How to Choose the Right Legal Entity

Which legal entity is the right one for your new business? Here are the points to consider:

• Is limited liability protection important?
• The nature, size and growth path of the business.
• Likely sources of financing.
• Income tax issues.

A one-man operation can be run as a “dba” (doing business as) sole-proprietorship. Where there are a handful of venturers, a simple partnership agreement may suffice.

However, Ohio entrepreneurs should consider operating through a limited liability company (“LLC”).

The LLC:

• Provides personal liability protection to its owners (members).
• Can be managed by all the members or by a managing member.
• Can provide for non-pro rata distribution of income and losses.
• Does not require a separate tax filing where there is only one member.
• Can choose to be taxed as a pass-through entity (filing a partnership return and distributing to members’ income and losses on K-1’s), or
• Can be taxed as a corporation.
• Operates without the requirement of a board or directors, minutes and resolutions.

S-corporations also offer limited liability. Income, losses and deductions also flow out on K-1’s. The owner can take a reasonable salary and receive remaining profits as a distribution – the latter not being subject to FICA deductions.

With S-corporations:

• There can be only one class of stock with up to 100 stockholders.
• Pass-through losses are limited to stockholders active in the business.
• Only individuals, estates and special trusts are permitted shareholders.
• Shareholders must be U.S. citizens, or U.S. residents.

Under the new tax law, pass-through entities such as partnerships, S-corporations and LLCs electing partnership status can deduct up to 20% of “qualified business income.” The deduction is not available to “service” companies and phases out as income rises.

C-corporation status is appropriate for larger enterprises. Taxes are paid at the corporate level and then, again, when shareholders receive dividends. With the 2018 tax reform, C-corporation taxes have been reduced from a maximum 35% to a flat 21% rate.

Whether operating as a C-corporation is attractive depends on the size of your business and your growth path. With C-corporations:

• It is easier to raise capital by the sale of stock or bonds.
• Multiple classes of stock are permitted, easing capital raises.
• State and local taxes are fully deductible (individuals have a $10,000 limitation).
• The corporation can fully deduct its share of payroll taxes.
• Deferred compensation, insurance and retirement benefits can be deducted.
• A calendar fiscal year does not need to be used.
• There are fewer share ownership restrictions and shares are typically freely transferable.
• There is more extensive and expensive paperwork.
• State franchise taxes might be higher.
• If most earnings come out as salary, double taxation can be avoided.
• Venture capitalists prefer the C-corporation structure and, if the entity is someday to go public, C-corporation structure will be used.
• For C-corporations with less than $50,000 of income, owners will pay more taxes.

Smaller businesses, not likely to grow beyond a certain size, are LLC candidates. Owners who take the lion’s share of profits out in salaries and benefits, may save taxes with a C-corporation. Companies that need access to the capital markets, do business overseas and expect to go public will want a C-corporation.

Copyright 2024 The Business Journal, Youngstown, Ohio.