What is the best structure for my company?

International Profit Associates on business structures

“What’s the best entity for my business?” As you may know, there are different types of entities: the limited liability company (LLC), the corporation (subchapter S or C), the sole proprietorship and the partnership. What’s the best one? To put it simply, none of them. If there was one perfect entity, then every business would be structured identically. No one entity produces optimal results for every business situation. Prior to making a recommendation pertaining to structure, professionals must consider a number of factors including, but not limited to, state corporate law, Federal taxation law, state tax law, the nature of the business, ownership, and locality of operations. Each of these factors must be considered. Therefore, only through due diligence of all the facts and circumstances can a recommendation with the most favorable structure be appropriately determined. I will explain some of the issues professionals research when recommending legal business structuring.

State corporate law. Business entities are created under state law, not Federal law as many believe. When business owners choose to incorporate or organize, they do so with the Secretary of State, not with the Federal government. An owner that chooses to operate as a corporation will incorporate his/her business. If s/he desires to conduct business as a limited liability company, s/he would organize. Owners of a corporation are referred to as shareholders. Owners of an LLC are called members. Because entities are actually “children” of the state, the laws of the state where the company is incorporated or formed govern the business. Additionally, states in which the entity is “doing business” can also subject the entity to its laws. States have varying filing and reporting requirements, as well as differences among the business structures themselves. Each state has its own court decisions which establish precedents in their respective jurisdictions regarding liability and asset protection.

State tax law. Every state has its own tax code. Some states even impose tax on entities that may be exempt at the Federal level. For example, Texas has a state tax on all corporations, including those that have elected subchapter S status (S corporation) with the Internal Revenue Service. (S corporations are not subject to corporate income tax at the Federal level.)

Internal Revenue Code. In addition to researching the state laws, professionals must also consider the Federal tax code. Corporations and LLCs can be taxed at the entity level or as flow-through entities, ultimately being taxed on the owners’ personal returns. A corporation is assumed by the Federal tax code to be a C corporation and taxed at the corporate level on Form 1120. The alternative is to elect subchapter S status which taxes corporate income on the owners’ individual returns (Form 1040). An S corporation files a Form 1120S even though the income flows through to the personal return. The tax possibilities of LLCs are similar to corporations. Members may elect for the income to be taxed at the company level by filing a Form 1120 (similar to a C corporation), or they may file a Form 1065 (partnership) causing the income to be taxed at the individual level on Form 1040. LLCs with a single member report on the owner’s Schedule C of the 1040. No filing of separate entity form is required.

The tax treatment of certain types of businesses also exists within the Code. So, another consideration in entity structuring is the nature of the business. For example, owners that are engaged in the business of engineering must beware of service corporation rules in the Code, which tax any profit in a C corporation at the highest marginal individual rate (presently 35%). (C corporations that are not subject to the service corporation rules benefit from marginal tax rates starting at 15 %.)

So, imagine the breadth and depth of analysis that would have to occur when recommending a structure to an engineering business in Texas, presently operated as a sole proprietorship by an owner worth $5 million. A consultant would have to consider that a C corporation is subject to the service corporation rules, but an S corporation would be subject to the state tax on S corporations. To remain a sole proprietorship would expose $5 million of assets to any unfavorable judgment against the business. One can easily imagine the scrutiny involved with the existence of fifty different corporate laws, fifty state tax codes, fifty sets of state court precedent, 92 districts of Federal Court precedent, the Federal Tax Court, and the Internal Revenue Code that has 9,451 pages. To recommend an entity absent adequate legal and tax research would be premature and, in some jurisdictions, might be construed as the unauthorized practice of law.

Article provided by the International Profit Associates tax division.