Factors for Choice of Business Entity

Before discussing about the factors for choice of business entity, we should have a good understanding of options that a business can choose from

There are some differences between legal entities and tax purpose entities.

1. Federal Tax – Sole Proprietorship, Partnerships, C Corporations and S Corporations
2. Legal Entities –

• • Sole Proprietorship –
  •  Partnerships (various types)
  •  Corporations will be treated on the federal income tax as C Corporation by default.  However, a corporation can choose to be taxed as S Corporation (if others qualifications are satisfied)
  • Limited Liability Companies (LLC) are normally treated on the federal income tax purpose either as:
    • Partnership (more than 1 member)
    • Sole Proprietorship (single member)
    • C Corporation ( Form 8832, entity classification election to be taxed as a corporation)
    • S Corporation ( to be taxed as S corporation on federal tax, file both form 8832 and form 2553, small business corporation election)

Business Entities are created at the State level, not created with the IRS.  For example, for California, business entities are created and filed with the California Secretary of the State’s Office
https://www.sos.ca.gov/business-programs/

Primary factors for choice of business entity

There are many factors that determine the type of entity for a business.  However, these are primary factors for business

• Liability protection
• Tax burden for the business and its owners (including compliance costs)
• The number and type of business owners.

AICPA has a good comparison of business entities which include general tax rules and non-tax aspects applicable to each of the business entity type.  The below table is referenced from AICPA website

Federal Tax Factors

• Sole Proprietorship – income and expenses of the proprietorship retain the character when reported.  For example, ordinary income of the proprietorship is treated as ordinary income while capital gain is treated as capital gain when reported by sole proprietor.  In general, proprietors can take a deduction for qualified business income (QBI – section 199A) which is 20% of proprietorship net income.
• Partnerships are not subject to a Federal income tax. Partnership ordinary business income (loss) and other items are allocated to partners according to the ownership interests.
• Corporations are governed by Subchapter C (C corporations) or Subchapter S (S corporations) of the Internal Revenue Code
  • C corporations are subject to an entity-level Federal income tax which is a flat rate of 21%.  When a C corporation distributes its income, the shareholders reports dividend income on the 1040 tax returns; however, there’s no deduction is allowed for the dividend paid.  This results to a double taxation (on the entity level and on the shareholder level)
  • S corporations generally are not subject to an entity-level Federal income tax like partnerships.  S corporation ordinary business income (loss) and other items are allocated to the shareholders according to the ownership interests.

Other State Considerations when choosing an Entity in California

The main focus of this article is for LLCs as LLC is a very popular type of entities for small businesses.

A Limited liability company (either single-member or multi-member LLC) which is organized in California must file an annual California LLC tax return (Form 568).  Annual California LLC taxes ($800) and potential annual LLC fees are imposed directly on the LLC (bases on the gross receipts).  Don’t confuse between LLC taxes and LLC fees as they are separate items.  LLCs are subject to pay both LLC taxes and LLC fees (if applicable)

• It’s very critical to understand that LLC tax ($800) is imposed even if LLC has no net income or does not conduct business in the state. The $800 LLC tax is due by the 15th day of the 4th month after the beginning of the tax year.  Please note that the $800 annual LLC tax will continue every year until all three of these conditions occur:
  • The LLC files the final Form 568 return and pays the $800 LLC tax for the final tax year
  • The LLC does not do business in California after the final taxable year
  • File cancellation documents with the California Secretary of State within 12 months of a timely filed the final Form 568

•  California LLC Fees are bases on California-based gross receipts (not the net income) of $250,000 or more.  LLC fees must estimate and pay the fee by the 15th day of the 6th month of the current tax year.  The below image is referenced from FTB website for the LLC fees

Other taxes that a business encounters

A business is subjected to pay these taxes if applicable.

• Property Tax
• Sales/Use Taxes
• Business License Taxes
• Payroll Tax including unemployment insurance
  • A sole proprietorship is subject to federal self-employment tax of 15.3% on net income as are some partnership allocation of income to partner.  Wages paid to a shareholder-employee of a corporation are also subject to payroll taxes.  Payroll tax burden should be taken into consideration of the choice of business entity.

Factors Choice of Business Entity

A business entity may face many taxes and fees.  Also nontax considerations may override tax considerations and lead owners to conclude that a business should be operated as a LLC, a corporation or a sole proprietors/general partners in partnerships.

Example:  Mr. Smith plans to start a business in the current tax year.  He expects operating losses for the first 3 years and highly profitable after 3 years.  Mr. Smith should operates as sole proprietorship if his business is not a high risk of liability as proprietorship is the cheapest entity to operate and he can also deduct the losses against any other type of income on his personal return.  On the other hand, if his business is a high risk of liability business he should choose S corporation because the losses will flow through and be deductible on his personal return and he also limits the business liability from his personal liability.    When the business becomes profitable, he should switch to C corporation status.

If a business has employees who are not the owner immediate family or if the business has substantial properties, to a void lawsuits and to protect properties a sole proprietorship may not be a good entity choice.

Recommendations

Factors for choice of business entity will depend on each entity’s situation

• An LLC with S corporation election usually results in lowest tax with the new 20% of qualified business income deduction (QBI) while limits its liability.  S corporation owners may be able to eliminate a substantial social security and medicate taxes by paying yourself as little as possible in salary, however, must be “reasonable” and the  remaining distribution as dividends to save tax.
• Personal service businesses like legal, medical, accounting, financial services, actuary, consulting, athletics, performing art, and possibly realtors, that make over $415,000 for married coupon or $207,500 for single earner (2020) should consider C corporation as it is not eligible for 20% QBI deduction.

Jessica Le, MBA, CPA.

Khanh Le, preferred name as Jessica Le, is a licensed Certified Public Accountant (CPA). Jessica also earned a Master of Business Administration (MBA) from San Jose State University.