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Commercial Finance 701 – Business entity selection: Choose wisely or pay later

By Clark C. Luke

The choice of entity form is perhaps one of the most confusing and difficult decisions an entrepreneur will face.  The decision will have significant implications for future taxation, personal liability, management\voting rights, ease of financing, and subsequent transfers of assets or ownership.

My law partners Molly Jeffcoat Moody and Ben Williams, the regular authors of this column, asked me to address business entity selection.  Our primary focuses are on choices and taxation.

The choices
Entity options are dictated by state law.  In Mississippi, the general business entity choices are sole proprietorship, corporation, limited liability company (LLC), general partnership (GP), and limited partnership (LP).  The mere legal formation of an entity can usually be accomplished in just a few minutes, but proper organization (bylaws, operating agreement, etc.) is more involved.
If the owner chooses not to form an entity, or neglects to do so, one of two default classifications will apply: if the business has only one owner, it will be deemed to be a sole proprietorship; if the business has more than one owner, it will likely be deemed a general partnership.

Liability comes with the name
Personal liability is one of several drivers of entity selection.  A sole proprietor, partner in a GP, and a general partner of an LP generally have no personal liability shield.  The other entities, if properly formed and operated, afford personal liability protection for their owners.

In general, for federal tax purposes the possible tax classifications are: (1) disregarded entity; (2) partnership; (3) C-corp; or (4) S-corp.   Common sense aside, the tax classification of an entity may differ from the chosen form.  Corporations are taxed as either C-corps or S-corps.  Any other entity can use its default tax classification, or choose to be taxed as a corporation. Thus, an LLC could elect to be taxed as a corporation.

Disregarded entities
Like a sole proprietorship, a disregarded entity has a single owner and is ignored for federal tax purposes. The disregarded entity does not file a tax return, and all items of income and expense are reported on the owner’s tax return. In many cases, the disregarded entity will use the owner’s tax identification number.

Multi-member LLCs, LPs and GPs are by default taxed as partnerships. For income tax purposes, a partnership is a “pass-through” entity – meaning it passes through its profits and losses to its owners, who include their respective shares of those items on their personal income tax returns. Though it must file an informational tax return, the partnership itself typically pays no income taxes.

Corporations are by default taxed as C-corps. C-corps pay corporate income taxes on corporate income, and C-corp shareholders pay taxes on corporate dividends. Relief from this double-taxation is available for eligible corporations by filing an election with the IRS to be taxed as an “S-corp.”

Like a partnership, an S-corp files an informational tax return and passes its corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes. The shareholders report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S-corps to avoid double taxation on corporate income. Generally, to be eligible to make an “S” election, a domestic corporation must have fewer than 100 owners, resident individuals as shareholders, and only one class of stock.   According to IRS statistics, the majority of corporations have elected to be taxed as S-corps, though the vast majority of corporate assets are held by C-corps.

An entity with multiple owners that is not by default classified as a corporation may elect to be taxed as a C- or S-corp for federal tax purposes. For example, a multi-member LLC may opt out of its default partnership tax classification to be taxed as an S-corp or a C-corp. A single member LLC may also elect to be taxed as an S-corp or a C-corp.

Tax Comparison: S-corp and partnership
Although S-corps and partnerships are both pass-through entities, they are subject to different rules, which can result in different tax outcomes.  Partnerships are generally considered more flexible than S-corps.   A partnership can generally divide its profits as it sees fit while an S-corp must divide its profits in proportion to share ownership.

Another tax difference between an S-corp and a partnership is that, in a partnership, distributions of appreciated property will generally be tax-free. However, the distribution of appreciated assets in an S-corp is a deemed sale of the assets and may cause the shareholders to have taxable income.

Self-employment taxes are one area where S-corps may have an advantage over partnerships. If the partnership is a trade or business, all partnership income will be considered self-employment income for the partners, and, as such, will be subject to the 15.3% self-employment tax. In an S-corporation, only the compensation (and not the profits) paid to shareholders would be subject to the self-employment tax.

Entity selection and tax classification have profound economic and business impacts.   The important decision should be made only after careful consideration of ownership, liability, and tax issues, and consultation with your CPA or attorney.
Albert Einstein summed it up well when he said, “The hardest thing in the world to understand is the income tax.”

Clark C. Luke  is a tax attorney at Watkins & Eager PLLC.  Clark is a Certified Public Accountant, and earned a Bachelor of Accountancy, Master of Taxation and Juris Doctor from the University of Mississippi, and an LL.M. in Taxation from the University of Florida.  Clark can be contacted at cluke@watkinseager.com .


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