by Garrett Fisher
May 15, 2013
There is a common misunderstanding in the business world between the type of legal entities and taxation methods. It is very common to hear someone say that they “have an S Corporation” or that they are “taxed as an LLC” – neither of which are possible situations. What is happening in such statements is that type and taxation is mixed up – and the business owner is confusing what they own with how it is taxed.
Forms of Legal Entities
The two most common forms of commercial legal entities in the United States are Corporations and Limited Liability Companies. Limited Partnerships are another form – whereas Professional Limited Liability Companies, Professional Associations, Limited Liability Partnerships and Limited Liability Limited Partnerships are generally reserved for professional purposes (lawyers, doctors, architects, etc).
So when referring to what a business owner owns – they more than likely own a corporation or limited liability company. It is as simple as that. The reasons for choosing one over another are numerous – and are rooted in the law. Both types offer differing protections, structure, obligations, jurisdictions and compliance overheads. As a rule, LLCs are newer forms and generally easier to deal with.
Entities in the United States are formed on the state level exclusively and the choice of form is made with the state of formation.
Taxation is first a federal election determining how the entity wishes to be taxed. Most states tax the entity the same as the federal election – although some states require a state level election.
In the case of a LLC, there are four taxation methods to choose from: disregarded entity, partnership, S corporation or C corporation. Corporations are permitted S Corporation or C Corporation elections.
- Disregarded entities are allowed for single member LLCs – where there is one owner. The IRS effectively disregards the existence of the LLC for tax purposes and the income or loss flows to the owner’s personal Schedule C. The entity exists for legal purposes – and effectively is no different than a sole proprietorship for tax purposes.
- Partnership taxation is for LLCs with more than one member. The income flows to the partners’ personal tax returns and avoids double taxation. Partnerships are relatively nimble when multiple owners are involved – as they allow multiple classes of stock and allow distributions to be made per partner agreement – which may differ from stock ownership.
- S Corporations are similar to partnerships in that the income flows to the shareholder’s return. An advantage is that one owner is allowed. There are numerous disadvantages when compared to partnerships in that there are limitations on stock classes, distribution flexibility and owner types and amounts.
- C Corporations are exposed to double taxation as the net income and loss are not mapped to shareholder returns. The most common way to relate C corporation ownership to the ordinary person is the possession of public company stock in a portfolio (which are C Corporations in the majority of cases). The person owns the stock, can sell it and may receive dividends but otherwise is not exposed to the taxation of the company. For small businesses, C Corporations are rarely, if ever, advantageous – especially with a LLC.
Deciding Which Entity to Form and How to Tax It
There is no turnkey solution to the best entity to form. There are standard considerations that would need to be factored. Most businesses are best served to get competent assistance.
- State of Jurisdiction. Small businesses are best suited to form an entity in the state they are based out of. Complex entities with multiple shareholders should consider future operating locations and which states shareholders will live in. The objective here is to determine if the entity should be formed in a corporate and tax friendly state or the home state of the business. Sometimes taxation and jurisdiction work together – and the entire strategy needs to be worked out before being able to pick the state.
- Entity Form. For most, it will be a choice between LLC or Corporation. State law in the state of operation comes into play – as does taxation – and the specific objectives of the company. Each entity form offers specific advantages and disadvantages.
- Taxation. LLCs offer more nimble taxation options – so often times the choice of taxation is linked with the entity form. Nonetheless, the tax picture needs to be weaved into the overall plan.
- Structure. After picking an entity and taxation form, the structure of the entity itself, especially when operating with LLCs is very flexible. Share classes, voting, officers and other terms can be spelled out in bylaws and operating agreements. Structuring decisions can run afoul of entity law and taxation requirements – so structure must yield to entity form and taxation impositions.
The bottom line is that the maximization of legal protections, flexibility and tax advantages require the balancing of quite the handful of characteristics. Most business owners wishing to form a company will find that the cheapest option in the long-term is to engage the services of a competent advisor – linking their long-term business plans with sensible tax and legal options.