By checking the box, business owners can choose a tax structure with huge financial implications both now and in the future. However, they may find themselves in a situation where corporate formalities were not observed, thus opening the door to personal responsibility. The choice of business entity is clearly very important. So is there an easy answer to which entity would be the best from a legal, tax and business standpoint? Unfortunately not. The entity to select will depend on a plethora of factors, including the decision to issue securities, the desire to attract investment, the management structure of the company, estate planning objectives, the number and type of employees, the forms of compensation of employees and the potential for short- and long-term profit and loss. In this article, we discuss three main points that business owners need to address when considering the choice of an entity.

1. Two levels of taxation or one?

First, business owners must consider what the effects of taxation will be at the corporate level. It is commonly claimed that S-Corporations, partnerships, and certain LLCs are superior to C-Corporations because they offer a “pass-through” tax treatment—that is, a tax layer. This is true in many cases: thanks to a tax layer, shareholders or members of pass-through entities often pay far less tax than C Corporation shareholders.

Proponents of C corporations often object, citing the deductions that are available to the corporation for employee wages, or the current low capital gains tax rates available to shareholders. The tax structure could also be seen as an incentive to keep profits at the corporate level to support growth and reinvestment. However, the IRS has tools to discourage the payment of unreasonably high wages for tax breaks in a C corporation, just as it has tools to discourage unreasonably high distributions in an S corporation. Furthermore, there is no guarantee that the capital rates to long term remain low. AC Corporation may be a superior entity for attracting investment, but the use of other entities early in the life of the business should not be overlooked. Ultimately, it can be a losing game to try to manipulate the tax system to make a C corporation work when a different entity is more appropriate.

2. Do you have the time or temperament to observe corporate formalities?

Second, business owners need to consider how their business operates and what business structure would be best for their particular needs. Small business owners consistently fail to comply with corporate formalities by maintaining minutes, resolutions, and other corporate records. In some cases, this can expose business owners to liability from litigants seeking to “pierce the corporate veil” and reach shareholders directly. In some cases, business owners are doing themselves a huge favor by choosing a legal entity that requires minimal corporate paperwork.

With an LLC, for example, a business operating agreement can be customized to the particular needs of the business. It’s a rare member-manager who wants to maintain any and all corporate formalities, and that’s not a problem with an LLC. The operating agreement may specify that certain records do not need to be kept. This can save owner-managers a great deal of time and money in the production of corporate records. It can also prevent disputants from lifting the veil.

3. Money

Third, business owners must also consider money. Are there current gains or losses? If there are multiple owners, would one benefit from recognizing losses, while the other could recognize more gains? What is the long-term potential for profit and loss? These issues will greatly influence the final choice of the entity. With an LLC, for example, members can recognize both profits and losses. The operating agreement can also be customized to allocate profits to one member and losses to another.

IRS CIRCULAR DISCLOSURE 230: To ensure compliance with the requirements imposed by the IRS, we advise you that any US tax advice (i) avoid penalties under the Internal Revenue Code or (ii) promote, market or recommend to a third party any transaction or matter discussed herein.
 
General Disclosure: This article is intended to provide general information on business entity selection and should not be considered a substitute for legal advice from a qualified attorney.