Plan structure of company with maturity in mind

It is not unusual for businesses to go through (or at least consider) different organizational structures during their life cycles.

This article will outline some of the more common structures available to new and growing businesses as well as point out times at which the structure that was initially chosen may no longer be appropriate.

Pros and cons
The most common entity choices for ongoing businesses are the following, with each having pros and cons:

• Sole proprietorship;
• Limited liability company or LLC (can be single or multiple member);
• Partnership (general partnership, limited partnership, limited liability partnership);
• Corporation (S corporation or C corporation).

Think back to the time your business began.

If you began your business as the sole owner, your organizational choices included: sole proprietorship, limited liability company (if you began your business within the last 15 years or so), or corporation (S or C).

If you were not the sole owner of your business when it began your choices included: LLC-multiple member, partnership or corporation (S or C).

The pros and cons, as well as the restrictions surrounding the use of these different organizational structures, can be confusing.

From a planning standpoint, let’s generally eliminate the advisability of using a sole proprietor. While administratively simple (no additional income tax filings are required and generally fewer legal documents might be required), the lack of liability protection can and should be avoided.

Recognizing that liability protection is critical, the other organizational structures described above, when properly maintained, will generally shield the personal liability of the owner from most activities conducted by the business. (A complete discussion of absolute liability protection is beyond the scope of this article.)

Even if the business is owned 100 percent by one individual, a simple alternative to the sole proprietorship is the single member LLC. The profits or losses of a business owned by an individual who has formed a single member LLC are reported on Form 1040 Schedule C and are a part of the individual tax return for the owner.

In addition to the liability issue, there is a choice to be made regarding tax implications. The business can either be taxed as a separate entity or taxes can flow directly to the personal/business returns of its owners.

A regular or C corporation is a separate tax-paying entity, while the other structures noted above are “pass throughs,” where the income or loss from the business passes through and is reported on the tax returns of the owners.

Ask taxing questions
The answers to the following questions weigh heavily on whether you want a separate taxpayer or whether a pass through (and which pass through) fits the bill.

• Will the business be immediately profitable or will there be developmental losses?
• Are the owners of the business also the funders of the business?
• Are the owners of the business active in the business?
• Will the active owners of the business draw income from the business?
• What is the organizational structure of the owners?
• How is the business going to fund its growth?

Most often, if the business is going to have developmental losses and the owners are active in and fund the business, starting out as an LLC makes a lot of sense.

With an LLC, active owners can deduct losses incurred by the business up to their investment in the business. This can either offset the taxes that they would pay on other income and/or create net operating losses that can be carried back and/or forward to get refunds of other taxes previously paid by the owners. (In certain cases inactive owners can also deduct their share of losses).

LLCs can have many different types of owners and many types of special allocations, which S corporations can’t have.

For companies that are profitable (or will become profitable) and have actively involved owners, operating as an S corporation can be very effective if there are fewer than 100 owners, the owners are individuals (or certain types of trusts) and there are no special allocations desired.

One benefit of the S corporation, especially for the active owner, is the ability to minimize FICA/Medicare taxes. For most active owners of a profitable business operating as an LLC or Limited Liability Partnership, all allocated profits are subject to both income and FICA/Medicare taxes. For active owners of a profitable S corporation, the wages that that owner receives are subject to these payroll taxes, while allocations of the profits are not. This savings can be substantial.

Federal income tax rates for a C corporation (separate taxpayer) are generally more attractive (15 percent on the first $50,000 and 25 percent of the next $25,000) then might be the case for businesses whose profits are passed through to their owners. Minnesota has a flat 9.8 percent tax rate on the profit from C corporations allocated to Minnesota. This compares to the 7.85 percent top tax rate a Minnesota resident would pay on pass-through income.

C corporations can be ideal solutions for businesses with a number of owners that don’t want to have their personal tax situation complicated by the results of the business, as well as for businesses that plan to look to outside investors to fund growth.

Double taxation
The primary negative of a C corporation is the double taxation of earnings. Once profits are earned or retained, the only way to subsequently get those profits to the owners is through a dividend. This is a distribution after earnings have been subject to corporate tax. Even in the current environment of lower tax rates (15 percent federal) on many dividends, the total tax cost of getting operational profits from the business to the owner in most cases is more expensive in a C corporate environment.

Additionally, the stockholder in a C corporation gets no additional tax benefit for the earnings that are retained by the business for future growth. This is contrasted for LLC’s, partnerships and S corporations, where earnings retained by the business in one year create additional tax basis for the owners, and can also create an opportunity for future distributions free from tax, or can dramatically reduce the tax costs of selling the business.