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Entity Selection for the Business Owner

The "choice of entity" decision is one of the most important decisions facing those who own and operate businesses. There are several forms to choose from, each of which generates different legal and tax consequences. Further, there is no single form of entity that is appropriate for every type of business owner or entity.

Choosing the appropriate form of entity in which to operate a business is a complex decision. It depends upon many factors, including the owners' needs and desires and the particular characteristics and needs of the business in question. Federal and state tax consequences of each type of entity also play an important role; especially in closely held entities where the parties' combined tax liabilities should be analyzed as part of the decision-making process. In order to chose the proper entity it is important to understand the characteristics of each type. The choices primarily are as follows:

Sole Proprietorship

General - A sole proprietorship ("SP") is an unincorporated form of business with one owner. For tax purposes, the income and expenses of the business are reported on in the personal tax return of the owner (Schedule C, Form 1040 ). In addition to income taxes, the SP is also subject to self-employment (social security & medicare) taxes at a current rate of up to 15.3%.

Liability protection - A legal SP is not a separate legal entity from its owner. However, a single-member LLC or LLP is separate from its owner, even though, for tax purposes, it is not treated as a separate entity.

Taxation - For tax purposes only, an SP includes a single-member entity, such as a limited liability company ("LLC") or limited liability partnership ("LLP"), which has not elected to be taxed as a corporation. The default tax classification of a single-member entity is SP, if the owner is an individual, or a branch or division of a business entity.

Partnerships

General Partnership

General - A general partnership is an unincorporated entity (either U.S. or non-U.S.), with at least two owners, which is organized to carry on a trade or business. A general partnership is not registered in a specific state, since there is no formal registration required to form a general partnership. Instead, a general partnership comes into being as soon as two or more persons join together to own and operate a business. Ownership of a general partnership is in the form of partnership units, shares, or percentages. A general partnership must have at least two owners, but there is no upper limit on the number of owners. In addition, there are no restrictions on the kinds of owners that can be partners.

Liability protection - A general partnership ordinarily owns its assets, although not always. Sometimes property is held in the name of individual partners, and is used in the partnership. A general partnership is nominally responsible for its own debts; that is, money may be borrowed in the name of the partnership. However, general partners are also personally responsible for all partnership recourse debt.

Transfer of income to partners - A general partnership can hire employees who are not partners. Partners, however, are not employees of the partnership. Such partners may provide services to the partnership, and be paid for those services; however, the partners are not classified as employees.

Employees of a general partnership are eligible to receive a variety of tax-free fringe benefits, such as health care. However, partners cannot receive these benefits tax-free. Both partners and employees, however, can participate in company-sponsored retirement plans.

Taxation of a general partnership - A general partnership does not pay tax.

Taxation of partners - Partners of a general partnership are taxed directly on partnership-level income. Partners are taxable regardless of whether that income is distributed to partners in the form of cash or property. Like a sole proprietor, a partner is also subject to self-employment tax at a rate of up to 15.3%.

Partners can deduct on their personal tax returns losses recognized at the partnership-level. This is one of the great advantages of a general partnership. However, the ability to deduct losses is subject to a number of limitations. In general, partners can deduct losses equal only to their investments in the company (in the form of capital contributions, and share of partnership-level liability). In addition, partners are limited in their ability to deduct losses if they do not actively participate in the business.

Estate planning - The general partnership is a somewhat useful device for minimizing estate and gift tax. In general, an interest in a general partnership may be valued (for estate and gift tax purposes) at a discount to the value of assets owned by the partnership. However, discounts in relation to interests in general partnerships are not as deep as those for corporations, limited partnerships, or limited liability companies.

Limited Partnership (LP) - When the liability of partners for the debts of the partnership is a problem, a limited partnership may be a solution, but at a cost. Limited partners are generally not liable for debts of the partnership, but they must restrict participation in management of the partnership or risk loss of their limited liability. In addition, a limited partnership requires at least one general partner. Although the use of a corporate general partner provides a solution to these problems, it also introduces some complexity.

Limited Liability Partnership (LLP) - A limited liability partnership ("LLP") is a hybrid entity that confers partial limited liability to its members, and, for tax purposes, can choose to be taxed either as a corporation or partnership. An LLP is created under state law by registering under a state LLP statute. These entities are similar to limited liability companies ("LLCs"); however, the liability protection is not as complete as LLCs.

In general, LLPs operate and are governed by the same rules applicable to general partnerships. Therefore, LLPs are essentially general partnerships with the addition of a liability shield.

C Corporation

General - A C corporation is a corporate entity (either U.S. or non-U.S.). A U.S. corporation is organized in a single state, although the corporation may do business in many states. Ownership of a corporation is in the form of stock. There is no limit to the number of shareholders that can own a single C corporation. In addition, there is no limit on the number of classes of stock that can be issued. A corporation comes into being when its organizers file articles of incorporation with a state (or country, in the case of a foreign corporation).

Liability protection - A corporation owns its assets and is liable for its debts. Shareholders are not liable for corporate debt. The fact that the shareholders are not liable for corporation debt is one of the primary advantages of the corporation as a form of business.

Transfer of income to shareholders - Shareholders who provide services to a C corporation are treated either as employees or independent contractors, depending on the specific circumstances, and are taxable on compensation received. When shareholders are employees of a C corporation they are eligible to receive tax-free fringe benefits, such as health care benefits. They can also participate in company-sponsored retirement plans.

Taxation - A C corporation is taxable on the income it earns. Shareholders of a C corporation are not directly taxable on this income. A C corporation is the only business form where this is the case. All other forms of business are pass-through entities, where owners are taxed directly on entity-level income.

Although shareholders are not taxed directly on corporation income, they can be indirectly taxable on the income. If a C corporation distributes the income in the form of dividends, then the shareholders pay tax.

Personal service corporations (PSC) - A PSC is a hybrid form of the C corporation. PSCs are defined as corporations established to provide personal services, such as medical or legal services. PSCs limit the liability of the owners for business debts but do not limit the liability of the owners for their personal professional malpractice. The Internal Revenue Code currently taxes PSCs at the corporate level, at a rate of 35% so income is usually distributed to shareholders in the form of a bonus prior to year end.

Estate planning - The C corporation is a useful device for minimizing estate and gift tax. In general, stock in a C corporation is often valued (for estate and gift tax purposes) at a discount to the value of assets owned by the corporation.

S Corporation

General - An S corporation is a U.S. corporation that elects to be taxed as an S corporation. A U.S. corporation is organized in a single state, although the corporation may do business in many states. Ownership of a corporation is in the form of stock. An S corporation can have no more than 100 shareholders, and can have only one class of stock. In addition, eligible shareholders include only individuals, certain estates, certain trusts, and certain other S corporations. A corporation comes into being when its organizers file articles of incorporation with a state; and an S corporation is created by filing an S corporation election with the Internal Revenue Service.

Liability protection - Same as C corporation as outlined above.

Taxation of an S corporation - With some exceptions, an S corporation is not taxable on the income it earns.

Taxation of shareholders - Shareholders of an S corporation are taxed on corporate-level income. Shareholders are taxable on corporate-level income regardless of whether that income is distributed to shareholders in the form of cash or property.

Estate planning - Same as C corporation as outlined above.

Limited Liability Company (LLC)

A limited liability company ("LLC") is a hybrid entity that is treated like a corporation for limited liability purposes, but, for tax purposes can choose to be taxed either as a corporation, partnership, or disregarded entity (single-member LLC). An LLC is created under state law by registering under a state LLC statute. Like corporate shareholders, LLC members are not personally liable for the obligations of the LLC; instead, their liability is limited to their financial investment in the enterprise. Unlike a limited partnership, where general partners remain liable for partnership debt, all members of an LLC have limited liability.

For an LLC that chooses to be taxed as a partnership, the tax rules are the same as those of general partnerships, except for minor differences. Similarly, an LLC that elects to be taxed as a corporation will be taxed in the same way as a corporation.

Tax and non-tax differences in the various business forms.

  1. Formalities of Existence - Of the major forms of business, C and S corporations have the most burdensome requirements regarding formalities of existence. These requirements reflect the fact that a corporation is a separate legal entity from its owners. A corporation must file articles of incorporation with the secretary of the state in the jurisdiction of organization. It must also adopt bylaws, elect a board of directors, hold organizational meetings, and keep minutes thereof. Although these are the general rules with regard to the formalities a corporation must observe, each state has its own incorporation requirements that must be examined and observed.
    A general partnership usually has no formal registration requirements. It may be established informally without a written agreement. A limited partnership, as a creature of state statute, must observe certain formalities. In particular, a certificate of limited partnership must be filed with the secretary of the state of formation. In addition, the partnership must follow the organizational requirements imposed by that state. Similarly, a limited liability company must file with articles of organization a state, and must comply with state requirements that are a condition of its limited liability status.
  2. Limited Liability of Owners - In general, the owners of a C or an S corporation are not personally liable for the entity's obligations. However, an owner who guarantees a debt or commits a tort while acting on behalf of the entity may lose this protection. This protection may also be lost if the corporate veil is "pierced." This can occur if the entity either is poorly capitalized or fails to maintain a separate identity from its owners.
    A limited liability company also provides its owners with limited liability.
    Unlike a corporation or limited liability company, a general partnership does not afford its owners limited personal liability. The owners are personally liable for partnership debts and for the acts of fellow owners performed in furtherance of partnership business. General partners in a limited partnership have the same type of personal liability as do their counterparts in a general partnership. However, the liability of limited partners who do not manage the business is limited to the extent of their respective investment in the enterprise.
  3. Taxation as Separate Entity versus Pass-Through Entity - One of the biggest factors affecting the choice of entity decision is whether the entity should be taxed as a separate entity or whether its items of income, credit, loss, and deduction should pass through and be reported by the owners on their personal tax returns. C corporations are taxed as separate entities. One disadvantage to a C corporation is that its earnings can be taxed twice-once when earned at the corporate level and again when distributed to shareholders. This double taxation often can be minimized in the context of closely held corporations, however, if the entity pays out most or all of its earnings as deductible salary (the amount must be reasonable) or rent.
    S corporations, partnerships, and limited liability companies taxed as partnerships provide pass-through treatment. In general, there is no entity-level tax so the earnings are only taxed once-at the owners' marginal rates. Unlike S corporations, partnerships permit special allocations of tax attributes provided such allocations have substantial economic effect. Such allocations can often help a business raise equity capital from outside investors while enabling the general partners to maintain control of the business. Pass-through entities are often good choices for businesses that are expected to generate losses in the early years because the active owners ordinarily can apply those losses against income from other sources.
    Sole proprietors, general partners and LLC members taxed as sole proprietors or general partners are generally subject to self-employment (SE) tax. SE tax is essentially the same as social security and medicare tax.. It is assessed at 15.3% of net income up to the social security earnings limit ($90,000 for 2005) and 2.9% of income above that limit. S corporation shareholders are not subject to SE tax on their S corp. earnings but do pay social security and medicare tax on their wages.
  4. Owner Compensation - An owner of a C corporation can be compensated through salary, fringe benefits, pension and profit sharing plans, and dividends. Of these types of compensation, dividends are usually the least preferred because they are subject to tax at both the entity and shareholder levels. Nonliquidating distributions to shareholders are dividends to the extent of corporate earnings and profits. The excess is treated as a return of capital. Salaries, to the extent they are reasonable in amount, are effectively taxed only once (as income to the owner) because they are deductible by the entity. Most types of fringe benefits and pension and profit sharing plans receive tax-favored treatment in that they can be funded with pre-tax dollars and often do not generate current income to the recipient.
    Because S corporations, partnerships, and limited liability companies taxed as partnerships are pass-through entities, each owner is allocated a share of the entity's income and other tax attributes based on the owner's ownership interest. These items are then reported on the owner's individual return. When an S corporation distributes property, the owner-recipient generally recognizes gain only to the extent the value of the property exceeds the owner's stock basis. An S corporation may also compensate its owners through salary. Salary is includible in the owner's income and is deductible by the corporation.
    A partner (or LLC member) generally recognizes no gain or loss on a current distribution of property by the partnership. However, a partner receiving a cash distribution must recognize gain to the extent that the amount received exceeds his basis in his partnership interest.
  5. Fringe Benefits - A C corporation has the greatest ability to provide fringe benefits on a tax-favored basis. Such benefits can include life insurance (with limits), health insurance, certain death benefits, medical reimbursement plans and meals and lodging in limited circumstances. In addition, contributions by the corporation to a qualified pension plan may also be deductible when made but not currently taxable. The corporation can also set up a cafeteria plan to let employees pick and choose fringe benefits. This flexibility is much greater than that afforded partnerships and S corporations.

In general, a partnership or a limited liability company may deduct the cost of providing the benefit, but the owners must include the value of such benefit in income. Thus, there is no real tax benefit to either the entity or the owners. This same rule applies to any shareholder in an S corporation who owns at least 2% of the corporation's stock.

State Registration, Taxation & Minimum Fees

In choosing the proper form of entity in which to do business, it is important not to overlook State taxation and annual fees. While there may be sometimes only be a marginal advantage from one entity to anther as based on the criteria above, State taxes and annual fees can sometimes end up being the determining factor in entity selection. As there are 50 different states, each with their own set of rules, it is not practical to cover each one in this article. We will therefore limit this analysis to Pennsylvania and New Jersey. For questions regarding another State, please contact someone from our office.

Pennsylvania

Registration - In Pennsylvania, each type of business entity, except for the sole proprietor, must register with the PA Department of State Corporation Bureau. S Corporation status is not automatic with a federal election; a PA S Corporation election must be filed with the Pennsylvania Department of Revenue within 75 days of the beginning of the fiscal year. PA Limited Partnerships (LP), Limited Liability Partnerships (LLP) and Limited Liability Companies (LLC) must register their status with the Corporation Bureau as well. Registration with the state will initiate the flow of forms and information regarding sales and employment taxes as well.

Taxation - Pennsylvania Corporations, S Corporations, and LLCs are subject to a Capital Stock or Franchise tax. This tax is calculated on an average of book net income and the net worth of the business over five years. If the entity continually shows substantial net income, this tax could be quit costly. PA S corporations also file an informational return that generates K1s to the shareholders, who in turn, report the pass-through income on their individual Pennsylvania tax returns. Similarly, PA partnerships file informational returns that generate K1s to the partners. PA partnerships are not subject to the capital stock tax. Sole proprietors' income is reported on the PA individual tax return and is taxed at the individual rate. LLCs, file either as a sole proprietor or a partnership, in addition to filing the Capitol Stock tax return.

Minimum Taxes and Annual Fees

Professional LLC's are subject to an annual fee of $380 per member. This factor alone would make the LLC a prohibitive choice for doctors, dentists and attorneys doing business in Pennsylvania. Professional Limited Liability Partnerships (LLPs) are subject to an annual fee of $250 per partner. There are currently no minimum taxes for the other business entities in Pennsylvania.

New Jersey

Registration - In New Jersey, every type of business entity, including a sole proprietor, must register with the New Jersey Division of Revenue. This registration ensures compliance with all filing requirements, including those for employment, sales, and income tax. New Jersey requires a separate state election for S Corporations, which must be filed within 75 days of the fiscal year.

Taxation - All New Jersey corporations are subject to a Corporation Business tax for the privilege of having a corporate charter and deriving income in New Jersey. Sole proprietors report net business income on the New Jersey individual tax return. S Corporations, Partnerships, LLPs and LLCs are subject to pass-through taxation; they have informational reporting requirements and generate state K1s to their shareholders, partners or members. New Jersey Single Member LLCs are treated as Sole Proprietors and report income on the New Jersey individual income tax return.

Minimum Taxes and Annual Fees

Corporations are subject to a combined minimum tax and annual fee of $550. Partnerships and LLCs are subject to an annual fee of $150 per partner or member (if there is more that one member in the case of an LLC).

Posted: December 1, 2004

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