Determining Choice of Entity

By Benjamin Aspir, CPA, MST, EisnerAmper LLP – September 24, 2020
Determining Choice of Entity

“How should I structure my business?” is one of the most common questions a CPA will be asked. Choosing an entity structure has far-reaching consequences, including tax and legal implications. There are at least a half a dozen different business structures that can be chosen. This article will focus on the three most prevalent structures: LLC taxed as a partner­ships, C corporations and S corporations.

The table below summarizes some key considerations when deciding on an en­tity structure. A few additional points should be considered:

  • If the business is planning an initial public offering, a C corporation is often the only viable choice.
  • Real estate should generally not be held by a C or S corporation as contributions and/or distributions of the real estate may accelerate tax.
  • A business operating in many states may consider a C corporation in order to reduce the state tax compliance burden to its owners.
  • The number and types of shareholders of an S corporation are limited whereas there is no such limitation on a C corporation or an LLC taxed as a partnership.  
  • Certain investors (such as tax-exempt entities) tend to avoid investing directly in partnerships because they might be subjected to adverse income tax consequences.
  • LLCs generally are the most flexible in terms of ownership and distribution preference. However, they are more complex from a tax perspective.

 

  LLC S CORPORATION C CORPORATION
Liability protection Generally limited to committed capital Generally limited to contributed capital Generally limited to contributed capital
Company control Varies depending on the operating agreement Voting and non-voting shares allowed Voting and non-voting shares allowed
Distributions — flexibility Can vary by operating agreement Distributions must be ratable based on stock ownership Can vary by class of stock
Top tax rate= Federal 37 percent-Individual 37 percent-Individual (unless the S corporation is subject to built-in gains tax) 21 percent and tax on any dividends distributed
Basis Partner has basis in equity plus partner’s share of debt Contributions/ distributions and income/loss affect basis Owner has basis in equity plus direct shareholder loans to corporation. Contributions/ distributions and income/loss affect basis Cost of stock purchased
Adjustment of inside basis to equal outside basis §754 election or mandatory basis adjustment None, however, flow-through gains will increase outside basis. None
Allocation of income/ losses Partner’s share of income/loss is flexible under §704(b) Shareholder’s share of losses is determined on per-share, per-day basis. None
Fringe benefits to owners Taxable Taxable for >2 percent shareholders Fringe benefits not included in shareholder income
Employee equity compensation Profits interest generally not taxable Bargain element generally taxable to employee and deductible to corporation Bargain element generally taxable to employee and deductible to corporation
20-percent qualified business deduction (if business meets criteria) Yes Yes No
Self-employment (SE) tax/net investment income tax (NII) SE to owners who materially participate but generally no NII Generally no SE/NII tax for shareholder who received reasonable compensation and materially participates Salary subject to FICA & Medicare. All dividends subject to NII.
Sale of interest Salary subject to FICA & Medicare. All dividends subject to NII. Capital gain Capital gain
Qualified small business stock exclusion (§1202) No No Yes
Treatment of redemption proceeds A mixture of ordinary income and capital gain Capital gain Capital gain
Estate planning Flexible Very limited Flexible

It is important for CPAs to keep in mind that a choice-of-entity decision is not driven solely by tax considerations. The optimal choice of entity comes down to many factors. A full analysis should be performed to understand a client’s current and future goals for their company.


Benjamin  Aspir

Benjamin Aspir

Benjamin Aspir, CPA, MST, is a senior manager at EisnerAmper LLP. He is the vice chair of the NJCPA Federal Taxation Interest Group, a member of the NJCPA Emerging Leaders Council and Cannabis Advisory Group. Benjamin can be reached at benjamin.aspir@eisneramper.com.

More content by Benjamin Aspir:

This article appeared in the September/October 2020 issue of New Jersey CPA magazine. Read the full issue.

 

 

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