The Corporate Law and Tax Counselor is a monthly e-newsletter providing business owners and executives updates and PRACTICAL COUNSEL related to current business and tax law happenings.
In each issue, we will highlight bottom-line implications and/or opportunities business owners/executives should consider in response to new laws, court and agency decisions, and other matters discussed in the newsletter.
Starting a Business in the Washington Metro Area: What is the Proper Form of Business Entity for My Business?
Every business owner should give serious consideration to forming a business entity to minimize his/her individual liability for the debts and other obligations of his/her business. Having a separate business entity allows you to separate your personal assets from those of your business and protect your personal assets from most claims against your business.
To achieve this liability protection, you must properly organize and register your business entity with a State or the District of Columbia. You will have a range of entity types to choose from. As a practical matter, however, most new businesses are being formed either as a limited liability company or a corporation. The choice between the two depends on (1) the tax treatment you want for your business, and (2) the desired ownership structure and management of your business.
Liability protection comes with a choice of tax treatments for your business. The IRS will permit you to treat your business entity in one of three ways:
- As a flow thru entity, or
- As a corporation.
If an entity is disregarded for tax purposes or treated as a flow thru, then the entity itself does not pay tax on its income. Instead, the business owner(s) is personally taxed on all of the entity’s income.
If the entity is treated as a corporation for tax purposes, then the entity- often referred to as a “C-corp.” — will normally pay income tax on its earnings. Moreover, if those earnings are then paid to the owners of that corporation as dividends, the owners will also pay individual income tax on those dividends, currently at a reduced 15% rate on so-called “qualified dividends” –which generally are dividends payable by domestic corporations to shareholders who have owned their shares for more than 60 days during the 120-day period beginning 60 days before the dividend declaration date. However, the tax rate on qualified dividends for higher-income taxpayers—e.g., single taxpayers with taxable income above $413,200, and married couples filing jointly with taxable income in excess of $464,850– is now 20%. (Non-qualified dividends are taxable at a taxpayer’s ordinary income tax rate). While this “double-taxation” of a corporation’s income can be costly, that cost may be somewhat offset by deductions available only to C corporations.
Corporations that meet certain requirements may elect S-corporation status, which eliminates the double-taxation issue by assigning the S-corporation’s income and tax liability to the individual owners. However, S-corporation status brings with it significant restrictions on the financing, structure and ownership of the business entity and eliminates many of the deductions available to C-corps.
The choice of tax treatment is an important financial and tax decision, and best made in consultation with a qualified tax attorney. The chart below summarizes the tax treatment available for a given entity type. Note that, while a corporation may be treated as a C-corporation or S-corporation for tax purposes, a limited liability company with two or more members may choose to be taxed as either a C or S corporation or as a partnership.
Separately, you should consider how you are going to organize the management of your business. Corporations have a predictable management structure: its shareholders elect a Board of Directors, which in turn appoints the officers of the corporation, and the officers carry out the corporation’s day-to-day business. In a C-corporation, different shareholders may have different voting rights. In an S-corporation, all shareholders who have voting rights must have the same voting rights. Shareholders in a corporation often enter into a shareholders’ agreement that directs such things as how they will vote or impose limitations on the transfer of their shares.
Limited liability companies, on the other hand, can have wide-ranging management structures. Such companies may be managed by all of its owners or by one or more managers. Generally, managers need not be owners. Thus, owners can delegate management responsibility to outside professional advisors.
The operations of a limited liability company are governed by the company’s operating agreement, and the applicable state limited liability company rules. Because the operating agreement is so important, it is essential to put it in writing, even for a limited liability company with only one owner. The operating agreement will lay out the overall management of the company, its day-to-day decision making procedures and the rules for the interaction of the company’s owners, such as restrictions on the transfer of ownership interests or the disposition of such interests on an owner’s death or disability. The operating agreement should be signed by all of the owners, as well as the limited liability company itself.
The predictability of the corporate management structure can be attractive to outside investors because it does not present the risk that they will be confused by the quirks of a limited liability operating agreement. However, the flexibility of the limited liability company’s management structure often enables business owners to exercise effective and more cost efficient control over the management of their businesses.
Business Entities Comparison Chart
PRACTICAL COUNSEL: Choosing the appropriate form of entity for your business involves a number of considerations, and is best done in conjunction with a capable legal professional. The business and tax attorneys at General Counsel, P.C. can help you evaluate the advantages and disadvantages of the various available forms of entities and make the best decision for you and your business.
If you would like further information as to how to choose the right entity for your business, please feel free to contact Norman L. Eule, chair of our Corporate Law and Tax Practice Group, at firstname.lastname@example.org or 703-556-0411.
General Counsel, P.C. – Every Business Needs a General Counsel: General Counsel’s Business and Tax Practice Group has over 40 years of professional experience in counseling business owners on all aspects of business and tax matters. Our attorneys have extensive experience representing a wide range of local, regional, and national companies and business ventures. If we can be of any assistance, please contact either Norman L. Eule or Merritt J. Green, Founder and General Counsel, P.C.’s Managing Partner.