← Articles of Interest

Choice of Entity


By Donald P. Eppich and Paul M. Polito

One of the most "often asked" question by business owners is "what form of ownership should I use for my business?"

The attached check list is designed to chart comparisons between the five most common entities. As with most decisions in life one must weigh competing advantages and disadvantages. There is no "perfect answer."

The three main issues to be considered when choosing an entity are:

  1. Simplicity
  2. Liability
  3. Taxes

The simplest two forms for business ownership are the sole proprietorship and the general partnership. There is no liability protection and there is no way to control the "character breakdown" of the income or loss.

Corporations, limited partnerships and LLC's (LLP's for personal service businesses) limit liability but add complexity and tax compliance costs.

S Corps allow some ability to "tax tune" the nature of the income and to a degree allow some tax deferral for a limited period of time.

C Corporations can result in double taxation but provide potentially lower tax rates on the first $50,000 of taxable income. Personal Service Corporations are taxed at the maximum corporate rate on all income.

Sometimes clients come to us with complex entities recommended by other professionals because they are afraid of liability.

The tax compliance cost of an entity often exceeds the cost of additional liability insurance. In addition, simplicity is lost and focus on the important elements of the business may be lost.

Our advice to clients in business…

Focus on making money. If you focus on tax deductions you will make less. Our tax rates are the lowest in over 30 years. Make decisions based on economics and common sense!

This following checklist is designed to chart comparisons between the 5 most common entities.

Description Sole Prop "C" Corp "S" Corp General Partnership LLC
Limited liability no yes yes no yes
Lower audit profile no depends maybe yes yes
Number of owners 1 1 or more 1-100 2 or more 1 or more
Continuity of life no yes yes maybe maybe
Can easily select a fiscal year end no yes limited no no
Can deduct 100% of owners health insurance no yes no no no
Able to use lower corporate tax rate no yes no no no
Can split income between family members no yes yes yes yes
Can avoid double taxation of income N/A no yes yes yes
Can limit FICA taxes by:          
a. Distributions no no yes no no
b. Paying children under 18 yes no no no no
Not Subject to:          
a. AMT maybe maybe maybe maybe maybe
c. Accumulated earnings tax yes no yes yes yes
d. Gross receipts tax (LLC fee) yes yes yes yes no
Able to deduct business loss on individual return yes no yes yes yes
Basis for loss includes owner's share of company debt N/A N/A no yes yes
Can increase basis by 'step-up' election N/A N/A no yes yes
Can specially allocate items of income and expense N/A no no yes yes
Can deduct interest on money borrowed yes no yes yes yes
Can use cash basis even if sales > $5,000,000 yes no yes yes yes
Existence of reliable case law yes yes yes yes no
Limit on charitable contributions no yes no no no

Note: A ‘yes’ answer suggests a favorable response. A ‘no’ answer suggests an unfavorable response

Note well: This checklist should only be used as a guide. Consult a seasoned professional to explain the advantages and disadvantages as they relate to your unique set of circumstances.

Choice of Entity Notes

Considerations for choosing a particular type of business entity:
  1. What is the intended purpose of the business?
    • A. "make a living"... single taxpayer options:
    • i. Sole proprietor
    • ii. Singlemember LLC
    • iii. S Corp.
    • B. Build wealth; eventually sell to a public company/become a public company:
    • i. C Corp.
    • ii. LLC
    • iii. S Corp
    • C. Establish a long-term family business:
    • i. S Corp
    • ii. LLC
    • D. Hold assets for appreciation:
    • i. Limited Partnership
    • ii. Trust
    • iii. LLC
  2. Differences relate mostly to how tax-efficient the entity will be throughout its existence and, upon liquidation or transition.
  3. Other considerations are governance, liability exposure,regulatory environments, etc. These issues can sometimes influence the decision.
  4. Owner-partner-agreements are critical:
    • A. Best to provide for the entity as a first priority (protect the “Golden Goose”).
    • B. People and circumstances change…it is really important to provide for an orderly winding down or separation should that become necessary.
    • i. Death
    • ii. Divorce
    • iii. Legal problems
    • iv. Incarcerations
    • v. Integrity issues
    • vi. Just plain desire to go do something else

LLC’s are frequently “touted” as the best or “default” choice of business entity.

For most trades or businesses, more tax will be paid by the members of and LLC vs. the shareholders of an S Corporation.

Generally, the income from a trade or business is all subject to self employment tax (Social Security & Medicare). With an S Corp, only the salary taken by the shareholders is subject to Social Security and Medicare.

There are some tax advantages to an LLC over an S Corp, but they are limited:

The most significant advantage of LLC’s (taxed as partnerships) is the ability to move assets in and out of an LLC (except receivables, inventory and similar assets) without generating a taxable event. The assets are simply distributed out to the member or members at tax basis. With an S Corp, any asset removed must be “sold” at Fair Market Value creating a taxable event. LLC’s can also provide for disparate profit and loss sharing ratios where an S Corporation distributes profits pro-rata to shareholders.

LLC’s tend to work best for holding investment property or real estate, whereas S Corps are usually a better fit for an entity operating a business.

What follow are two examples of the taxes paid by a sole proprietor vs. an S Corp for a commissioned salesperson and an LLC vs. an S Corp for a business with high trade or business income. These illustrate the savings achieved by utilizing an S Corp over the Sole proprietor or LLC. Please note, in the Commissioned Sales example, a single member LLC would generate more tax and not provide the lower compliance cost achieved by a sole proprietor.

It always makes sense to consult with a ‘tax expert’ before you organize a new business. What you may not know could cost you a lot of money!

For related articles, read “Choice of Entity” and our article and blog post covering 1202 Stock.

Sample Commissioned Sales Insurance Agent

2005 Tax Rates
  Sole Proprietor 12,500 SEP S-Corp (Low Wages) 12,500 SEP Sole Proprietor Max. SEP S-Corp Max. SEP
Business Income:        
Commissions
$425,000
$425,000
$425,000
$425,000
Wages
(50,000)
(210,000)
Business Expenses
(110,000)
(110,000)
(110,000)
(110,000)
Pension Plan
(12,500)
(42,000)
Home Office Deduction
(2,500)
(2,500)
Home Office Rent
(3,000)
(3,000)
CA Tax Deduction
Payroll Tax Deduction
(3,825)
(3,825)
State Tax Deduction
(3,743)
(800)
Net Taxable Income- Business
$312,500
$241,932
$312,500
$50,575
 
Business Taxes:
SS/FICA INC W/H
19,529
7,650
19,529
13,770
Medicare on excess of $90,000
3,480
Minimum Corp Tax
800
800
CA S-Corp. Tax
2,943
TOTAL: SS and Corp. Taxes
19,529
11,393
19,529
18,050
 
Form 1040
Wages
$50,000
$210,000
Schedule C
$312,500
$312,500
Schedule E page 1
500
500
Schedule E page 2
241,932
50,575
Adjustments:
1/2 SE Tax
9,765
9,765
SEP Contribution
12,500
42,000
AGI
$290,235
$292,432
$260,735
$261,075
Standard Deduction (MFJ)
10,000
10,000
10,000
10,000
Exemption Deduction
2,688
2,560
4,224
4,224
Taxable Income
$277,547
$279,872
$246,511
$246,851
Fed Tax
72,182
72,949
61,940
62,052
State Tax
22,174
22,379
19,407
19,438
TOTAL: Fed, SE, & Corp Tax
$113,886
$106,721
$100,877
$99,540
*Includes AMT
Annual Tax Compliance Costs
Schedule C
500
500
Bookkeeping
300
1000
300
1000
Annual Meeting
1000
1000
Corporate Tax Return
1200
1200
TOTAL: Compliance
800
3200
800
3200
TOTAL: Taxes and Compliance
$114,686
$109,921
$101,677
$102,740
Estimated Extra Owner Hours
24
24

Comparison of Tax as S CORP vs. LLC

Assuming $16,000,000 Distributible Income
  S CORP LLC SAVINGS
Minimum Tax
800
800
LLC Fee
0
111,790
Self-Employment Tax
0
428,504
State Corporate Tax
240,000
0
Taxable Income
15,759,200
15,987,410
Gross Income
15,759,200
15,987,410
1/2 Self-Employment Tax
0
(214,252)
Adjusted Gross Income
15,759,200
15,773,158
State Income Tax Based on 16MM/15,988,210
1,484,167
1,483,071
Federal Taxable
14,275,033
14,290,087
Total Taxes
Federal Tax
4,983,583
4,988,852
Minimum Tax
800
800
LLC-Tax
0
11,790
Self-Employment Tax
0
428,504
State Corporate Tax
240,000
0
State Individual Tax
1,484,167
1,483,071
Federal Individual Tax
4,983,583
4,988,852
TOTALS
6,708,550
6,913,017
204,467

For quick questions on this subject, to suggest a new topic for an overview paper, or more information on how Polito Eppich can help you make the right choices for your circumstances, please contact Paul Polito (pmp@politoeppch.com) or Don Eppich (pmp@politoeppch.com) at 760-599-9900.