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”).
- 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.
- 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 2023 The Business Journal, Youngstown, Ohio.