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.

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

Comparison of Tax as S CORP vs. LLC

Assuming $16,000,000 Distributible Income

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.