Choosing the right form of entity for your business

August 27, 2021





Yen-Yi Anderson, Managing Partner of Anderson & Associates, founded the law firm in January 2014. Yen-Yi Anderson focuses her practice on excellence in business immigration, commercial law, and civil litigation.

Philipp Kirschbaum is an associate at Anderson & Associates and a contributing author for the Anderson & Associates blog.

One of the most important steps when forming a business entity is choosing what type of entity should be used. The type of entity we would recommend for your business depends on two main factors: liability and taxation. Liability defines what the owners of the business stand to lose when their business incurs debts. Taxation refers to whether the business will be taxed as a pass through or double-taxation entity. Pass through entities are not taxed at the entity level, but instead the owners will be taxed directly on the profit or losses by filing a “Schedule K-1.” In contrast, the profit of a business subject to double taxation will be taxed at the entity level when earned and their shareholders pay tax again when that profit is distributed to them.

As an example of the tax benefits of a pass-through entity consider the following two cases based on the presumption that a corporation has 4 equal shareholders and a taxable income of $1,000,000 which will:

  1. Distribute $165,000 to each shareholder if it is subject to double taxation. First, the entity would pay 34% ($340,000) in taxes on its income. If the remaining $660,000 is distributed, each of the 4 shareholders will receive $165,000. Then, each shareholder would pay their respective income tax on their $165,000.

  2. Distribute $250,000 to each shareholder if it is a pass-through entity. Each shareholder would then pay their respective income tax on their $250,000 distribution. This is because pass-through entities are not taxed at the entity level, so their full income can be distributed to shareholders before it is taxed. Even though this increased income may put the shareholder in a new tax bracket, the increased dividend amount will more than likely offset the increase in personal income tax paid.

Corporation

The main advantage to the corporate entity form is that the owners (“shareholders”) are only liable for the amount they invest in the corporation. In terms of taxation, corporations can take the form of either an “S Corp” or “C Corp.” The difference between the two is that an S Corp is taxed on a pass-through basis, whereas a C Corp’s distributed profits are subject to double taxation. Importantly, when a corporation is first formed it is a C Corp by default; the corporation will need to affirmatively elect to be considered an S Corp (if it qualifies) to receive S Corp tax treatment. Broadly speaking, corporations qualify for S Corp status if they have fewer than 100 shareholders and only one class of stock.

Partnership

There are 3 main types of partnerships: general partnerships, limited partnerships, and limited liability partnerships. The key differences between the three types of partnerships are to what extent the owners (“partners”) can be held liable for the partnerships’ debts. General partnerships offer no liability protection. If one partner or the partnership is liable for their actions in relation to the partnership’s business, all the other partners are equally liable. Limited partnerships consist of both general and limited partners. General partners are allowed to manage the day-to-day activities of the partnership and are fully liable for the debts of the partnerships, whereas limited partners cannot manage day-to-day business but are only liable for the amount they invested. Limited liability partnerships consist entirely of limited partners who are not liable for the partnership’s debt but can manage the daily business. Other minor differences between the different forms of partnerships exist, such as requirements for formation and how they can be dissolved. However, none of these differences are impactful enough to go into further detail in this broad overview, aside from that a general partnership is the default entity formed when there is no written agreement to the contrary. A general partnership will result when 2 or more people carry on a business for profit. Lastly, even though all forms of partnerships must still file tax returns, all partnerships are taxed on a pass-through basis.

Limited Liability Company (LLC)

LLCs combine the advantages of a partnership with the advantages of corporations. LLCs are the newest of the 3 entities, having only been available since 1977. An LLC is taxed on a pass-through basis and the owners (“members”) are not personally liable for LLC debts beyond their investment.

The loophole that can make owners of a corporation or LLC personally liable for its debts.

The “corporate veil” is a legal doctrine that protects the owners of corporations and LLCs from personal liability for the entity’s debts and obligations. However, this protection is not absolute. All 50 states have legislation governing how the corporate veil may be pierced. One important distinction is that entities formed in Delaware are far less likely to have their veil pierced in comparison to other states due to favorable case law. As implied above, the term “piercing the corporate veil” is not limited in application to corporations, an LLC may have its veil pierced in the same manner. When the corporate veil is pierced by a plaintiff in litigation, the owners of the defendant entity will be held personally liable for its debts and obligations.

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