Legal Forms of Operations
Choosing the most tax-efficient legal form for operating your business is critically important.
Entity structuring for your business must fit your short-term objectives and long-term business needs. As your business grows or your personal financial situation changes, the business form in which you operate may need to change, as well. Keep in mind that the types of business structures you choose will impact your personal liability, as well as the amount of federal, state and local taxes owed by the business entity and/or the equity holders. Larger business operations will have a variety of legal forms to maximize flexibility while minimizing overall taxes.
There is a variety of tax, financial, and legal implications associated with the legal formation of your operations and this should be evaluated annually to ensure your short-term and long-term objectives are being achieved.
Limited Liability Companies and Limited Liability Partnerships
The most commonly used legal structure for newly formed domestic entities involves Limited Liability Companies (LLCs) and Limited Liability Partnerships (LLPs) generally offer limited liability and flow-through taxation. If your business will have multi-state or international activities, additional analysis will be required to ensure that tax withholding and other onerous tax reporting consequences are not triggered.
The structure of the LLCs and LLPs offers many legal advantages and is flexible for the equity owners and the operators of the entity. LLCs and LLPs can generally elect to be taxed as Partnerships (most common), C Corporations, or as “Disregarded Entities”. Also, special allocations of debt, income, and losses (for those electing Partnership treatment), as well as investments in other entities, are not generally limited.
S corporations generally pay no federal income tax, and income and losses are passed through to shareholders. However, California imposes a tax of the greater of: i) 1.5% of California taxable income or ii) $800. The permissible number of shareholders is 100, and eligible members of the same family may be treated as a single shareholder. Estates, certain trusts, and tax-exempt organizations may also be shareholders.
S corporations avoid the double federal taxation inherent in C corporations, but they must follow strict rules. S corporations that were previously C corporations can trigger corporate-level tax in certain situations involving the sale of appreciated assets held at the date of conversion, or in cases where the S corporation has excessive investment or passive income.
For tax year 2010, the amount of time that an S corporation that has converted from a C corporation must hold on to its assets to avoid taxes on any built-in gains at the time of the conversion has been shortened from ten to seven years. Under the Small Business Jobs Act of 2010, this holding period will be further shortened to five years starting in 2011.
S corporations may own any percentage of the stock of their corporations. Fully owned subsidiaries may also elect “S” status, but the qualified subsidiary is a disregarded entity for tax purposes and generally treated as a “division” for tax purposes.
C corporations are taxed as separate entities from their shareholders. The corporation pays taxes and the shareholder pays taxes again on any dividend payments – the so called “double taxation”. Investors are taxed on the dividends they receive.
While C corporations are used infrequently for new entities, they can offer benefits for international operations, as well as potential federal tax breaks upon sale for certain industries. They can also generally offer more tax-advantaged fringe benefits than S corporations and partnerships. However, C corporations may receive more IRS scrutiny. Salary paid to you and other shareholders must be reasonable, or a portion of it may be reclassified as a non-deductible dividend payment. If earnings are accumulated beyond the reasonable needs of the corporation, an additional tax of 15% will be imposed on these earnings.
In order to choose the optimal legal form for your business entity, careful analysis is required at the time of formation, and should factor in projected start-up losses, future income and potential exit possibilities.
HCVT has decades of experience with these issues and can assist you in making the right decisions.