See this article as it originally appeared in Newsweek.
Choosing the right business entity form for a new company seems like a straightforward choice, but there’s actually a lot of nuance — and potentially a lot at stake in regard to future tax liability.
While it’s easy to organize as an LLC and move to a corporate structure, moving from a standalone corporation to a partnership down the line often results in paying income tax on the appreciated tangible and intangible assets — so choosing the right entity is worth careful consideration as the company is being founded. These questions can help guide the process.
Is this business your career or a lottery ticket?
A great place to start is by defining your intention for the business. Are you starting a lifestyle business you plan to use to earn a comfortable living and run until you retire? Or are you aiming to create a cash cow and hockey stick your way to a big payoff within a few years?
If you anticipate the business will be your career, an LLC is the easiest and most flexible tax entity to legally organize. The tax advantage of an LLC, or other legal partnership entity such as an LLP, is that there’s a single layer of taxation.
For example, consider a sole-owner LLC (sole proprietor). That person files a Schedule C with their tax return and is taxed on the income of the business. The income is taxed at their blended individual tax rate, so the income tax rate is, at most, 37%, plus self-employment tax. Taxes are paid as the income is earned, and there’s no additional tax for the owner to take money out of the business. If there is more than one owner of the LLC, then a partnership return is filed; however, the partnership itself does not pay the tax. The owners pay the tax on their individual 1040s.
If a company is organized as a C corporation, the business pays taxes on its earnings each tax year. When the owners want to take money out of the business in their capacity as shareholders, they have to declare a dividend and pay capital gains tax on it. As a result, the earnings of the corporation are taxed twice.
The advantage of a C corporation is that the federal tax rate is currently 21%. If you’re a growth company and you have to reinvest all the money you’re making, then the corporate structure is going to be advantageous. The current corporate tax rate is lower than the individual rate, and since you’re not taking money out of the business, you won’t encounter the second layer.
But if you want access to operational money beyond your wage — in other words, if you want to benefit financially off the success of the business — then an LLC is a much better tax vehicle than a C corp.
One interesting option that may be a good fit for some businesses leaning toward a partnership is an S corporation. An S corporation is a hybrid between a traditional C corporation and a partnership. An S corp does not pay taxes at the entity level and each shareholder is taxed on their share of the income. Unlike partners in an LLC, shareholders in an S Corporation are not subject to self-employment tax on their share of the ordinary income.
The tax rate for certain sole proprietorships, partnerships and S corporations can also be reduced by deducting 20% of qualified business income. The rules around this deduction are complex and contain limitations and restrictions, so it’s always best to consult your tax advisor.
What is your exit strategy?
When you’re starting a new company, it’s important to look down the road at how you may exit the business. While a lot will happen between now and then, the decisions you make at the formation of the company can have a profound impact on future exit options.
Like earnings, the sale of an LLC or partnership is taxed solely at the individual level. It’s effectively considered an asset sale and taxed according to the type of assets sold. Although most assets receive capital gain treatment, the gain on some assets, such as accounts receivable and fixed assets, can be taxed as ordinary income. Buyers like entities that result in additional tax deductions at little or no tax cost to the seller.
The sale of C corp assets involves the same two layers of tax as its income. The corporation pays tax, currently at 21% plus state, on the gain from the sale of assets. Then it must distribute the money or liquidate the corp, which is the second layer of tax, paid as capital gains at the individual level. However, if the shares of the corporation are sold, then there is only one layer of tax. Buyers prefer assets to stock so they can get additional tax deductions.
Despite the two layers, a C corp remains the best entity for exiting a growth company as a result of a favorable tax incentive for investing in growth companies. The tax incentive is for qualified small business stock, which allows individuals to exclude the greater of $10 million, or 10 times their basis when they sell originally issued shares. So if you sell for $10 million, instead of paying $2 million to the federal government for capital gains tax, you pay nothing. This exclusion does not exist for a partnership, and only applies to qualified small business stock that has been held for at least five years.
Calculating which entity will be more advantageous under different hypothetical circumstances can be difficult. Hopefully these questions can provide some food for thought, but I would recommend exploring the particulars of the business you’re forming with an accountant.