Choosing the Entity that’s Right for your Startup
By Wiss Associate
As you start your business, you have decisions to make regarding capital needs, product/service mix, customer acquisition, location and countless other things. However, one of the most important decisions you have to make is under what type of corporate entity you’ll do business. If you get it wrong, you’ll regret the decision every time you fill out your tax forms or get a letter from the IRS.
There are three basic choices of entities, with several nuanced differences and gray areas among them.
Below is some information that might suggest a course of action for your company, but the issue is complex, so be sure to consult a trusted accountant and tax advisor before you commit to anything.
- Characteristics. This entity is only for corporations with 100 or fewer individual owners and no foreign shareholders are permitted. S Corporations can issue common stock, not preferred, and there are no corporate taxes paid at the entity level. Profit and loss tax responsibility follows ownership ratio and is passed through via K-1 to the individual shareholders. For example, shareholders with 50 percent ownership assume half of the profit and loss tax responsibility.
- Advantages. S Corporations are simple to set up. There’s no double taxation, meaning that corporate income is taxed on the owner’s personal income tax return and not at the corporate level. Corporate profits can be accessed to pay personal income tax via tax-free distribution. Also, there are no self-employment taxes on profits, but shareholders pay employment taxes on salaries taken out of the business.
- Best choice when the company is primarily self-financed or financed by friends and family, and owners don’t want to limit or surrender control. Owners have no intention of going public — which is not permitted under this designation — inviting foreign investment or increasing ownership beyond 100 shareholders.
- Cautions and limitations. New York City does not recognize S Corporation status so the corporation must pay an 8.85 percent city tax on profits. It is important to note that businesses in New York, New Jersey and a couple of other states need to file separate S Corporation elections after submitting Form 2553 with the IRS. Owners should take “reasonable compensation” from a profitable S Corporation. While the IRS doesn’t define the meaning of that phrase, owners should draw at least up to $118,500 (the 2015 FICA limit) if corporate profits allow, avoiding the appearance of dodging FICA/Medicare taxes. Also keep in mind that this entity would lose “S” status if it decided to become a public company.
- Characteristics. The C Corporation is a separate tax-paying entity and the shareholders will pay tax again on salary and dividend distributions taken from the corporation. An unlimited number of owners are possible and common and preferred stock can be issued.
- Advantages. C Corporations can go public and solicit foreign investment, and because shareholder count is unlimited, employees can receive stock compensation.
- Best choice when owners are most interested in raising capital and feel that their business is poised for public investment. It’s also ideal when cash is tight, as company shares can be offered as part of compensation packages.
- Cautions and limitations. The entity is subject to taxation on company profits and the shareholders are subject to tax on salaries or dividends the owners receive from the corporation.
- Characteristics. These two entities are very similar, although LLPs tend to be professional firms. Liability is limited, and owners can assign the profit/loss weight of each investor according to operating agreements.
- Advantages. There’s no double taxation, as owners only pay income taxes on earnings from the partnership and self-employment taxes on the profits. There can be an unlimited number of members, including foreign. With profit/loss allocation according to an operating agreement, owners can seek investors who will assume responsibility for the full loss for tax purposes during the early stages of the company, when losses might predominate. Also, it is painless to transition to either an “S” or “C” Corporation.
- Best choice when owners wish to attract investors with deeper pockets who want the business tax deduction from early stage operating losses.
- Cautions and liabilities. General partners must pay self-employment taxes on profits that the company earns. If there are two owners and one passes away, the partnership is deemed dissolved and a new entity needs to be formed.
As you can see, it’s complicated. That’s why your first step should be consulting with a trusted accountant. Changing entity type midstream is possible, but it can be a daunting and sometimes costly task. If the transition is done incorrectly, you can get caught up in having to pay taxes on phantom income — a subject for another day.
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