Business owners should periodically review their choice of entity in light of ever-changing tax laws, assessment of the potential liabilities and the owner’s long range exit strategy.

Business owners can operate their business as a sole proprietorship, a general partnership (“Partnership”), a limited partnership (“Ltd”), a limited liability company (“LLC”), a C Corporation (“C”) or as an S Corporation (“S”).

Assets can normally be contributed to any of these entities tax-free. The distribution of assets from either a “C” or an “S”, if they have appreciated, will cause a taxable event. In the case of a “C”, the gain will be taxed twice—first at the corporate level and again at the shareholder level.

A corporation, LLC or Ltd. will protect the owners from the debts of the business, yet enable them to control day-to-day operations. “C’s” can elect any taxable year-end the shareholders would like. All other entities normally must have a calendar year-end.

Since a “C” is taxed as a separate entity, all items of income, credit or loss are computed at the entity level in arriving at corporate taxable income. A disadvantage of a “C” for a new business is that losses are trapped at the entity level and thus generally cannot be deducted by the owners. However, one advantage of a “C” is that the first $50,000 of corporate taxable income is taxed at the 15 percent federal rate.

A drawback of the “C” is the potential for double taxation. If you compensate out most of the corporate earnings, the risk of double taxation is minimal since the corporation can deduct all “reasonable salary” that it pays to its shareholders. When a business becomes successful, it may not be possible to distribute 100 percent of earnings out as compensation.

Sole Proprietorships, Partnerships and a “C” that compensates out all of its earnings expose the owner of the business to high Social Security and Medicare taxes. Operation as a Ltd., LLC or “S” with proper planning can minimize Social Security and Medicare tax payments.

The question of double taxation is most problematic when a business gets sold, because the sales of most businesses are structured as asset sales. A “C” selling assets at a substantial gain generates a corporate tax and the net distribution to the shareholder again creates a second taxable event. If the owner of a “C” is fortunate enough to arrange for the sale of stock of his company, the earnings of the “C” have not increased the shareholder basis in his or her stock. Again, the gain is higher than the gain on sale of stock in an “S” or from the sale of an interest in a partnership or LLC.

A “C” can also be used to provide fringe benefits on a tax-favored basis. Subject to certain limits, the corporation can deduct the cost of a variety of benefits such as health insurance and group life insurance without adverse tax consequences to its shareholders.

The tax costs of these entities vary. A partnership pays no taxes or fees. A Ltd., LLC and an “S” corporation may be assessed annual fees or be taxed on a percentage of taxable income.

Generally speaking, “C’s” are considered the least tax advantaged of all of the entities.

Hugh Saddington, Partner, Saddington Shusko LLP, Irvine, CA

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