Choosing the “Right” Form of Entity: C-Corp, S-Corp, GP or LLC

Successful businesses choose an organizational structure based on its future goals.

These businesses consider both the current and future capital needs of the business, owner’s liability for the actions of the business and tax minimization that may be achieved by selecting the proper form of business. While it is important to choose the proper entity structure at the beginning, key changes in the business environment—whether economic, regulatory or legislative—should also lead a business to consider whether its current organizational form is optimal. While changing the form of an ongoing business is possible, careful consideration should be made to avoid possible unintended tax consequences from the restructuring.

The four main entity structures in use today are the C Corporation, the S Corporation, the General Partnership and the Limited Liability Company. The most popular entity choice for large businesses is the C Corporation. The major advantage of doing business as a C Corporation is that, except in very rare circumstances, shareholders are not liable for the actions of the corporation. The C Corporation is also the simplest form of ownership in a business as there are no issues of special allocations or flow-through activity as there are in other entity forms. These advantages make it easier for a corporation to raise capital. Additionally, the graduated tax bracket structure for corporations may make it an attractive alternative for businesses with lower levels of income, such as small closely held businesses. For example, a C Corporation with $75,000 of taxable income will pay $13,750 in tax or an average rate of 18.33% in 2009. In contrast, a single individual with $75,000 of income would pay $14,937 in tax or an average rate of 19.92% in 2009. The difference becomes more apparent when the individual has personal income from other sources that would cause income to be taxed at the higher tax bracket (the top individual bracket was 35% in 2009). This distinction is likely to become an even more important consideration with the probable increase in individual tax rates anticipated in 2010. Ownership through a C Corporation, however, is the least tax efficient solution for most businesses because its income is taxed twice; once as income to the corporation and once as dividend income to shareholders. Additionally, C Corporations may be subject to the Corporate Alternative Minimum Tax, Accumulated Earnings Tax, Personal Holding Company Tax as well as the personal service corporation rules.

The S Corporation is a special form of corporation that has been popular for closely held businesses. S Corporations have the advantage in that the income earned is not taxed at the entity level, but rather flows out of the entity and is taxed at the individual level. In addition, this income may not be subject to additional employment taxes. As this form of entity was intended to provide this special treatment to small business owners, there are significant limitations on the qualification of an S Corporation. S Corporations are also limited to having one hundred or fewer owners. The S Corporation may only issue one class of stock. Additionally, shareholders can only be natural persons, ESOPs, or certain trusts. These restrictions may significantly limit the ability of an S Corporation to raise equity capital. Like C Corporations, owners of S Corporations enjoy limited liability for the actions of the corporation. S Corporations also offer the advantage of not being subject to the Corporate Alternative Minimum Tax, the Accumulated Earnings Tax or the Personal Holding Company Tax. Provided the current or anticipated income is sufficient, the avoidance of double taxation is important and the future capital requirements of the entity would not require investment from disqualified owners (see above), then the S Corporation form may be advantageous.

Partnerships are perhaps the oldest form of business entity. Modern partnerships are usually formed with one General Partner that bears liability for the actions of the partnership along with many Limited Partners who bear no such liability. Unlike S Corporations, owners of a partnership are not limited to natural persons, ESOP and certain trusts; therefore, it may be possible to achieve total limited liability if the General Partner is an entity with limited liability (i.e. a C Corporation). Partnerships are still less likely to be used than the Limited Liability Company, discussed below, because of liability issues. Additionally, accounting for partnership items such as contributions to the partnership, special allocations to partners, the treatment of undistributed income and the basis for non-recourse liabilities of the partnership can be extremely complex. While they are complex, these special allocations may help to achieve an appropriate economic result for an investment. For example, a partnership may issue preferred interests that would provide a more consistent return on investment and may attract new investors. The main advantages of the partnership are that it is a pass-through entity whose income is only subject to one level of tax and its distribution of assets is typically tax free. It should be noted that the income from a partner who is actively involved in the business will be subject to self-employment taxes, in contrast to the S Corporation owner who may not be after considering reasonable compensation.

In more recent years, the Limited Liability Company (LLC) has become a more popular choice of business entity for small and medium size businesses because it combines many of the advantages of the C Corporation, S Corporation, and the partnership. Like the C Corporation and Partnership, LLCs allow for unlimited ownership, which allows for a wider range of possible investors. The LLC also allows for the same limited liability enjoyed by the owners of a C Corporation. Unlike the C Corporation, however, the LLC is a pass-through entity, thus the income of the business is only subject to one level of tax. The LLC does have many of the same complexities as the partnership, including the requirements to calculate the equity basis for contributions to the LLC by its members and issues involving both special allocations of income, the treatment of undistributed income and self-employment taxation of actively involved partners.

Many important considerations go into choosing the form of entity including owner’s liability, raising equity capital, potential exit strategies and the tax effects of the form chosen. Businesses should consult with their tax advisors when choosing the form of entity in which they want to operate and should continue to consult with their advisor when the business environment changes.