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:
- Simplicity
- Liability
- 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:
- 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
- Differences relate mostly to how tax-efficient the entity will be throughout its existence and, upon liquidation or transition.
- Other considerations are governance, liability exposure,regulatory environments, etc. These issues can sometimes influence the decision.
- 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.
100 E San Marcos Blvd. Ste. 100, San Marcos, CA 92069 | Phone (760)-599-9900 | Fax (760)-599-9911 | info@PolitoEppich.com