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Choice of Entity Decisions
-- One Size Does Not Fit All
By: Angela T. Campion, Esq.
Angela.campion@wilaw.com
414.276.5000
One of the first hurdles new business owners face is how to organize their business entity. This important decision will impact the business owner's tax liability, administrative obligations, flexibility in ownership and growth, and liability for the debts and obligations of the business. Determining the proper business structure for your company involves the careful consideration of a myriad of factors and selection of the form that best fits the current and proposed future shape of your business. This article will provide a brief review of the most common entity options, and highlight the key factors new business owners should consider when determining which entity is the “best fit.”
Which Entity is the Right Choice?
For those who struggle with decision-making there is good news: if you fail to select the form of entity for your business, for tax purposes, the decision will be made for you. While I generally do not recommend this strategy, it is nevertheless helpful to understand how these rules work. Quite simply, if a business is conducted by an individual, the business will be treated as a sole-proprietorship; and if two or more persons carry on a trade or business, the business will be treated as a partnership.
Sole Proprietorship
The sole proprietorship is simply a business conducted by an individual without the organization of a separate legal entity. The income and loss from the operation of the sole proprietorship are treated as the income and loss of the individual owner, and are reported directly on that individual's income tax return. A sole proprietor has unlimited liability for the debts and liabilities arising from the operation of the sole proprietorship.
Partnership
Where there are two or more persons organized as co-owners to carry on a trade or business, a partnership has been created. Partners in a partnership can include individuals, other partnerships, corporations, trusts, estates, and other associations. The income and loss of the partnership is reported on an informational partnership tax return. However, there is generally no tax at the entity level. Rather, the income and loss flow through and are taxed to the individual partners. Partners in a general partnership have unlimited liability for the debts and liabilities arising from the operation of the partnership.
One of the largest drawbacks operating as a sole proprietorship or general partnership is that the owners remain liable for the debts and obligations of the business. As a result, several other entity options that insulate owners from unlimited liability are often a better choice.
C Corporation
Incorporating as a C Corporation can insulate individuals from unlimited liability. A C Corporation is recognized as an entity separate from its owners, and is relatively simple to create and maintain. The C Corporation is organized by filing the Articles of Incorporation with the Wisconsin Department of Financial Institutions. Under state law, the Articles of Incorporation and corporate bylaws shall govern, and the corporation's shareholders and board of directors shall control the operations of the C Corporation.
C Corporation income is subject to a “double tax.” First, the corporation is subject to a corporate level tax on its income. In addition, the shareholders are subject to tax on the subsequent dividend distribution of income from the corporation to the shareholder. In addition to the “double tax” effect, an individual shareholder in a C Corporation does not derive the benefit of corporate losses. If the corporation has a loss, the shareholder may not use the corporate loss to offset his or her personal income.
Additionally, if a C Corporation retains too much of its earnings and profits and has no plans for their use, the C Corporation is subject to the accumulated earnings tax. C Corporations may also be subject to the corporate alternative minimum tax at a rate of 20% on the corporation's AMT income in excess of certain exemption amounts.
S Corporation
Individual shareholders of an S Corporation are also generally shielded from personal liability for the activities or liabilities of the S Corporation. However, an S Corporation will generally not have to pay corporate level income tax. Instead the corporation's gains, losses, deductions and credits are passed through to the shareholders, and are reported on the individual shareholders' returns. The pass-through nature of S Corporations avoids the double taxation inherent in C Corporations. Liquidating distributions are also subject to only one level of tax. Perhaps just as important as a single tax effect, the shareholders of an S Corporation may offset corporate losses against other personal income. The S Corporation's loss, however, is deductible to the shareholders only to the extent of their adjusted basis of their interest in the S Corporation. In addition, this loss deduction is constrained by at risk and passive activity limitations. Organizing as an S Corporation will also avoid the accumulated earnings tax and corporate alternative minimum tax, otherwise applicable to corporations.
The organization of an S Corporation is identical to a C Corporation under Wisconsin law. However, in addition, an S Corporation election must be filed with the IRS on or before the 15th day of the third month after the Articles of Incorporation are filed, or the first taxable year of the corporation. Because the S Corporation is an entity created by federal law, certain limitations apply for an entity to qualify as an S Corporation. First, an S Corporation may only have a maximum of 100 shareholders. Second, only individuals, estates, certain charities, certain trusts, and certain benefit plans qualify as eligible S Corporation shareholders. Finally, S Corporations may only have one class of stock.
Limited Liability Company
Organizing as a limited liability company (LLC) can also shield individual members from personal liability for the activities or liabilities of the LLC. However, LLCs are not subject to the strict statutory requirements for qualification as an S Corporation. Like a partnership, the income and loss of a multi-member LLC is reported on an informational partnership return. There is no income tax at the entity level. Rather, the income and loss flow through and are taxed to the individual members. The members of an LLC are generally subject to self-employment tax on their distributions from the LLC. As a result, for some business owners there may be a tax benefit to organizing as an S Corporation rather than an LLC.
Other Considerations
While most choice of entity decisions are initially driven by tax and liability protection considerations, several other factors often influence the initial organizational decision. Some of these factors include:
Should you have any questions regarding the best choice of entity for your business, please call Angela Campion at (414) 276-5000 for assistance.
*All information appearing in this article is for informational purposes only and is not legal advice. This article does not create an attorney-client relationship with any reader. Do not act upon any information contained in this article without seeking professional legal counsel.
