Entity Choice and Structures
A common question that we get from both experienced business owners and start-ups relates to exactly how they should structure their business in order to save on taxes, protect assets, and to grow their company. There is no blanket answer available, no right answer, and no wrong answer, but rather one of the many business decisions an owner will have to make over the course of the life of their business.
Generally speaking, the three most popular choices for initial entity formation for tax purposes are a Limited Liability Company (“LLC”), S Corp, and C Corp. All three will offer the owner a form of legal protection, but each structure has very different tax rules that need to be considered.
A LLC is a relatively new structure for business ownership. For tax purposes, there are 2 types of LLCs – multi-member LLCs and single member LLCs, and each has different tax reporting requirements.
A multi-member LLC is treated as a partnership for tax purposes and the income flows-through to the owners, which means that there there is no entity level tax. The income is considered self-employment income and will be subject to self-employment tax. A single member LLC is treated as a “disregarded entity” and will be reported on the owner’s tax return as if a separate legal entity did not exist. The income here will also be considered self-employment income and subject to self-employment tax.
An S Corp is a form of corporation that is a flow-through entity, meaning that the profits of the company are taxed at the owner’s level, and not on the entity level. This structure is extremely fluid for the owner as much of the rigor that corporations can be known for is removed.
However, a major drawback of the S Corp is the requirement for reasonable compensation. Unlike an LLC flow-through, S Corp income is not considered self-employment and therefore per Internal Revenue Service regulations the shareholders of an S Corp will need to be paid a salary that is reasonable for the work that they perform for the company. This will require the filing of quarterly and annually payroll tax returns and the timely payment of payroll taxes, which can be an administrative burden for a small business.
A C Corp is the traditional business structure that has been around since the Dutch East India Company. The C Corp is a separate legal entity that also has an entity level tax – that is, the C Corp itself must pay tax on annual profits. Additionally, because the C Corp pays tax at the entity, and the income does not flow through to the C Corp owners, when the C Corp distributes money to the C Corp owners, the owners themselves must pay tax again – also known as double taxation. In order for the same profit to reach the final owner, taxes must be paid twice, which can drastically increase the taxes due.
Each entity has both positives and drawbacks. As mentioned earlier, there is no blanket answer for what is the best way to form your business. The answer can depend on whether you will be taking on investors, your current tax situation, and even your exact industry. We have experience in working with all of these structures and can help examine your situation to find the best solution for you and your business.
Edward McWilliams, CPA
Ed is a Partner in the firm’s tax and business advisory practice focusing on providing services to middle market private companies across different industries as well as to early stage startups. Ed has over a decade of experience providing tax and business consulting services to these companies of different sizes and across different industries, bringing a broad and diverse knowledge base and strategic solutions to the many complex issues that businesses face.