Barbara Weltman
Not all business owners carefully think through the legal and tax ramifications of how they are set up when they begin. An individual starting a business on his or her own may, for example, take the easiest road and operate as a sole proprietor. Or another person may have rushed to incorporate but now thinks that decision was hasty. If you think you may have gotten started on the wrong foot--entity speaking and are seeking to make a change, take heart and remember:
- Choose the best type of entity to suit your needs.
- Go ahead and change your entity type, but recognize that there may be a tax and other costs for doing so.
Which entity is best for you?
There are five basic entity types: a sole proprietorship, partnership, limited liability company (LLC), S corporation and C (regular) corporation. Each entity has advantages and disadvantages that make it more suitable to certain types of ventures.
Personal liability protection. Companies that are concerned about liability exposure for owners should be set up to give the owners personal liability protection. LLCs and both types of corporations do this, so that if the business is sued, only business assets can be used to satisfy the claims of creditors.
For sole proprietorships and partnerships, owners' personal assets home, car, bank account, etc. are exposed to claims against the business. For certain types of businesses, this may not matter too much. A freelance writer, for example, has minimal liability exposure. Also, owners can be protected from many liabilities by carrying adequate insurance.
General rule: Any business with the potential for claims against it, which includes most businesses with employees as well as those with customers who visit the business premises, should probably opt for an entity type that protects owners' personal assets.
Income tax treatment. Sole proprietorships, partnerships, LLCs, and S corporations are entities that don't pay taxes (there are some exceptions where S corporations are concerned). Instead, owners pay tax on their share of net profits from the business. This is commonly referred as "pass through" tax treatment because the obligation for taxes on earnings is passed through to owners.
C corporations, however, are separate taxpayers-the corporations pay tax on their profits. Their owners pay tax only on distributions to them in the form of salary, dividends, and taxable fringe benefits. C corporations carry the potential of "double taxation" when earnings are taxed first to the corporation and then again to shareholders when they are distributed to them as dividends.
- Employment tax treatment. Owners of unincorporated businesses proprietors, partners, and LLC members-pay self employment tax (the employer and employee share of Social Security and Medicare taxes) on their share of net earnings from the business.
In contrast, shareholders in corporations only pay FICA (Social Security and Medicare taxes) on compensation paid to them by their corporations. In other words, owners of unincorporated businesses can pay substantially greater employment taxes than their shareholder counterparts.
Other considerations. There are several other factors to take into account in making an entity choice, including:
- Access to tax free fringe benefits for owners only C corporations can offer the broadest range of benefit options.
- Audit risk sole proprietorships on average face a greater chance of being audited than other entity types.
- State tax issues the rules at the state level vary greatly.
Making a switch in entity selection
Changing from certain entity types to others may be easy and involve minimal cost. For example, if you're a sole proprietor and want to become an LLC or a corporation, the only cost is the state filing fees (and related fees that may be incurred for professional services or online self incorporator services, and publication in legal notices, if required). There are no tax costs to make this change.
However, switching from corporate status to any other entity choice is not that simple. The corporation must be terminated in accordance with the law of the state in which it was set up. Also, there may be tax costs. For example, if a C corporation holding appreciated assets wants to become an LLC, it must first be liquidated this results in tax at both the entity and owner levels.
Combining entity choices
The tax law lets certain entities elect how they'll be taxed, despite the legal way in which they are organized. For example, an LLC is usually taxed like a sole proprietorship if there is one owner or as a partnership if there are two or more owners. However, the LLC can opt to be taxed like a corporation and can even elect to be taxed as an S corporation.
Why would an LLC want to elect S corporation status? There may be state tax advantages. For instance, in California, an LLC pays a higher gross receipts tax than an S corporation on similar income.There may also be an employment tax advantage. Some tax professionals maintain that electing S corporation status limits an owner's employment tax costs to FICA on wages, rather than on all net earnings from the business. Note: The IRS has yet to rule on the concept of an LLC electing S status to limit employment tax exposure.
Bottom line
The choice of entity type is yours to make. If you didn't get it right the first time, consider making a change. But do this carefully and with the advice of an attorney, accountant, or other trusted advisor.
Barbara Weltman is one of the nation's leading authorities on small business. She is a contributing writer for Inc.com, PINK magazine and New York Enterprise Report, and is a sought after media commentator who has been featured in The New York Times, The Wall Street Journal, The Washington Post, Reuters, Forbes.com, Marketwatch.com, WABC-TV, Fox News, CNNRadio and CNBC.
Prior to relying on any legal, tax or financial advice or recommendations provided herein, you are advised to consult with your attorney, financial adviser and/or tax professional to verify the information provided and to determine the applicability of any federal, state or industry specific laws and/or regulations that may apply to you. Bank of America shall have no liability for legal, investment, finance and/or tax decisions based on the information provided.
