A CPA’s Perspective on Small Business Entity Types
The initial selection or potential conversion of a business entity structure is a critical decision that warrants careful evaluation and professional legal and tax guidance. While not set in stone, changing an entity structure may often cause a taxable event. Business owners should consider many factors, such as ability to scale, how capital will be contributed, and the level of owner involvement.
Many small businesses often start as a sole proprietorship. A legal entity has not been formed, but rather the individual operates in their own name, which requires minimal setup time and cost. However, a sole proprietor has no legal liability protection for business operations, so sole proprietors will often advance to the formation of a legal entity.
One primary area of confusion for taxpayers is the difference of entity type for state law formation versus tax classification. In most states, the common legal entity types are limited liability company (LLC) and corporation. These designations have a default income tax status with the IRS, but an alternative tax classification can be selected upon setup. For example, an LLC could be taxed as a disregarded entity, partnership, S corporation, or C corporation.
A disregarded LLC is wholly owned by one individual or entity, and liability protection is afforded to the owner. Similar to a sole proprietorship in that there is no separate federal income tax filing requirement, the income or loss is reported on the individual’s personal income tax return. Disregarded LLCs are a great option for holding real estate investments because of the liability protection and minimal effort to maintain. However, for an operating business, all earnings of the disregarded LLC will generally be subject to self-employment tax.
An S corp structure is often considered for its potential self-employment tax savings. An S corp files a separate federal income tax return, but tax generally is not paid at the entity level. It is referred to as a flow-through or pass-through entity. Any income or loss earned by the S corp flows out to the owners and is included in their individual income tax return.
An S corp can be owned by one individual or multiple; however, there are limitations on the types and number of S corp shareholders. A maximum of 100 shareholders is permitted in an S corp. Certain trusts and estates can hold S corp shares, while partnerships and other corporations may not.
If an S corp structure is a fit for the ownership of the business, there are a few other considerations that the CPA can assist in evaluating. First is that S corp shareholders wear two hats: employee and business owner. The IRS requires that a shareholder be “reasonably” compensated for their services provided as an employee through W-2 wages subject to FICA and Medicare payroll taxes. Earnings from the business in excess of the shareholder’s W-2 wages are able to be paid out through shareholder distributions, which are not subject to FICA and Medicare payroll taxes—a significant benefit of the S corp structure.
Let’s consider this difference between a sole proprietor or disregarded LLC as compared to an S corp. Joe Smith owns a small manufacturing business with three employees and earns net $120,000 for the year. As a sole proprietor or disregarded LLC, the full $120,000 would be subject to self-employment taxes at 15.3 percent (7.65 percent for both employee and employer portion although the employer portion is deductible). If instead he was organized as an S corp and determined a reasonable salary for his time and expertise was $40,000 a year, then $40,000 would be subject to payroll taxes and the remaining $80,000 would not.
There are many tax court examples where shareholders have attempted to pay little or no W-2 wages to the owner so all earnings of the business avoid payroll taxes, which is why the IRS instituted a “reasonable” compensation requirement.
With this savings opportunity, why wouldn’t S corps be the top choice? Primarily because these savings would have to be worth the cost. An S corp pays state unemployment taxes, potential state minimum fees, and incurs the cost of running payroll and filing an annual income tax return.
S corps generally require proportionate distributions between shareholders—meaning that if there are two 50 percent owners and one owner takes out $10,000, the other owner needs to distribute $10,000 as well. One mechanism to help address disproportionate cash outlay for shareholders would be through adjusting the owners’ W-2 salaries rather than attempting uneven distributions.
A partnership is another entity type available for multiple owner organizations that provides more flexibility than an S corp. A partnership also is a flow-through entity that files a separate income tax return and passes through the income or loss to the individual owners. A partnership is less restrictive about who can own an interest—partners can be trusts, estates, S corps, or C corps.
Partnerships can draft their agreements to allow for disproportionate contributions, distributions, and even special allocations of income and loss items between partners. Partnerships also allow for different kinds of ownership interest. For example, one method for compensating high-level employees is to offer a profits interest in the partnership, which provides a right to a share of future profits and appreciation of the partnership from the date of grant, but not in the capital or accumulated profits or value of the partnership prior to the date of grant.
Lastly, a C corp is another option, although less common for small businesses because its primary benefit is the ability to raise significant amounts of capital from stockholders, which is generally important for larger businesses. A corporation is not a pass-through entity; instead, it is treated as a separate taxpayer and pays tax at the entity level on net earnings. Tax is paid at the corporate level, and then again at the individual level once distributed as a dividend to shareholders; thus, there is double taxation in a C corp structure. One potentially significant benefit is that a C corp may be eligible for qualified small business stock (QSBS) treatment in the event of a stock sale (see this BKD Thoughtware® article for more information on QSBS).
If you have questions on entity structure for your new or existing business, please contact your BKD Trusted Advisor™ or connect with us using the Contact Us form below. You also can learn about our services for small to midsize businesses by checking out our Outsourced Accounting Services webpage.