One of the most important decisions that entrepreneurs must make when launching a new venture is to decide how to organize as a legal entity. Businesses can choose between three principal types of business entities, including pass-through, corporate, and non profit. There are advantages and disadvantages of each type of entity, but none of them are appropriate in all situations. Below is a full overview of what each form of business entity has to offer for entrepreneurs. If you have any questions about your selection feel free to call or email Inc. Plan (USA).
Pass-through entities offer limited liability protection for shareholders and are not subject to income taxation at the corporate level. The income taxes incurred by pass-through entities are transferred to individual shareholders who report the entity’s profits as ordinary income on their personal tax returns. However, personal income tax liabilities are incurred regardless of whether profits are actually distributed to shareholders.
Profits realized by pass-through entities are subject to self-employment taxes, which require individual shareholders to pay both the personal and employer portions of the Medicare and Social Security taxes. Pass-through entities come in the form of LLCs and S-corporations, which are organized under the rules found in Subchapter S of Chapter 1 in the Internal Revenue Code.
Corporate entities are treated as entirely separate persons from their owners and, therefore, are subject to corporate income taxation. When profits are distributed to shareholders in the form of dividends, individual recipients must also pay capital gains taxes on profits that exceed vested contributions. However, no personal income tax liabilities are incurred when profits are reinvested into the corporation.
Ambitious entrepreneurs often favor incorporation because retained earnings are taxed at a lower rate, losses can be deducted across several years, and the sale of founding shares is taxed as a capital gain. Member salaries are deductible from corporate income if they are reasonable, consistent, and calculated in good faith. The C-corporation is the most common form of corporate entity in the United States, but LLCs and S-corporations can also elect to be taxed as corporate entities.
Advantages of Pass-Through
Pass-through entities are favorable for smaller enterprises that are more certain and offer a return on investment in the short-term. During a good year, federal taxes incurred at the top marginal rate could be as low as 43.4 percent for pass-through entities. Businesses that do not need to reinvest a significant portion of earnings could, therefore, save a significant amount of money on taxes by utilizing a pass-through entity. Pass-through entities are also inexpensive to form, and most states still do not require annual franchise fees or other additional expenses to maintain good standing. The administrative requirements imposed on corporations are also waived for most pass-through entities, especially LLCs.
Pass-through entities are appropriate for new businesses that are self-financed, bank financed, or seeking to raise initial seed capital. Pass-through entity members can always elect to incorporate at a later date with much lower tax consequences than with unincorporation. Many individuals also choose pass-through entities as a personal investment vehicle to enjoy limited liability protection without incurring a second layer of taxation. Individuals conducting business as independent contractors, such as consultants, can also enhance their legitimacy and reduce risk by utilizing a pass-through entity. Single member entities enjoy the same protections provided to multiple member organizations and can easily add new members or employees in the future.
Disadvantages of Pass-Through
Pass-through structuring is not appropriate for enterprises that have a significant number of investors or entail a high degree of uncertainty. Current federal rules under the Investment Company Act limit an S-corporation to having 99 shareholders before being required to restructure as a C-corporation. S-corporation status also requires the written consent of all shareholders, which can be difficult to obtain as the number of investors grows. LLCs can have as many as 2000 shareholders but must submit quarterly filings to the SEC upon exceeding 99 shareholders. Incorporating allows for an unlimited number of investors and waives the SEC filing requirements until the business has ten million dollars in assets and 500 shareholders.
Many investors are unwilling to invest in pass-through entities that entail a high degree of risk due to concerns about personal tax liabilities that are not funded by the business. Courts have long upheld that members are strictly liable for unfunded personal tax liabilities associated with a stake in a pass-through entity, even if the losses were incurred in good faith. Some businesses attempt to mitigate fears of phantom profits through contractual obligations to shareholders that require the distribution of amounts equivalent to tax liabilities at the end of each year. Unfortunately, passive investors cannot guarantee that income tax payments will be made in the event of business failure. Therefore, businesses dependent on funding from a significant number of investors should consider incorporating to alleviate investor concerns.
Many charities are formed as tax-exempt nonprofit organizations, but this form of entity also entails adherence to strict rules and a permanent loss of funds. Charitable individuals often choose to conduct their activities in the name of a for-profit entity to maintain greater flexibility and autonomy. Corporate entities can deduct no more than 10 percent of their annual income for charitable purposes. In contrast, pass-through entities enable individuals to deduct charitable contributions from up to 50 percent of their personal income, which could come from other sources or the business itself. Funds vested into a pass-through entity can also be legally returned. Therefore, pass-through entities are the most advantageous choice for revocable charitable contributions in the name of an organization.
Selecting the Appropriate Entity Form
Business owners must carefully evaluate the advantages and disadvantages of each entity form to maximize the value that their business can offer. Generally, enterprises with ambitious business goals or capital intensity should incorporate after obtaining the financial and human resources needed to structure a corporate entity properly.
Individuals or small partnerships that rely on managerial expertise will realize greater benefit from a pass-through entity with inherent limited liability protection, such as an LLC or S-corporation. Closely held charitable organizations that do not want nonprofit status are usually better off with pass-through tax treatment. Carefully evaluating the nature of a business opportunity is the most advantageous method of determining the most appropriate business entity form in specific scenarios. Inc. Plan (USA) can guide you through the decision making process.