Entity Selection Impacts Tax Efficiency & Liability Protection

There is more to selecting the entity type of a business than liking the sound of “LLC” or “Inc” after the company name. Selection of entity type is a key issue for any new business. Among other factors, it sets the business up for tax efficiency and liability protection. But startups are not the only businesses that should pay close attention to entity structure. Changing entity type is sometimes a beneficial move for a company that has been in business for a while. 

Making the right choice of entity structure depends on several factors. First, what are the business owner’s goals for the entity structure? Tax efficiency is one of the top considerations for many business owners, and liability protection for owners and partners is another. 

The key questions business owners need to consider when selecting an entity type are: 

  • Is protection from legal liability a concern for the owner and/or partners? 
  • What is the makeup of the ownership group? If it includes other entities (i.e., partnerships), then the choice of entity types is limited. 
  • What are the tax implications of each entity type, given the needs and circumstances of the company owners? 
  • What are the owner’s needs regarding debt basis, which potentially enables owners to deduct losses? 

The most common business entity structures in the U.S. are sole proprietorships, partnerships (mostly Limited Liability Companies), S corporations and C corporations. 

A brief overview of the advantages and disadvantages that each of the major entity types offers: 

Sole Proprietorship 

By far the most prevalent business entity structure in the U.S., the sole proprietorship also is the most flexible and the easiest to start up. You set up an entity, you own it, and it gets included on your Form 1040. There are no special tax filings, although a Schedule C Profit or Loss From Business will be included, or a Schedule F Profit or Loss from Farming if you are a farmer.  A rental business would be reported on a Schedule E. 

The sole proprietorship has two main drawbacks. The first is that, in addition to income taxes owed on the income, the owner is also subject to self-employment taxes. Self-employment taxes consist of Social Security (12.4%) and Medicare taxes (2.9%) primarily for individuals who work for themselves. It is similar to the Social Security and Medicare taxes withheld from the pay of most wage earners, but half of which gets paid by the employer when you are an employee. 

The second drawback is that the owner has no protection from personal legal liability. For a business owner who is selling a product or service that carries little risk of harm or damage, this may not be an issue. But if you own a toy store, and therefore assume the risk of a child getting hurt by a toy you have sold, the limited legal liability of an LLC may be more appropriate for you. 

The primary tax form used to report sole proprietorship income is the Form 1040 with usually a Schedule C or Schedule F. 

Limited Liability Company (LLC) 

An LLC is classified as a partnership if there is more than one member (owner), and ownership is open to both individuals and other business entities such as other LLCs and corporations. The income paid to members of a partnership LLC is reported on a Schedule K-1. An LLC can also be owned solely by one member – if so, it is known as a disregarded entity and is treated similarly to a sole proprietorship for income tax purposes. 

One of the key advantages of the LLC structure is that members are protected from personal liability. Additionally, an LLC is not limited in terms of who can be an owner, so entities with ownership groups that include other partnerships or corporations can qualify as LLCs. A partnership can also have special allocations of income or loss which can be very beneficial. 

An LLC can also elect to be taxed as an S corporation, but only if all shareholders are qualified individuals or trusts (not other partnerships or corporations) and they all agree to the S election in writing. The income from an LLC partnership could be subject to self-employment taxes depending on the owners’ level of involvement in the LLC. 

The compensation paid to partners in a partnership is called a guaranteed payment, and it is subject to self-employment taxes.  This compensation is not subject to annual information reporting on a W-2, but rather gets reported to the partner on their Schedule K-1. 

The primary tax form used to report partnership LLC income is the Form 1065. However, if an LLC is owned by a single owner, it is considered to be “disregarded” for tax purposes, meaning the income can be reported directly on a Form 1040. 

S Corporation 

The S corporation is also frequently called a “pass-through” entity because it passes income, losses, deductions and credits through to shareholders for federal tax purposes. Hence, the S corporation itself does not pay a federal corporate income tax. All income is reported on shareholders’ Form 1040s and is taxed at individual marginal income tax rates. It is important to note partnerships are also pass-through entities and share these same general characteristics with S corporations.  

Shareholders that provide services to the S corporation must be paid a W-2 salary and it must meet a “reasonableness” standard, meaning the salary can’t be artificially low to avoid payroll taxes. Shareholders also often draw a separate distribution which, in certain circumstances, is non-taxable depending on the shareholder’s tax and debt basis in the company. 

An important advantage is that shareholders are not subject to self-employment tax on their pass-through income from the S corporation.  Shareholders also receive liability protection through the corporate structure.  However, all S corporation distributions and allocations of taxable income or loss are required to be done pro-rata by ownership percentage, so they aren’t as flexible as partnerships in this regard. 

From a tax perspective, the S corporation – like LLCs and sole proprietorships – can qualify for the 20% Qualified Business Income (QBI) deduction, meaning owners of smaller S corporation businesses – individuals with total taxable income of less than $383,900 (joint filers) or $191,950 (single filers) in 2024 – can potentially fully deduct 20% of eligible income. While this is an important tax advantage for shareholders in smaller pass-through businesses, this tax break is scheduled to expire on Dec. 31, 2025, under the provisions of the Tax Cuts and Jobs Act (TCJA) of 2017. 

The S corporation is limited in the type of owners it can have; they generally have to be individuals or certain trusts, and the individuals must be U.S. citizens or permanent residents.  S corporations also may have no more than 100 shareholders and face other IRS restrictions. 

Another disadvantage is that S corporation shareholders may only receive debt basis from a shareholder loan made directly to the company. Debt basis gets combined with tax basis to allow a shareholder to deduct S corporation losses on their federal tax returns. By contrast, the LLC structure offers three different types of potential debt basis. So, if flexibility in deducting losses is a major concern for shareholders, an LLC structure may win out over the S corporation entity. 

The primary tax form used to report S corporation income is the Form 1120-S. 

C Corporation 

When people think of “corporations,” the C corporation is probably the model that most frequently comes to mind. The C corporation entity structure is generally used for very large, complex companies but can also be used by smaller companies 

From a tax perspective, the C corporation is a double-edged sword due to “double taxation”. This is because the corporation itself will pay income taxes on its net taxable income. However, to take that profit out of a C corporation, shareholders are paid dividends, and the shareholders will pay tax on these dividends on their personal returns at qualified dividend rates which are generally 15-20%. The good news is that, under TCJA, the top tax rate for C corporations was set at 21%.  

For example, ABC Corp. makes a profit of $1 million and pays $210,000 (21%) in federal income tax (ignoring state income tax implications), with the remainder distributed to a shareholder as a dividend. If the remaining $790,000 is taxed on the individual level at the higher end of 20% as a qualified dividend, that’s another $158,000 in taxes, bringing the remaining net cash down to $632,000, for a blended tax rate of about 36.8%, not taking into account a potential 3.8% Net Investment Income Tax on the qualified dividends. Another downside is that a C corporation is not eligible for the 20% Qualified Business Income Deduction that the other entities are eligible for.  If this same $1,000,000 income was made by a partnership or S corporation owner that qualified for the QBI deduction, only $800,000 of the income would be taxed at a potential 37% rate, resulting in only $296,000 of tax or a blended tax rate of 29.6%. 

A C corporation can elect to be taxed as an S corporation but must consider the issue of “built-in gains” for a five-year period. At the time of S election, a snapshot of the company’s financial situation is established. For the next five years, if the company sells an asset, it still must pay C corporation built-in taxes on the gain.  If electing S status, ownership also has to be looked at to make sure all shareholders qualify as a S corporation shareholders. 

The benefits of electing S corporation status include potentially qualifying for the Qualified Business Income deduction.  Additionally, if a C corporation owns real estate or other investments it does not qualify for the lower long term capital gains tax rates upon the sale of those assets; but with S corporation tax treatment it does qualify. 

A C corporation that elects S corporation tax treatment is still a corporate entity with all the legal protections; it’s just taxed differently by the IRS. 

The C corporation entity offers flexibility on who can be owners, and owners do not receive K-1 forms because the company pays the income tax. Owners receive Form 1099 if they receive dividends.  Certain stock can also qualify for special tax treatment upon sale. 

The primary tax form used to report C corporation income is the Form 1120. 

Why Change Entity? 

While most business owners select their entity structure upon startup, there are circumstances in which it’s advantageous for a mature company to change entities. If your business has changed and you require more liability protection, changing from a sole proprietorship to an LLC makes sense. Changing tax situations also compel business owners to change entity structure.  

If you are starting up a business or considering changing entity structure, contact an Adams Brown advisor for a full discussion of your options and the benefits of each.