Business Entity Selection

Business Entity Selection – “The Most Important Tax Planning Tool”:

When deciding the start a business one should always pay careful attention to business entity selection. Choosing the best form of entity of your business (e.g. “S” corporation, limited liability company, sole proprietor, “C” corporation) is a critical decision that will have longstanding tax implications, both positive or negative. It is the single most important tax planning tool available to businesses and needs to be considered before any businesses is started. Ryan Jarus, CPA can assist you in business entity selection by evaluating the pros and cons of each business entity type to help you zero in on the most advantageous form of business for your particular business.

Major Considerations

Capitalization:

For a corporation, the contribution of property solely in exchange for at least 80% of the corporation’s stock is typically tax-free under IRC section 351. When looking at flexibility in capital structure, C corporations and LLCs offer more flexibility than S corporations, which are subject to statutory restrictions on the classes of stock and the number and type of shareholders. Depending on the client’s objectives and goals, these restrictions can have a critical effect on the choice-of-entity decision. For example, if the organizer of a new business foresees the need to raise equity capital that provides a fixed rate of return (such as preferred stock) and limited liquidation rights, an S corporation would not be appropriate. However for a single shareholder or perhaps a couple operating a businesses there may be advantages by way of savings on self employment tax of up to 7.65% which can be saved under an S Corp structure (LLC managing members have no way of avoiding this tax).

Compensation:

Compensation structure can have both tax and non tax effects on the choice of entity because LLC members cannot be treated as employees. Therefore, to design a compensation plan other than one based solely on ownership, an LLC’s operating agreement must provide for guaranteed payments. Since routinely updating an LLC operating agreement is not convenient some businesses which require compensation flexibility may fare better as an entity other than an LLC.

Distributions:

The entity’s stockholder or operating agreement should specify the amount and timing of distributions of property or cash. This is particularly important to the holder of a minority interest. The tax treatment of a non-liquidating distribution is determined by the type of entity making the distribution, the type of entity or person receiving it and the type of property being distributed. Property distributions from either C or S corporations trigger a recognized corporate-level gain to the extent the fair market value of the property distributed exceeds its basis where basis may be carried over with a pass through entity such as an LLC or partnership. All future possibilities should be carefully considered before making a decision regarding your business entity selection.

Please call Jarus & Co an Orange County CPA practice for a free consultation regarding business entity selection.