their optimal structure. If you have any further question, feel free to contact Kislay Shah CPA at kislay@shahcpaus.com or call 646-328-1326.