Navigating Business Entity Selection with a CPA

Understanding the Importance of Business Entity Selection

The organization of a firm is referred to as its entity structure. When starting a new firm, this is often one of the first choices made by entrepreneurs. From sole proprietorship to C-Corporation, there are a number of alternatives accessible in the United States. Choosing the best corporate form for a company is a difficult choice that requires careful consideration of many different factors.

However, the business's performance depends on selecting the best entity structure. It may impact many aspects of the organization, including operations and tax strategy, and have significant short-, medium-, and long-term effects.

Later in a company's history, changing the entity type is obviously doable, sometimes with no negative tax repercussions. But in other cases, changing a company's corporate structure may be expensive and disruptive, which emphasizes how crucial it is to consider all of your alternatives up front.

Overview of Common Legal Structures

Business owners should take into account a number of crucial factors before choosing an organization. These often call for consideration of the company's long-term objectives as well as its short-term ambitions.

Numerous areas may be impacted by the entity selection. These consist of:

Tax implications
Operational considerations
Liability protection
Attractiveness to investors

Let's take a closer look at each of these issues and see how they influence a company's choice of entity.

The Tax Implications of Entity Choice

The effect that the entity selection will have on tax strategy is perhaps the most evident factor to take into account when evaluating entity structure. The tax treatment varies depending on the kind of company structure.

The tax treatment of the most popular entity formations is summarized as follows:

C-Corporation

These organizations pay taxes independently of their owners. In addition to the relevant state income tax rate, the company itself pays a federal corporate income tax of 21%. Additionally, the business does not obtain a deduction for the dividends it distributes to its shareholders from those earnings. However, 20% federal income tax + 3.8% Net Investment Income Tax (NITT) and the relevant state income tax rate will be paid by the individual owners who receive the corporation's dividends or distributions.

This basically implies that, to the degree that dividends are paid, the corporation's earnings are taxed twice. When the rates of the company and individual owners are combined, the prospective total tax rate is 44.8% federal tax + state tax.

S-Corporation

Although an S-Corporation is technically a C-Corporation by default, it has chosen to be taxed as such and is so eligible for pass-through income tax treatment.

The corporate level income taxes mentioned in the previous section on C-businesses are not paid by these businesses. As an alternative, only individual shareholders are subject to taxation on all earnings. The profits' tax rate will be determined by the individual graded rates according to filing status and income level.

If the owner actively participates in the company activities, the S-Corporation income is exempt from the 3.8% extra tax rate imposed by NITT. Additionally, self-employment tax is often not applied to S-Corporation income. Owners are not subject to taxes on distributions made from business earnings.

An extra deduction that lowers the owner's taxable income by 20% of the S-Corporation's Qualified Business Income (QBI) is another advantage accessible to S-Corporation owners. Although there are certain restrictions on who may claim the deduction, many companies across a broad range of sectors are eligible. Only taxpayers who are not non-resident aliens of the United States may be eligible to own an S-Corporation. Certain trusts and estates will also be eligible. There can only be 100 shareholders in an S-corporation.

LLC (Limited Liability Company)

A business with several owners that was legally established as an LLC is taxed as a partnership. Because partnerships are regarded as pass-through companies for tax purposes—that is, tax is paid at the person level rather than the business level—they are comparable to S-Corporations.

However, the revenues of a partnership are often subject to self-employment taxes in addition to regular rates, unlike S-Corporations. Similar to S-Corporations, LLCs do not have to pay taxes on cash distributions made from their earnings and are exempt from the 3.8% NITT tax rate with active participation.

The 20% QBI deduction that is specified in the S-Corporation definition is also applicable to LLCs. It is simpler to transfer valued property to owners in an LLC that is taxed as a partnership since there is less tax exposure. The number of owners of an LLC taxed as a partnership is often unrestricted and might include US or international people, corporations, estates, and trusts. By submitting an appropriate Entity Classification Election Form 8832 to the IRS, an LLC—which is normally a partnership by default rules—can choose to be taxed as a C-Corporation or S-Corporation.

When choosing a certain organization form, business owners should look about long-term factors in addition to the immediate tax ramifications.

By using the Qualified Small firm Stock Exclusion for investors in companies that fulfill the rules, choosing to organize a firm as a C-Corporation may save millions of dollars in capital gains tax for shareholders in the case of a sale. These advantages may be a significant tax benefit for C-Corporation shareholders and are not accessible to S-Corporations or LLCs.

Operational Considerations in Entity Choice

The flexibility and administrative needs of each corporate form that company owners may choose from differ.

In terms of operations, a C-Corporation is the least adaptable corporate form. C-Corps have a number of administrative requirements. For example, maintaining regular records, such as minutes from regular board meetings, board of directors vote records, corporate bylaws, etc., is necessary to preserve the corporate veil and liability protection, which are covered below. The legal setup and upkeep of corporate records can be costly.

On the opposite end of the spectrum, LLCs usually provide the most operationally flexible entity form. Business owners simply require an Operating Agreement to create an LLC; this document does not need to be updated or modified annually.

Business owners must think about the long-term effects of their decision while choosing the best corporate structure for their company. There are also operational and tax considerations that need to be made if the company plans to enter foreign markets.

Level of Liability Protection

A layer of liability protection is provided to shareholders by the majority of entity forms. Individual shareholders are protected by this clause against the company's debts and its known and unknown creditors.

As long as all conditions are fulfilled to preserve the corporate veil, corporations provide the greatest degree of liability protection to their stockholders. They are regarded as completely autonomous legal entities and are a suitable option for companies deemed to be more risky.

Although they must exercise caution to avoid piercing the corporate veil that divides their personal assets from the business's assets, LLC owners also benefit from liability protections.

This degree of liability protection is not provided by all organizations. No liability protection is provided by a sole proprietorship. Partnerships also provide their owners little protection from legal responsibility, unless they are set up as limited partnerships.

Attractiveness to Investors

Before choosing an organization, business owners should also think about their current and future financial strategies. In this sense, each of the several entity structures has unique qualities:

C-Corporations: Due to its ease of issuing shares, C-Corporations are often preferred by venture capital firms and major institutional investors. Additionally, C-Corporations are permitted to have an infinite number of stockholders. This structure often includes stock option schemes, which may be a compelling incentive for workers and senior executives.
S-Corporations: S-Corporation shareholders may only be people or certain kinds of trusts. S-Corporations are only allowed to have one class of stock and no more than 100 shareholders; they are also not allowed to have foreign owners.
LLCs: Although institutional and international investors are allowed to participate in LLCs, the flow-through nature of the partnership structure makes LLCs less appealing to these investors than C-Corporations. To encourage possible investors or workers, LLCs might provide several classes of LLC interests as an alternative to stock options.

When it comes to choosing the best corporate form for a firm, there is often no one correct solution. There are several variables to take into account, and each one may have varying weights based on the owners' immediate and long-term objectives.

The CPA’s Role in Entity Selection

By taking into account the tax ramifications and other aspects, a certified public accountant, such as Evans Sternau CPA, may assist company owners in choosing the best entity form, such as an LLC, C corporation, or S corporation.

Factors to consider

Tax implications
How each entity type will be taxed, given the business's needs and circumstances

Legal liability
Whether the owners or partners need protection from legal liability

Ownership group
The makeup of the ownership group, including whether it includes other entities

Debt basis
The owner's needs regarding debt basis, which may allow them to deduct losses

How a CPA can help

A CPA can help business owners understand the tax implications of each entity type
A CPA can help business owners consider the legal liability implications of each entity type
A CPA can help business owners consider the makeup of their ownership group
A CPA can help business owners consider their needs regarding debt basis.