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.