CHOICE OF ENTITY
C-Corporations, Sub-S Corporations, Limited Partnerships, Limited Liability Companies, Partnerships – What are they? What type of operating entity is best for your business.
In selecting the operating entity to best fit your needs, a number of factors should be considered.
Factors to Consider
- Liability
: In general, there are two types of liability - tort and contract. Tort liability arises out of a civil wrong, for example, you negligently operate the company vehicle and injure someone. Your product is claimed to be defective and a consumer claims to be injured. People who do business be a sole proprietor or in a partnership are liable for the torts committed by themselves and for torts committed in the course of the business by their agent and/or partners. However, one may avoid tort liability for the acts of business associates if they operate their business as a corporation or a limited liability company. Thus, the choice of entity is to perceived to have potential benefit if one is concerned about limiting one’s tort liability. Remember that regardless of what type of business organization you select, you are liable for torts committed by yourself, i.e., if you are driving the company vehicle and are involved in an accident you are liable if you negligently operated the vehicle whether you operate as a corporation, partnership or sole proprietor.Every business person should carefully consider the potential risks involved and thoroughly discuss them with an insurance professional. Assuming one has appropriate insurance, the perceived benefit of avoiding personal liability through choice of entity perhaps is overstated - we often tell clients that is what one should have insurance for.
Contractual Liability: An entity such as a corporation or a limited liability company may protect one’s personal assets should the operator incur a significant contractual liability from the business operation. For example, assume a building contractor signs a contract to construct an office building for a business client and fails to meet the contractual deadline, the business client holds the contractor liable for consequential damages - profits lost for the time the client is not able to occupy the new building. Particularly in the construction area, contractual liability may exceed simply the contract price. So long as one does not personally guarantee the contract of the business entity, his or her personal assets, assets owned outside the corporation or LLC, are protected as the corporate operator should not be personally liable for the corporate debts, contracts and contractual liabilities. Often, however, people dealing with corporations demand that the principals of the corporation personally guarantee the contracts.
- Control
: A sole proprietor answers only to himself. If he takes on a partner and operates under the Uniform Partnership Act, unless the partners agree to the contrary, they must agree on all major decisions. If there is a disagreement, any partner may not only withdraw, but demand that the partnership be dissolved and that his interest in the partnership be distributed to him. This right to control - to have things your way or have the business terminate - found in partnerships, should be carefully compared to the control, or lack of control, one might have in a corporation.In a corporation, the majority controls. And thus, one might own 49% of the stock and yet have virtually no say in major corporate decisions. The fact that a person is a shareholder in a corporation does not guarantee continuing right to employment or even the right to be a director of an officer.
Because of these concerns, we urge clients who are considering doing business as a partnership or a corporation to consider a buy-sell agreement.
By means of a buy-sell agreement, the owners of the corporation agree to not follow the strict majority control rules set forth in the Model Corporation Act. Rather, they provide that for a specific dispute resolution process should a shareholder with to withdraw, should the majority shareholders wish to terminate a shareholder as an employee, should a shareholder die or with to be bought out. Absent a buy-sell agreement, control, and lack of control can be a very critical issue for people doing business particularly as a corporation.
- Tax Issues
:a) Income Taxes. We expect that perceived tax benefits/detriments are the principle factors which people consider in selecting a particular choice of entity. A sole proprietor simply reports his income and expenses on his personal return. A partnership is similar. The partnership files a partnership return, but then distributes the income and expenses proportionate to the individual partners. The partnership itself does not pay taxes. In other words, the income is reported and the taxes paid by the individual partners in the ratio to their partnership interest.
A C-Corporation is a taxable entity which pays taxes on its net profit. This raises the concern of double taxation. If a corporation hires as an employee its major shareholder, the corporation may deduct the shareholder’s salary as a business expense. The shareholder reports that salary on his or her personal return as income. But if the corporation has a profit in excess of its expenses, including the salaries paid to its owners, that profit is taxed. If the profit is thereafter distributed to the shareholders as a dividend, the shareholders pay tax on the dividend as ordinary income - the income ends up being taxed twice. To avoid the potential for double taxation, businesses often consider electing to be taxed as a "Sub S-Corporation. A Sub S-Corporation provides the limited liability protection available to a corporation and yet provides the perceived tax benefits of a partnership. The income and expenses are distributed from the corporation to the individual shareholders and taxes at their level.
b) Self-Employment Taxes - Social Security Taxes. These often play a role in selection of business entity. See LLC v. Subchapter S Considerations
c) Transfer Taxes. A corporation is considered a distinct taxable entity - even if Sub S status is elected. Thus, transfers of assets to and from the corporate entity may have significant tax consequences. Transfer of real estate to a corporation carries with it a 1.53% excise transfer tax in the State of Washington. Of greater concern is when a corporation attempts to transfer assets out of a corporation. This is usually considered a sale and triggers tax should the value of the transferred asset exceed its tax basis.
In general, we discourage our corporate clients from having the corporate entity own real estate. If the corporate entity is going to utilize real estate often it is best to have the corporation lease it from the shareholder.
d) Deductibility. Corporations are perceived to provide certain tax advantages in terms of deductibility of certain expenses. For example, employee benefits such as payment for health insurance premiums and reimbursement for uninsured health insurance expenses can be a deduction against profit and yet not be taxable income to an employee. Likewise, certain living expenses - cost of maintaining a home and groceries can be a deduction for the corporate employer and not be considered taxable income to the shareholder employee.
