New businesses and startups must consider the appropriate company structure for both tax and non-tax reasons. The enactment of the Tax Cuts and Jobs Act (TCJA) in December 2017 raised many questions about tax structures which business entities should consider.
One major aspect of the TCJA is the reduction of the C corporation income tax rate from 35% to 21%. Another major item is the qualified business income (QBI) deduction for pass-through entities such as S corporations, partnerships, trusts, estates, and sole proprietorships. The QBI deduction can be up to 20% of the net income of the trade or business if the trade or business qualifies for the deduction.
The 20% QBI deduction may require a comparative analysis on how the 20% deduction will impact the individual tax return, if the entity selected is a partnership, S corporation or a single member LLC. A comparison also needs to be made if the entity selected is a C corporation that does not qualify for the 20% deduction.
So there are various factors to consider when using a C corporation, S corporation, partnership, or sole proprietorship. A limited liability company (LLC) can be treated as a partnership, S corporation, or a sole proprietorship.
Here is a summary of the various entity structures new businesses can consider.
A C corporation allows a business to be taxed and operated as a separate entity. For non-tax reasons, a C corporation can protect the owner personally from debts and liabilities the corporation incurs.
The major drawback of a C corporation is the element of double taxation. This means net income is taxed at both the corporate level and the shareholder level in the form of dividend payments. Double taxation may also occur when there is a liquidation and where capital gains could be taxed at both the corporate and shareholder levels.
Another pitfall of organizing a new business as a C corporation is if the business realizes losses early on. These losses are trapped at the entity level and cannot be used by shareholder(s). However, these losses can be carried forward to offset income in future years.
An S corporation is an entity structure that has similar non-tax advantages of a C corporation, such as protection from liabilities and debts on a personal basis.
One key advantage of an S corporation is that it does not have the double taxation risk of a C corporation. This is because S corporations are pass-through entities with only one level of tax paid at the individual shareholder level. The structure has similar characteristics to a partnership.
A disadvantage of an S corporation is its lack of flexibility in the number of shareholders it can have and who can qualify as a shareholder. Another drawback is that S corporations can only issue one class of stock. This can be a disadvantage for a growing business that needs to raise capital to expand its business and operations.
The third type of entity structure to consider is a partnership, which requires at least two partners. Income, deductions, and other taxable components are passed through and taxed at the individual level. There is no entity-level tax.
The partnership structure offers the most flexibility because the partnership agreement can allocate income, deductions, and other items with greater flexibility. This differs significantly from the S corporation structure in which shareholders are taxed on a per-share/per-day basis.
A sole proprietorship is the easiest structure to form because there are generally no organizing documents required except for a local DBA certificate. There is also no tax return required because income and deductions are reported directly on the owner’s tax return (Form 1040, Schedule C). However, a sole proprietorship involves the most risk because the proprietor’s personal assets are subject to liabilities and creditors.
Limited Liability Companies
An LLC is a hybrid entity that can enjoy both the limited liability features of a corporation and the tax treatment of a pass-through. LLC owners (also called members) are only liable for business debts to the extent of their investments. Therefore, LLC members’ personal assets are protected from liability. This is a major advantage over partnerships where general partners are personally liable for business debts.
LLCs are generally treated as partnerships for tax purposes, but also can be taxed as a corporation. An LLC can also be formed as a single-member LLC (SMLLC) if there is only one member, which results in taxation as a sole proprietorship. An SMLLC is usually a better alternative to a sole proprietorship for liability protection purposes.
The choice of entity structure is one of the most important decisions a new business can make. Please call us if you have any questions.