Choosing a Business Entity

Corporation? LLC? Subchapter S? Choosing A Business Entity

by Gary Anglin, CPA, Anglin · Reichmann · Snellgrove & Armstrong P.C. (for Huntsville Technology Today Magazine)

When starting a new business, there are many decisions to make that will have a long–lasting effect on your business. One of the most important of these decisions is that of choosing a business entity: Corporation? LLC? Subchapter S? The process can be quite confusing. As with most legal and tax issues, one size does not fit all; however, with a proper understanding of the specifics of each entity type and the goals and objectives of the business, the proper decision will usually become clear.

To start the evaluation process, we must begin by defining the most common alternatives. The simplest form of organization is a sole proprietorship. This is essentially an extension of the individual owner. The individual owner has complete management control and remains personally liable for all acts of the business. Two or more owners can form a general partnership, which would be operated in accordance with a partnership agreement. Once again, all partners have unlimited liability for all partnership debts. The net income or loss of the partnership flows through to the partners in proportion to their ownership percentage and is taxed on their individual tax return. A corporation is a distinct separate legal entity as defined by statute. The characteristics of a corporation are centralized management, unlimited life, limited liability to the owners and an easily transferable ownership interest. The last entity we will discuss is a Limited Liability Company, or LLC. The LLC retains many of the tax and organizational attributes of a partnership or proprietorship, but has the limited liability protection of a corporation.

If you are looking for simplicity or ease of operation, a proprietorship or general partnership may be the right choice. If you are, however, looking to limit your personal liability you should look at a corporation or an LLC. One point that is very important to note, a corporation must operate like a corporation or the owner(s) could still retain personal liability. Be sure that if you incorporate that you are aware of the legal requirements for maintaining a corporation. The LLC is much less restrictive and may be a good alternative.

A corporation may be taxed in one of two ways. A C Corporation is a separate taxable entity. The C Corporation pays a corporate level tax on all of the profits of the company. If they distribute these profits as dividends, they are taxed again to the shareholders. An S Corporation is taxed much like a partnership. The S Corporation acts like a conduit to pass through the corporate income directly to the shareholder(s). The shareholder individually pays tax on their pro rata share of the corporate taxable income. These profits can then be distributed to the shareholder without being taxed again. The avoidance of the double taxation is what makes using a "flow through" entity attractive. The LLC is generally taxed the same as a general partnership. An LLC can, however, elect to be taxed as a C Corporation.

Another factor to consider is the anticipated ownership structure. The S Corporation has certain restrictions on ownership that limit the type and number of shareholders that can own stock. Generally an S Corporation is limited to 75 shareholders and only having one class of stock. Also only individuals and certain qualifying trusts are permitted to own stock in an S Corporation. If another corporation or other non-qualifying entity is anticipated to be an owner then, a C Corporation or an LLC should be considered.

The method of distributing profits or compensating owners for work performed should also be considered. Owners who provide services to a corporation are considered employees and are paid a salary subject to payroll taxes and income tax withholdings. Profits are distributed as dividends. Owners of a partnership or LLC receive either guaranteed payments or draws. These payments are not subject to payroll withholdings but may be subject to individual self-employment tax. Partnerships and LLCs give additional flexibility in how profits or capital can be distributed to the owners.

As you can see there are a number of factors to be considered in determining your business entity of choice. Before making this decision, we suggest that you look not only at your current objectives, but also your long-range plans. Certain types of entities may place undesirable constraints on your business operations, your capital structure or the methods of owner's compensation and benefits. Fully exploring these alternatives on the front end may avoid a costly mistake in the future.

Gary Anglin is a Certified Public Accountant and a partner in Anglin · Reichmann · Snellgrove & Armstrong P.C. He can be reached at (256) 533-1040 or by e-mail.