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Selecting the Right Form of Business Entity

by Ms Beverly Kofoed, CPA

 

Early in the decision-making process of starting a new business the company owner/leaders must decide what form the entity will take. Several factors have a bearing on this decision.

 

Legal Forms of Business Entities (in the US)

Corporation

A Corporation is a type of entity that is generally taxed as either a C-Corporation or S-Corporation. For US federal tax purposes, corporations include businesses organized under a federal or state law that identifies the entity as a corporation, joint stock companies, banks (if insured by the FDIC), business entities wholly owned by a state or any political subdivision thereof, and certain foreign business entities. Non-corporate entities, such as sole proprietorships and partnerships, may elect to be taxed as corporations. Corporations cannot elect out of corporate tax treatment. If an entity is classified as a corporation under IRS regulations, the entity must file as a corporation.

A corporation formed under state law shields owners from liability for the corporation's actions. A shareholder's risk of loss is limited to the amount invested in stock. This is in contrast to sole proprietors or general partners in partnerships, who are personally liable for debts of the business.

Courts have disregarded the limited liability status of corporate shareholders in circumstances of fraud, bad faith, failure to observe corporate formalities, need to accomplish substantial justice, or when liability is directly linked to the individual.

C-Corporation

A C-Corp can have 1 or more stockholders. This form of corporation is not recommended for holding appreciating assets such as Real Estate or Stocks. Note that this is the only form of entity that can have a Medical Reimbursement Plan for the stockholders. For federal income tax purposes, a C-Corporation is a separate taxpaying entity. The corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders. This creates a "double tax" situation for the stockholders. Income is taxed to the corporation when earned and taxed again when distributed to the shareholders as dividends. The corporation does not receive a tax deduction for the distribution of dividends to shareholders. As a result, this form of corporation is generally not as appealing as other forms of entities. The US Federal Tax return is a Form 1120. Each state will have its specific tax returns that will be required to be filed. C-Corporations may be required to file a state Franchise Tax return as well.

S-Corporation

An S-Corp can have 1 or more shareholders. An eligible domestic corporation can elect to be taxed as an S-Corporation. An S-Corporation generally does not pay Federal income tax, its profits and losses pass through directly to stockholders. This avoids the C-Corporation double tax situation and allows stockholders to deduct corporation losses on their individual income tax returns. For tax purposes, S-Corporations are treated in a similar manner to partnerships. The US Federal Tax return is a Form 1120S. Each state will have its specific tax returns that will be required to be filed. Shareholders working for the S-Corporation are required to take a "reasonable" salary. The ordinary income reported on the S-Corporation's form K-1 is not subject to Self Employment taxes at this time.

Partnership

A business entity with two or more members is, by default, classified as a partnership for US federal tax purposes, unless it is a corporation, estate or trust. Co-ownership of property or sharing of expenses does not necessarily create a partnership. Every partnership engaging in a trade or business must file a tax return regardless of the amount of income or loss. The Federal Tax return is a Form 1065. Each state will have its specific tax returns that will be required to be filed.

A General Partnership is not strictly speaking an "entity" as it is not filed with the Secretary of State. It is a group of at least two persons that want to carry on a business venture and share equally in the income and loss of the venture. All partners are subject to personal liability and it may or may not have a written partnership agreement. There can be no limited partners.

A Limited Partnership is formally organized, is filed with the Secretary of State and will have a written partnership agreement. It must have two or more partners. There must be at least one general partner and one or more limited partners. The partnership does not pay US federal income tax — its profits and losses pass through directly to its partners. A general partner's income is subject to US self-employment tax. The limited partners generally will not have earnings subject to self-employment taxes unless the income is a guaranteed payment for the performance of services and not for the return of capital. Any loss will be a passive loss and subject to passive loss rules.

LLC

Limited liability companies are created and regulated under the laws of each individual state. An LLC has the limited liability characteristics of a corporation, but is generally treated as a partnership for US federal income tax purposes unless an election is made to be taxed otherwise. LLC members are generally only at risk for their investment in the LLC. An LLC taxed as a partnership is allowed pass-through taxation, avoiding double tax on in its income. The LLC can elect to be taxed as a C-Corporation or an S-Corporation, a Partnership (if there are two or more members) or a disregarded entity. If the LLC has more than one member, it can not be taxed as a disregarded entity. The tax election will determine the tax forms that are required to be filed.

Other types of entities include Family Limited Partnerships, Limited Liability Partnerships, Publicly Traded Partnerships also called Master Limited Partnerships, Personal Service Corporations, Professional Limited Liability Companies, and Personal Holding Companies.

Before making the decision on the type of entity you want to create you should seek the advice of an attorney and tax professional.

For more information, contact Klingenberg, and Associates, P.C. via email at webmaster@kenkling.com.

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About the author

Ms Beverly Kofoed, CPA

Ms Beverly Kofoed, CPA (USA)

Ms Kofoed obtained a Bachelor of Science degree with post-graduate work in accounting from the University of Central Oklahoma. She holds a real estate broker's license and is a CPA (Certified Public Accountant), a CVA (Certified Valuation Analyst) and holds an ABV (Accredited in Business Valuation).

 

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