Choice of entity is most often driven by tax considerations. We can provide limited advice in this area. Choice of entity questions are best answered by your CPA or other tax advisor. We will be happy to discuss the legal issues relating to choice of entity with you, but we defer to CPAs to provide in depth tax consultation.
Choice of Entity
I generally understand the differences between a C Corporation, an S Corporation and a Limited Liability Company. Which one should I choose?
Some of the general goals and principles of a good tax strategy are:
- Reduce your overall taxes
- Avoid filing unnecessary multiple tax returns
- Avoid having salary from more than one entity that exceeds the Social Security maximum ($132,900 in 2019)
- Avoid mixing active income activities with passive income activities
- Isolate potential liabilities of multiple business locations
Warning: The examples below are general in nature and there are exceptions to the general rule. You should seek professional advice specific to your situation before selecting your business entity.
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The U.S. tax code is incredibly complicated and has numerous tax traps. The following are a few examples we encounter often. There are many more that are not listed. Warning: These examples are general in nature and there are exceptions to the general rule. You should seek professional advice specific to your situation to make sure you avoid these or other tax traps.
- Imputed income. You have a great idea and quite a bit of experience, but little money. You are forming a corporation and you have a investor that intends to put up the money. You issue 500 shares to yourself at little or no cost. You issue 500 shares to the investor who pays $100,000 for his shares. Since you own one-half of the company that is worth $100,000 on day one, the IRS imputes $50,000 income to you which is taxable now.
- Personal service corporation. Doctors, attorneys, CPAs and a number of other business make the bulk of their money from the services of the owner. If the business is taxed as a C corporation, the IRS further classifies this as a personal service corporation. The sliding scale of tax rates do not then apply and all income is taxed at the maximum rate. (This does not apply to S corporations.)
- Contribution of appreciated assets. You are forming a LLC. One member is contributing $50,000 cash. The other member is contributing physical assets that have a market value of $50,000, but a lower tax basis. In many instances the member contributing physical assets is liable for taxes immediately.
- Holding real estate or other appreciating assets in a C corporation. You hold real estate in a C corporation. It goes up in value. You sell the real estate and then distribute the money to yourself. The sale is taxed to the corporation. Then when you pay out the funds to yourself, it is taxed again. This is called double taxation and is one of the hazards of a C corporation.
- Mixing active and passive activities. This often happens in real estate investing. The IRS considers rehabbing properties for a quick resale as an active business (and subject to social security and medicare taxes). Buy and hold properties are considered a passive investment (and not subject to social security and medicare taxes). If you mix these types of investments in one entity, you run the risk the IRS will classify all of it as active and assess social security and medicare taxes on your passive activities (along with massive penalties and interest).
- Options. Taxation of options is very complex. You should always seek tax advice if you intend to grant or receive an option as a part of your business. Here is a dramatic example. In the dot com boom of the late 1990s many key employees were awarded options to buy shares of the businesses as an incentive to grow the business. These businesses grew unrealistically in value. The time came to exercise the options. The employees exercised their options which resulted in a large amount of taxable income. They planned to sell some of the shares to pay their taxes. Soon after, the values of the businesses plummeted, but the employee shareholders were still liable for income tax on their then worthless stock. Many ended up in bankruptcy court.
This question and answer site is provided by the law firm of Robertson & Gable, LLC to educate the public generally about forming corporations, limited liability companies and other business entities. The answers provided are based on Georgia Law and are from the viewpoint of the small business owner. The answers provided are designed to apply to general situations and may not reflect current legal developments. You should not act or rely on any information in this website without seeking the advice of a licensed attorney in your state regarding your specific situation. Use of this site is subject to our full copyright disclaimer and full legal disclaimer.