Understanding Entity Selection

By: Jordan Sibley

Gone are the days of thorough evaluation to determine if an entity structure fits the goals and criteria of the business it serves.  Instead, ill-advised business owners comb through websites in an effort to understand a seemingly simple concept that, in reality, is quite convoluted.  Improper entity selection can bury its owners with unknown liabilities, or fail to capture the full range of liability protection that each entity provides.  A basic understanding of these entities is necessary to better position its owners, and to capture as many benefits as possible.

Keep in mind that there are numerous tax implications to consider when evaluating an entity.  Self-employment taxes, phantom income taxes, distribution of profits and loss allocations are all key factors that ultimately impact the business and its ownership.

The most commonly known entity is the Corporation “C-Corp”.  The C-Corp hosts a number of benefits, namely centralized management and liability protection. The “directors” oversee the operations of the business for the benefit of the owners, and the owners are known as “shareholders”. The C-Corp, as a separate entity, provides its shareholders with personal liability protection and pays its own taxes with no pass-through loss or income.  This kind of corporate liability protection means that the shareholders are not responsible for the debts or obligations of the C-Corp. 

C-Corps offer flexibility for the shareholder and entity alike.  Shareholders are capable of freely transferring their shares without a lengthy approval process.  Also, the C-Corp can establish different classes of stock which may have preferential voting and economic rights. 

Most importantly, the C-Corp provides tax-free reorganizations and “stock for stock” transactions with another C-Corp that can eliminate all corporate and shareholder taxes.[1]  This structure is very popular for emerging growth companies and the financiers that back them.  Another perk is that C-Corps are afforded very generous employment benefits at the entity level, which accommodates hiring staff and helps offset entity costs.

The biggest C-Corp negative is the double tax feature at the corporate and shareholder levels.  All C-Corps are subject to federal income taxes.  Additionally, C-Corp earnings distributed to shareholders in the form of dividends are also taxed at the shareholder’s individual tax rate.  With the C-Corp marginal tax rates ranging between 15-34%, you can understand why the tax burden on these entities is a political hot button.[2]  Additionally, since the C-Corp is an independent entity that reports its own earnings, it can become expensive as it requires ongoing regulatory compliance.    

For businesses with few employees, or those that have passive management, the C-Corp is not a great fit because of its compliance and tax burdens. Emerging growth companies, especially in the IT industry, find the C-Corp to be a tremendous entity with upside to scale the business and eventually go public.  In any event, the C-Corp is best reserved for large-scale organizations and emerging growth companies.

The S-Corporation “S-Corp” is a favorite for individual business owners.  While it is typically filed as a “For-Profit Corporation”, the S-Corp exists because of its tax election with the Internal Revenue Service.  Like the C-Corp, it has liability protection that distances entity claimants from the shareholders.  However, the S-Corp has a “pass-through” structure where profits and losses are reported by each shareholder and not paid by the entity.  The benefit is that the S-Corp shareholders utilize these losses to help offset the amounts owed on their personal tax returns, a perk that C-Corps cannot enjoy. 

For individual business owners in the services industry, the S-Corp is a tax beauty.  The S-Corp tax election provides an excellent self-employment tax benefit.  These benefits can offer a reduction in self-employment taxes, making entities taxed as an S-Corp a plus to shareholders that are employed full-time by the entity.

The biggest drawback for S-Corps is that they only permit individual owners and offer one class of stock.[3]  Additionally, distributions of profits and losses must be allocated pro-rata based on each shareholder’s ownership percentage. 

For individuals looking to grow a business with institutional investors, this is not the correct entity choice.  However, individuals that want to be an owner and receive salary from the entity makes the S-Corp a great fit.  Companies that provide professional services should take a hard look at the S-Corp tax election to reduce self-employment tax obligations. 

The Limited Liability Company “LLC” is the most flexible option for a new business entity.  It has the powers of a partnership with the liability protection of a corporation.  Furthermore, the LLC has flexible allocation and distribution features for its owners.  It is also a pass-through entity, so profits and losses are reported and taxed on the owners' individual returns.

An LLC is owned by “members” and managed by “managers”.  Members consist of individuals, trusts, or any other type of legal entity.  The LLC may be “member-managed” or “manager-managed”, but either designation must be identified on the LLC’s organizational filings.  The manager duties and obligations to the LLC are set forth in the LLC operating agreement. 

The biggest downside of the LLC is phantom income tax, where company revenue is taxed to the members but not always received by the members.  Any pass-through entity will have it, but the LLC is typically reserved for companies that are generating substantial revenue.  Depending on the liabilities of the LLC, this revenue does not always equate to net profits, but is allocated as income to each member anyway.  As a result, the members report taxable income generated by the LLC even though each member did not actually receive that amount of income.  As a workaround, an LLC should consider making distributions of cash to each member to offset phantom income tax consequences.  In any event, phantom income taxes can bury each member with taxable consequences unless structured correctly.

The LLC is a fan favorite for operating companies and businesses that need to depreciate hard assets like real estate or equipment.  Additionally, the LLC is preferred for investment or holding companies because the member’s only liability is the risk of loss to the value of their investment. 

In any respect, the LLC is more flexible than an S-Corp, has the liability protection of a C-Corp and receives the pass-through tax treatment of a partnership.  It is a hybrid entity that generally fits the needs of most businesses, and should always be considered for an entity choice. 

Now, the partnership.  The partnership is the oldest form of business entity between multiple parties, with partnership statutes traced to King Khammurabi of Babylon nearly 2,000 years ago.[4]  While several types of partnership entities exist, the Limited Partnership “LP” is the most sought after entity structure for those in finance and investment management.[5]  The LP requires at least one equity partner, the “limited partner”, and the LP business affairs are managed by the “general partner”.  The LP limited partners can be individuals, trusts, or any other legal entity. 

While each limited partner has liability protection from the debts or obligations of the LP, a primary disadvantage is that the general partner may be liable for the financial obligations of the Limited Partnership. Most general partners organize as an LLC in an effort to shield themselves from these LP liabilities, but some fail to understand the general partner’s exposure in a Limited Partnership.

The LP is a pass-through entity, like the LLC and S-Corp, so the profits and losses are paid at the partner level rather than the entity level.  If organized correctly, the limited partners contribute capital to the LP and share in its profits and losses without having any liability exposure to creditors of the business. An LP also allows for flexible allocations of profits and losses, which limited partners either enjoy or dislike. 

The Limited Partnership is a favorite for money managers and funds that pursue carried interests to share in the LP profits.  Additionally, the LP is a beneficial entity structure to place real estate holdings.  If a passive investor is looking to invest capital for another party to manage, the LP is the ideal fit.  However, all prospective limited partners should consider if they can handle the tax burden that follows allocated losses in the LP structure.

All in all, Texas entities afford a plethora of options for new businesses or ventures.  Each entity option should be carefully reviewed, with short-term and long-term considerations for both the business and its owners alike.