Legal Strategies

Nils Johnson Jr., Johnson & Johnson Law Office:
How to Choose the Right Legal Entity

April 23, 2018
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.

Published by The Business Journal, Youngstown, Ohio.