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If protecting your personal assets from business liabilities is the only goal you hope to accomplish by creating a separate business structure, then any of the “big three” entity types—limited liability company (LLC), S Corporation, or C Corporation will do the job. However, most business owners also want their company structure to provide them with tax advantages. For this reason, the “pass-through” tax advantages of the LLC or the S Corporation are viewed as particularly appealing.
Pass-through taxation means what the name implies: Profits are not taxed at the company level. Instead, profits, losses, and other tax items are “passed through” to the owners, reported on the individuals’ tax returns, and taxed at the individuals’ tax rates. Pass-through taxation eliminates the specter of dividend income being taxed on both the corporate tax return and on the shareholder’s individual tax return. While the Bush-era tax rates were in effect, the individual tax rates were often far lower than the corresponding corporate tax rate—which gave pass-throughs a definite advantage.
A recent study by the Tax Foundation found that pass-through companies have had an astonishing surge in popularity since the Tax Reform Act of 1986. According to the report, over 90 percent of U.S. businesses are now pass-through entities. The rise of the S Corporation was aided by law changes that increased the maximum number of shareholders from 35 to the current 100, while the LLC’s popularity took off starting in 1997 when the IRS instituted the partnership as the default taxation scheme for multi-member companies. These factors combined with reduced individual tax rates in effect from 2008 through 2012 resulted in the phenomenal growth of the pass-throughs as the business structure of choice.
However, just as your parents pointed out when you were a teenager: “Just because everyone is doing it, doesn’t mean you should.” More often than not, one company structure is better suited to your business or your business objectives than the others.
But, how do you make the choice? You need to balance a number of factors, in addition to limited liability protection. For a comparison of entity types on a range of dimensions, see the CT Smart Chart: What Business Structure Is Best For Your Company? For today, however, we will look at two questions:
As a rule of thumb, the LLC is the most flexible of all of the business forms. In fact, it is so flexible that is can elect to be taxed as an S Corporation, rather than as a partnership. But, this flexibility extends much further than how the company is taxed.
In terms of management, the LLC owners decide how the company will be managed—and who will manage it. While each state provides a default management structure, the LLC owners (who are referred to as members) can adopt an operating agreement that overrides the default terms.
An operating agreement can provide that the company will be run by one or more managers who are selected by the members, overriding the state default is that every member is entitled to fully participate in the day-to-day running of the company. And, as the company’s needs change, the ownership structure can be changed by amending the operating agreement.
In contrast, corporate shareholders do not manage directly—instead their role is limited to electing directors to run the company and voting on certain fundamental changes in the corporation’s structure. (Some states do provide for a “close corporation” that permits direct control by the shareholders where there are only a few shareholders.)
So, if you want maximum flexibility in choosing how the company will be managed, an LLC may be a better option than a corporation.
It seems odd that one question to consider when starting a business is how you plan to exit the business. Yet, thinking about the “end game” can help you choose the best structure for your company. Any business can be transferred by selling the ownership interest in the company, by selling the assets, or by a combination of the two. Because an LLC is generally taxed as a partnership, the tax rules involved in a sale of ownership interests is likely to be far more complex than sales of corporate stock. Structuring the deal properly is essential to avoid very unpleasant surprises at tax time.
It can also make a difference if you plan to exit by transferring ownership to other family members or by selling your company to another company. Often an LLC will enable more tax-advantaged transfers of ownership interests to family members while an S Corporation structure can provide more strategies in third-party acquisitions. While taxes should almost never be the primary driver for a business decision, it is crucial for you to discuss your exit plans with a qualified tax professional when you are making initial decisions regarding the type of entity.
Learn more about the differences among three business entity types: LLC vs S Corp vs C Corp.
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