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Helping Your Clients Optimize Their Legal Entity Selection

Are your clients looking to launch a new business, or perhaps looking to reevaluate an existing business with a fresh set of eyes? Choosing the right entity matters—and there are multiple types of business entities (legal entities) to choose from. Not only does entity choice matter for tax purposes, but it also plays a role when considering personal liability, administrative upkeep, growth potential, exit strategies, and others. Following is a simple chart that compares the most common entity types when it comes to three key factors: formation, liability, and tax treatment.

FormationS CorporationC CorporationPartnershipSole Proprietorship
Business RegistrationFile Articles of Incorporation with the stateFile Articles of Incorporation with the stateRegister a Fictitious Business Name and/or file Certificate of Limited Partnership (or similar) form with the stateNo formal business registration required
OwnershipNumber of shareholders limited to 100, no foreign investorsUnlimited number of shareholders2 or more partnersSingle individual
StockOnly offers one class of stockNo limit on stock classesNot applicableNot applicable
Operating AgreementsEstablish bylawsEstablish bylawsSign a partnership agreementNot applicable
Personal liability for business debts
In general, no personal liability associated with corporate obligations (only up to the amount of their investment)In general, no personal liability associated with corporate obligations (only up to the amount of their investment)General partners have unlimited personal liability for business obligations; limited partners are only personally liable for business obligations up to their investmentUnlimited personal liability for business obligations
Tax Forms
File Form 2553, Election by a Small Business Corporation to make an S election; S corporations report business earnings on Form 1120-S, U.S. Income Tax Return for an S Corporation; earnings flow down to individual shareholders to report distributive share on Schedule K-1File and pay tax using Form 1120, U.S. Corporation Income Tax ReturnPartnerships report business earnings on Form 1065, U.S. Return of Partnership Income; earnings flow down to individual partners to report distributive share on Schedule K-1Must make quarterly tax payments by filing Form 1040-ES, Estimated Tax for Individuals and use Schedule C, Profit or Loss From Business to report business earnings
Manner of taxationEntity generally not taxed; profits and losses are passed through to the individual shareholders and reported on individual returnsDouble taxation. Entity taxed on earnings at corporate level; shareholders taxed on any dividends distributed by the corporationEntity generally not taxed; profits and losses are passed through to the individual partners and reported on individual returnsDisregarded entity for tax purposes; profits and losses are reported on the individual’s tax return

At the most basic level, sole proprietorships provide the most flexibility and freedom, but the tradeoff is that owners are personally liable for business debts and liabilities. This means that their assets are on the line if the business cannot cover its liabilities, including personal assets like their home, car, bank accounts, etc. One way to avoid this downside is through a single-member limited liability company (LLC), which can provide limited liability while still taking advantage of disregarded entity tax treatment. Most states require an LLC to file some sort of registration statement similar to organizational documents filed by limited partnerships, but rules vary by state. 

On the other end of the spectrum, shareholders of C corporations remain separate from the business and are not liable for business debts or liabilities, but the entity is much more regulated and offers less freedom to the owners. Additionally, C corporation shareholders are saddled with double taxation. Not only will business earnings be taxed when you file the business return, those earnings will be taxed a second time when they are distributed as dividends.

While this won’t be a perfect fit for all your clients, a good balance between the sole proprietor and a C corp is often an S corp structure. This combines the best of both worlds: it limits owners’ personal liability for business debts, there is no double taxation, and owners have more control over business operations.

If you want to learn more about each of these four common entity structures, we invite you to explore a bit more here:

Your Client’s Optimal Legal Entity Choice May Change – and That’s Ok

The tax landscape often plays a role in choosing the right entity for your clients. For example, President Biden’s current tax proposal is to raise the corporate tax rate from its current record-setting low of 21% to 28%. This tax change may affect how your clients choose to structure their business. As the tax landscape continues to shift or if the ownership structure in your client’s business changes, it may be valuable to reconsider the various types of business entities to determine if their current legal entity is continuing to serve their best interests.

If your client has an existing business and is thinking about changing their entity structure, consider where their business started and where it’s going. What are their goals? What is the best possible tax position? The most common entity changes include:

Revoking an S Election

While corporate tax rates are still at their lowest in modern history, revoking an S election could save your clients tax dollars. Just remember that once an S election is revoked, the business must wait at least five years to reestablish as an S corporation.

Making an S Election

Transitioning from a C corporation to an S corporation will remove double taxation, could provide owners with the option to withdraw equity, and could reduce tax liability on capital gains which are taxed at a preferential rate on individuals’ returns.

Incorporating a Sole Proprietorship

This could provide your clients with liability protection and could open them up to business tax credits and incentives that are not available to a sole proprietorship.

Once you and your client have determined the most suitable entity selection for their current and future business goals, be sure to file the appropriate paperwork. The paperwork will vary based on your client’s home state. For example, if your client is transitioning from a sole proprietor to an LLC, they will need to file articles of incorporation and establish business licenses/permits required to operate. You’ll also need to guide them in filing documents with the IRS, such as making an S election or selecting how their entity will be taxed. Your client may also wish to establish an employer identification number (EIN), which can help them if they hope to hire employees.

As always, tax planning will be a major factor in your client’s business decision making. Entity selection is no exception. Use Corvee’s tax planning software to project what their business activity would look like under different entity structures. This software can generate an easy-to-read report that shows them their various options with all the types of business entities. These insights can add real value to the client/practitioner relationship. To see how legal entity variable tax planning looks in Corvee Tax Planning, request a demo today.

Compare Legal Entity Changes with Tax Planning Software

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