Choosing an entity for your business can be a difficult decision. There are many types of entities available, and you are not limited to forming an entity in your state. Further, the entity you choose does not necessarily determine how the entity will be taxed. For instance, you may choose to form a Maryland LLC but also choose to have it taxed as an s-corporation. The decision depends upon many factors including: the business purpose, the property to be owned, expectations to terminate or sell the business, the owner’s estate planning concerns, and, of course, taxes. There is no universal “best entity”, and choosing the proper entity requires every business to be individually analyzed.
Most states, including Maryland, provide you with the following popular state entity choices: the sole proprietorship, the general partnership, the limited liability company, and the corporation. Other entities for more specialized purposes also exist, such as the limited partnership and the professional association (a P.A. or P.C.).
I. Brief summaries of the four most popular entities:
Sole Proprietorship: A sole proprietorship is the default business entity for any business owned by a single person. The sole proprietorship provides no limited liability (discussed in Section III below) protection for its owner. If you have not chosen an entity and have no partners, then this is likely your current entity. It is not recommended that any active business operate in this form given the owner’s exposure to the company’s liabilities and lawsuits. For tax purposes, the IRS requires income from this form of business be reported on your Form 1040’s Schedule C, or, if real estate, Schedule E.
General Partnership: A general partnership is the default business entity for any business owned by multiple owners. Similar to the sole proprietorship, there is no limitation of liability for the business owners, known as its “partners”. The business generally does not need to file with the state to be considered a general partnership. State laws determine if a partnership exists, whether the owners intend to or not. If the state laws determine the group is a “partnership”, then the partners can be liable for acts of the business and their fellow partners. Similarly, IRS tax laws determine whether the group is a partnership for income tax purposes. For income tax purposes, the IRS requires groups it considers partnerships to file a partnership tax return, Form 1065. The partnership issues a K-1 to each partner which informs both the IRS and the partner how much income and expenses the partner should report on their Form 1040.
Limited Liability Company: The Limited Liability Company, or “LLC”, is today’s most popular entity form. It is the most popular because of its flexibility both in its operation and its available tax classifications. To form an LLC, the entity must be registered with the chosen state’s department that registers businesses, such as the Maryland SDAT (State Department of Assessments and Taxation) or the Delaware Secretary of State. The LLC offers limited liability to its owners, known as its “members”. Thus, if the LLC is sued or otherwise becomes in debt, then the members in most situations will not be personally liable to the creditors of the LLC. LLC members can choose how they want the IRS to tax the entity. Without making an IRS election, an LLC generally will be ignored for tax purposes if it has only one member or will be taxed as a partnership if it has multiple members. But, when making IRS elections, an LLC member or members can choose that the LLC to be taxed as a c-corporation or as an s-corporation (discussed in Section II below). A tax attorney would be able to guide you toward the optimal tax classification for your LLC.
Corporation: The corporation, in its modern form, has existed as a business entity for more than a century. Unlike more recently developed entities, such as the LLC, the laws governing corporations are well-developed. Thus, shareholders can be assured there will be few opportunities for a judge to surprise shareholders with their own new laws. The corporation’s business owners, the “shareholders”, have limited liability. This is the entity form best-suited for companies that foresee themselves “going public” in the near future. But the corporation does have its downsides. Corporate laws usually impose administrative burdens, such as annual meetings, that the more flexible LLC laws usually do not. Further, for tax purposes, the corporation must be taxed as a corporation, i.e. unlike the LLC, the corporation cannot choose to operate as a sole-proprietorship or as a partnership, even when the tax filing requirements seem unreasonable. The corporation may; however, elect to either be taxed as a c-corporation or as an s-corporation (discussed in Section II below). To make the corporation more flexible for small businesses, some states have created simplified corporate forms, such as the Maryland close corporation.
II. Tax Issues in Entity Choice:
While states can create new and unique entities, such as Delaware’s “series LLC”, the IRS lumps them together into a limited number of possible tax entities. For instance, there is no IRS tax form for an LLC. Through IRS eyes, a business with multiple members will be either a partnership, a c-corporation, or an s-corporation with few exceptions.
As stated above, while an LLC is normally taxed as a partnership, an LLC may choose to be taxed as an s-corporation or as a c-corporation. If operating as a c-corporation, the corporation pays taxes upon its income, and the shareholders pay taxes when the income is distributed. Thus, a c-corporation’s income is taxed twice. If operating as an s-corporation, the corporation itself generally pays no income tax and the corporate income is taxed only to the shareholder, regardless of whether the income is distributed. Today, most businesses operating as c-corporations are those that have no choice, such as a widely held or publicly traded company, and those with out of the ordinary tax situations.
There sometimes are tax benefits to being a c-corporation, and the proponents of c-corporations often proclaim its superiority with a certain level of fanaticism. But, in general, the advantage of an s-corporation’s single-layer of tax far outweighs any benefits offered by a c-corporation. My experience as a tax attorney is that when a small business operates as a c-corporation, there is a temptation to illegally deduct personal expenses through the business in order to avoid the two-layers of tax. An IRS audit of those businesses can be devastating when discovered personal deductions suddenly turn into huge tax bills for both the corporation and the now dividend-receiving shareholder, plus penalties and interest. Sadly, many such individuals were placed in that position by a tax consultant’s poor advice. Currently, few small companies have a legitimate reason to choose to be taxed as a c-corporation, and the only reasonable decision for most small companies is choosing to be taxed as either a partnership or as an s-corporation.
III. Limited Liability:
Some entities, such as the LLC and the Corporation, offer limited liability to their owners. Limited liability roughly means that the owners are not personally responsible for the company’s debts and that the company’s creditors can only seize the company’s assets, but there are exceptions. If an owner guarantees or “co-signs” for a company debt, then the company’s limited liability will not protect that person from the co-signed debt. Despite an entity’s limited liability, individuals also can be personally responsible for tax debts created for “trust fund” taxes, such as employment taxes or state sales taxes. Often, by law, certain liabilities cannot be limited by forming an entity, such as civil or criminal penalties or professional liability. Further, if a court determines that an entity’s owners never truly honored the entity’s existence, then courts can sometimes “pierce the corporate veil” to go after the owners. Veil piercing generally occurs when owners fail to properly separate their personal life from that of the entity, such as commingling checking accounts or doing business in the owner’s name. Additionally, courts can pierce the veil when the owners egregiously fail to adhere to corporate formalities, such as never holding required meetings or never seeking corporate approvals when required.
In conclusion, taking these factors into consideration, a tax attorney should be able to guide you toward the proper entity choice. The excitement of starting your own business should not cause you to rush this very important decision. Seeking proper advice before committing your company to years of high taxes is well worth the investment.
For further information or to form a business entity, please contact Jeff Rogyom at (410)929-4578. Please review the Disclaimer page regarding use of this website and its information.