Catch up on Business Entity Decisions Part One – Should My Business be a C-Corp or S-Corp?
One of the first decisions in starting a business is the selection of the form of the entity. Factors to consider include taxability issues, ownership flexibility, selection of year-end, fringe benefits, limitation of liability, accounting methods, basis issues, allocations of income or loss and compensation. In addition, certain forms of entity are more conducive to specific industry types. The more common entity types include Corporations (both “C” corporation and “S” corporation); Partnerships (either general or limited); Limited Liability Company (LLC) and Sole Proprietorship. All have their own advantages and disadvantages.
This article examines Partnerships, Limited Liability Companies (LLC) treated as partnerships and Sole Proprietorships or Single Member LLCs (SMLLC).
The recently enacted Tax Cuts and Jobs Act introduced a 20% deduction for qualified business income which is pertinent to partnerships, limited liability companies and sole proprietorships. While beyond the scope of this article, it should be considered when making an entity choice.
A partnership is not a separate legal entity and can be organized as either a general partnership (GP) or limited partnership (LP). In a GP, each partner is fully responsible for the liabilities and activities of the business. An LP must be organized with at least one general partner, which is frequently an “S” corporation. The remaining partners (limited partners) have limited liability but cannot be actively involved in the business without losing the liability protection. In both a GP and an LP, profits or losses flow through to the partners. Ownership is flexible but a partnership must have at least two partners and transferability of ownership may be limited based on provisions in the partnership agreement. Selection of a year end is generally limited and typically the partnership will file on a calendar year. Other advantages include the ability to specially allocate income, losses and distributions, avoidance of double taxation on income or upon liquidation or sale of assets, ability to deduct operating losses (within the confines of basis availability), minimal limitations on the use of the cash method of accounting, “step-up” basis adjustments for new partners and the ability to minimize payroll taxes on employment of owner’s children under 18. General partners are considered to have basis for entity level debt; limited partners may have basis through entity level non recourse debt. Profit flow-through to general partners may be subject to self-employment tax based on the category of income. Disadvantages include treatment of fringe benefits, partner basis issues, and passive activity regulations. A partnership is a frequently used vehicle to hold real estate.
An LLC is a legal entity, separate from its member owners, but profit or losses generally flow through to the members. Liability is limited, ownership is flexible and an LLC can have a single or multiple members. Transferability of ownership may be limited based on provisions in the operating agreement. Selection of a year end is limited; typically the entity will report on a calendar year. Other advantages include the ability to specially allocate income, losses and distributions, avoidance of double taxation on income or upon liquidation or sale of assets, ability to deduct operating losses (within the confines of available basis), minimal limitations on the use of the cash method of accounting, “step-up” basis adjustments for new members and the ability to minimize payroll taxes on employment of owner’s children under 18. Disadvantages include treatment of fringe benefits, member basis issues, and passive activity regulations. Profit flow-through to members may be subject to self-employment tax based on the category of income. Similar to a partnership, an LLC is a preferable vehicle to hold real estate.
In general, an entity which anticipates incurring losses in the formative years should organize as either a partnership or an LLC to facilitate the deduction of the loss at the owner level. In these situations, particular attention should be given to basis issues.
A Sole Proprietorship or Single Member LLC (SMLLC) has one owner. Liability for a sole proprietorship is unlimited; accordingly, one owner activities are predominately formed as an SMLLC to provide liability protection. Advantages are similar to those of partnerships and LLC’s, including avoidance of double taxation, ability to deduct operating losses, use of cash method accounting and ability to minimize payroll taxes on employment of owner’s children under 18. Similar disadvantages include treatment of fringe benefits, selection of tax year, passive activity regulations and self-employment tax based on the category of income.
Partnerships, LLC’s and Sole Proprietorships can be useful selections as an entity. Careful deliberation should be given to the advantages and disadvantages of each entity types and the prospective owner(s) should consider short term conditions such as initial operating losses, priorities such as fringe benefits and long term plans such as an eventual sale of the business. Your accountant and advisor is an integral part of this process.
Contact us for additional guidance in deciding the best entity for your business.
Associate Partner
Rich provides tax, accounting, and auditing services to a broad range of clients, with a specialty in real estate, manufacturing, wholesale, financial services, and other various service industries.
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