Entity Evaluation – Is Your Structure Satisfying Your Business's Needs?
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Entity Evaluation – Is Your Corporate Structure Satisfying Your Business’s Needs?
June 08, 2018
Entity_evaluation

Entity Evaluation – Is Your Corporate Structure Satisfying Your Business’s Needs?

June 08, 2018
In our complex and modern economy, U.S. laws permit numerous ways for business owners to set up their businesses. In this article, we’ll review the most common options for small business owners either looking to start a business or are considering a change of business entity. This list is by no means exclusive, so if you have a business entity structure that works for you, let us know how you’re organized and why you prefer this type of structure!

Please note that all of these corporate contain limited liability protection for the owners in one way or another. As always, it is important to check with your trusted advisor to ensure that your business entity is protecting you and meeting your needs.

C-Corporation

The C-Corp is the classic business formation, as nearly every publicly traded company is a C-Corporation. The primary advantage of the C-Corp is the ease of raising equity capital from a large number of people. For all C-Corporations, the signature factor is ownership of stock in the corporation. Generally, the transfer of stock from one person to another is fairly easy with a C-Corp. However, additional restrictions could apply for owners of stock in a closed C-Corporation. In addition, you should note that a closed C-Corp isn’t publicly traded.

In either situation, the life of a C-Corporation is perpetual, which means that ownership passes through generations and doesn’t end with the death of the holder of stock. The major disadvantages of the C-Corp are double taxation of income and dividends at the corporate and shareholder level. In addition, C-Corps require substantial tax filings and often independent management. The costs for those requirements can add up quickly, which can make the C-Corp a less than ideal entity for new businesses.

Pros:

  • Limited Liability: C Corporations offer limited liability, which is beneficial to owners. Each shareholder is only liable up to the amount of their initial investment, so the personal assets of each shareholder are protected.
  • Issuing stock: Corporations have the ability to issue stock to raise money from investors, which is attractive to potential stakeholders. As indicated above, C Corporations can have an unlimited number of owners, and ownership is easily transferrable. This makes restructuring from an ownership perspective much easier and the perpetual life of the company lends itself to sustainability, regardless of what may happen to any individual owner.

Cons:

  • Double Taxation: Corporate profits are subject to double taxation, as C Corporations are not pass-through entities. First, the corporation is subject to corporate income tax, and once the profits are distributed as dividends the shareholders pay tax a second time when they report the income on their personal returns.
  • Formation, maintenance, and compliance requirements: The formation of a C Corporation is more extensive than other entities. Typically, companies wait until they have grown larger to consider this structure for this reason. C Corporations must be created by the state through Certificates of Incorporations or Articles of Incorporation, both of which are equipped with a filing fee. There are also annual reports and fees to maintain compliant status. Furthermore, there are many compliance rules with regard to shareholder and director meetings, and documentation. If the rules aren’t followed, the company runs the risk of piercing the corporate veil, which means losing its limited liability.

S-Corporation

The S-Corp is the little brother to the C-Corporation. The first notable difference between a C-Corp and an S-Corp is the tax treatment. The S-Corp is a pass-through entity, meaning there are no taxes paid at the corporate level. Instead, the shareholder receives a special form from the company indicating each shareholder’s proportional share of the income from the company. An S-Corporation can also be easily converted to a C-Corporation as the company grows.

In addition, it’s important to note that an S-Corp can only have 100 shareholders. Therefore, if you want to grow your company, you’ll need to convert to a C-Corporation to take on additional shareholders. Also, shareholders of an S-Corp are limited to U.S. citizens or permanent residents, so foreign persons and other corporate entities aren’t allowed to be shareholders of an S-Corp.

Pros:

  • Eliminating double taxation: Profits and losses are passed through to shareholders, so taxes are only paid once, not at the entity level.
  • Protection from liability: Owners or shareholders of S Corporations personal assets are protected as they are separate from the business.
  • Easier accounting methods and less cumbersome formation: Not as many regulations and steps are required to incorporate, and in terms of accounting the methodologies are much simpler than they would be for other entity types.

Cons:

  • Rules and fees: Although the formation is less cumbersome than a C Corporation, there are several rules that must be abided by and fees that must be paid.
  • Shareholder restrictions: In S Corporations, shareholders will be taxed for any income the company generates, regardless of whether or not they received any of that income. This can create issues with passive shareholders. In C Corporations, shareholders are only taxed if they receive a dividend. There are also regulations regarding classes of stock, which can be deterring to certain investors, and number of shareholders (there can only be 100).
  • Salary Requirements: The IRS requires all officers and owners of S Corporations to draw a salary, regardless of profitability. This obviously creates issues for start-up companies that may not be in a position to compensate their employees.

LLC or Partnership

We’re reviewing the LLC and partnership together because the LLC has effectively replaced the partnership due to the ease of creation and convertibility of the LLC as compared to the partnership.

First things first, an LLC is a limited liability company, not a corporation. A corporation has a completely different tax and legal meaning as discussed above. So, what then is an LLC?  An LLC is a pass-through tax entity, similar to an S-Corp with one major difference: members of an LLC must account for a certain portion of their pass-through income as self-employment tax. In an S-Corp, the owners of the company are also employees so there is no need to treat a certain portion of those profits as self-employment income. Another thing to note, the members of an LLC are not technically employees of the business. For many small business owners, the LLC is the vehicle of choice due to the ease of creation.

Pros:

  • Pass through Taxation: Very similar to the S Corporation, limited liability companies and partnerships are not subject to double taxation, which is advantageous to business owners.
  • Ownership advantages: LLC’s can have as many or as few members as it wants. If there is just one member, it is a sole proprietorship. Additionally, the structure is less stringent as there is no requirement for a board of directors, shareholder meetings, and there is generally less paperwork involved which lends itself to easier formation.
  • Limited Liability: Members are typically not held liable for company debts or liabilities that they don’t personally guarantee. This allows members personal assets to be protected, unless the corporate veil is pierced (see above for explanation).

Cons:

  • Managing Member Taxation: Although LLC’s are not subject to double taxation, managing members are subject to self-employment tax.
  • Liability & Organization: There is the potential for the corporate veil to be pierced in which members could be held personally liable for the company’s acts. This is an area of law with very little precedent, which makes it difficult to predict certain consequences. As indicated, LLC’s are much more loosely structured and are subject to fewer regulations. This could potentially cause problems as the company grows and more regulations may be required.
  • Raising Money: Again, LLC’s are less structured, which can cause investors to shy away.

ESOP

The ESOP or “employee stock ownership plan” is a more obscure business form but one that can-do wonders to align the interests of management and employees, so we have been seeing it become increasingly popular over the last few years. In an ESOP, the employees own all or part of the company in proportional shares. Therefore, the employees have an interest in seeing the stock price of the company appreciate. Within the ESOP, the employees/shareholders enjoy significant tax advantages because the purchases of stock are tax deductible. All and all, the ESOP is gaining popularity as a business entity to align the values and financial interests of everyone involved.

Pros:

  • Tax Advantages: Many private business owners utilize an ESOP as an exit strategy, and if done correctly, the selling shareholders have the ability to roll proceeds from the sale of their shares into other investments tax free. Additionally, for all companies, payments made to the ESOP are tax deductible.
  • Flexibility: ESOP transactions can be done over time, and owners can remain active in the business even after the transaction is complete. Additionally, it allows for more confidentiality throughout the transaction as ESOP’s are privately owned.

Cons:

  • Exit Strategy: Although this is an advantage of an ESOP, it can also be a disadvantage. When an ESOP is utilized as an exit strategy, the price per share is limited to the fair market value of those share, which is always the best price that can be achieved.
  • Risky: ESOP’s only provide value to participants if the underlying shares are determined to have value. This makes it extremely important to determine the financial health of the company and evaluate future projections prior to converting.

There are many options for structuring your business, which is why it’s important to work with trusted advisors who will help you meet your financial, tax planning, and charitable goals. Your advisors have likely seen the life cycles of many businesses and know the pros and cons for each entity, so it’s tremendously valuable to ask them which entity will fit your business for the short term and the long term.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.

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Guest Post by: Ari Palmer
Ari Palmer is the Director of Business Development for Indago, a full-service Research & Development Tax Credit provider for innovative companies nationwide. She also co-founded the rad app: The first web-based R&D Tax Credit tool that is cost-effective and time-efficient to process R&D claims. With the rad app, users can complete a claim in just hours and receive expertly reviewed calculations and pertinent tax forms within a couple of business days, ensuring timely tax and payroll filings.
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