“C” Corporations, “S” Corporations, Limited Partnerships, Limited Liability Companies, Partnerships – What are they? What type of operating entity is best for your business? In selecting the operating entity to best fit your needs, a number of factors should be considered.
In general, there are two types of liability – tort and contract.
Tort liability arises out of a civil wrong – for example, if you negligently operate the company vehicle and injure someone, or your product is defective and a consumer is injured. Contract liability arises from damages for breach of an agreement. Many agreements are verbal, or do not anticipate every situation that may arise – for example, you loan money to a friend who does not pay you back as agreed, or you buy a new car that breaks down.
Tort Liability: People who do business as sole proprietors or in a partnership are liable for the torts committed by themselves and for torts committed in the course of the business by their agent and/or partners. The owners are also personally responsible for contractual obligations of their business. However, business owners may avoid personal liability for the tortious acts of business associates and/or the contractual obligations of their business if they operate their business as a corporation or a limited liability company. Thus, choice of entity is perceived to have potential benefit if a business owner is concerned about limiting tort and/or contractual liabilities.
Remember that regardless of what type of business organization you select, you are liable for torts committed by yourself and contracts executed by you personally. For example, if you are driving the company vehicle and are involved in an accident, you are liable if you negligently operated the vehicle whether you operate as a corporation, partnership or sole proprietor. Also, if you guarantee a loan to your business from a bank, you are personally liable to the bank.
Contractual Liability: An entity such as a corporation or a limited liability company may protect one’s personal assets should the operator incur a significant contractual liability from the business operation. For example, assume a building contractor signs a contract to construct an office building for a business client and fails to meet the contractual deadline and the business client holds the contractor liable for consequential damages – profits lost for the time the client is not able to occupy the new building. Particularly in the construction area, contractual liability may exceed the contract price. So long as one does not personally guarantee the contract of the business entity, his or her personal assets – assets owned outside the corporation or LLC – are protected, as the corporate operator should not be personally liable for the corporate debts, contracts and contractual liabilities.
Often, however, people dealing with corporations demand that the principals of the corporation personally guarantee its contracts. For example, most banks require the business owners to be co-borrowers or guarantors of any business loans.
Insurance Coverage: Every business person should carefully consider the potential risks involved and thoroughly discuss them with an insurance professional. Assuming one has appropriate insurance, the perceived benefit of avoiding personal tort liability through choice of entity perhaps is less significant – we often tell clients that is what one should have insurance for. On the other hand, there generally is no insurance available for contract obligations.
A sole proprietor answers only to himself. If he takes on a partner and forms a partnership, unless the partners agree to the contrary, they must agree on all major decisions. If there is a dispute, absent a specific agreement to the contrary, any partner may not only withdraw but demand that the partnership be dissolved and that his interest in the partnership be distributed to him. This right to control – to have things your way or have the business terminate – should be carefully considered in selecting and setting up the business entity.
In a corporation, the majority controls. And thus, one might own 49% of the stock and yet have virtually no say in major corporate decisions. The fact that a person is a shareholder in a corporation does not guarantee continuing right to employment or even the right to be a director of an officer.
Because of these concerns, we urge clients who are considering doing business as a partnership or a corporation to consider a buy-sell agreement.
By means of a buy-sell agreement, the owners of the business agree to not follow the general corporation majority control rules or the partnership dissolution rules. Rather, a buy-sell agreement should provide for a specific dispute resolution process should a shareholder (or partner) wish to withdraw, should the majority shareholders wish to terminate a shareholder as an employee, should a shareholder die or wish to be bought out. Absent a buy-sell agreement, control, and lack of control can be a very critical issue for people doing business, particularly as a corporation.
a) Income Taxes. We expect that perceived tax benefits/detriments are the principal factors which people consider in selecting a particular choice of entity. A sole proprietor simply reports his income and expenses on his personal return. A partnership is similar. The partnership files a partnership return, but then distributes the income and expenses proportionate to the individual partners. The partnership itself does not pay taxes. In other words, the income is reported and the taxes paid by the individual partners in the ratio to their partnership interest.
A “C” Corporation is a taxable entity which pays taxes on its net profit. This raises the concern of double taxation. If a corporation hires as an employee its shareholder, the corporation may deduct the shareholder’s salary as a business expense. The shareholder reports that salary on his or her personal return as income. But if the corporation has a profit in excess of its expenses, including the salaries paid to its owners, that profit is taxed. If the profit is thereafter distributed to the shareholders as a dividend, the shareholders pay tax on the dividend as ordinary income – the income ends up being taxed twice.
To avoid the potential for double taxation, businesses often consider electing to be taxed as an “S” Corporation. An “S” Corporation provides the limited liability protection available to a corporation and yet provides the tax benefits of a partnership. The income and expenses are distributed from the corporation to the individual shareholders and taxed at the shareholder level.
b) Deductibility. Corporations are perceived to provide certain tax advantages in terms of deductibility of certain expenses. For example, employee benefits such as payment for health insurance premiums can be a deduction against profit and yet not be taxable income to an employee. Likewise, certain living expenses – cost of maintaining a home and groceries can be a deduction for the corporate employer and not be considered taxable income to the shareholder employee.
c) Self-Employment Tax. Self-employment tax considerations often play a role in selection of business entity.
Self-employment tax, at 15.3%, is applied up to the maximum base which is $118,500 for 2015. The Medicare portion of 2.9% continues to be applied against all earnings which exceed the base. In an “S” Corporation, LLC, or limited partnership, one could pay themselves a salary, subject to social security withholding and draw out additional profit as unearned income – subject to income tax but not subject to self-employment tax.
For example, assume one’s net income the last three years has averaged $118,500 before taxes. If they operate as a sole proprietor or in a regular partnership, social security tax will be paid on the entire profit. On the other hand, if one operates as an “S” Corporation and has a written employment agreement, the employee could perhaps draw a $40,000 salary, pay out the remainder in dividends and save $12,010.50 per year in Social Security taxes. Here is the math:
x 15.3% SE tax rate
$18,130.50 normal self-employment (SE) tax
x 15.3% SE tax rate
$ 6,120 SE tax
$18,130.50 SE tax/full wage
– 6,120 SE tax/wage – dividend combination
$ 12,010.50 annual SE tax savings by combining wage and dividend
It is prudent to have a written employment agreement between the employee and the “S” Corporation. An owner should draw at least one third of the profit as salary.
If a business owner reduces his/her social security base, he/she potentially reduces the amount of his/her eventual social security benefit. Presumably, the tax savings invested today would more than offset a potential reduced social security benefit in the future, but that issue should be considered.
If an LLC is selected, the owner should consider allocating the income dramatically disproportionate in favor of the working spouse, i.e., 95 to 5 in order to maximize the social security base and benefit available to the married couple. And this could reduce taxes by allowing the working spouse to sooner reach the base.
d) Transfer Taxes. A corporation is considered a distinct taxable entity – even if an “S” status is elected. Thus, transfers of assets to and from the corporate entity may have significant income tax consequences. Of special concern is when a corporation attempts to transfer assets out of a corporation to a shareholder. This is usually considered a dividend and triggers income tax to both the corporation and the shareholder.
In general, we discourage our corporate clients from having the corporation own real estate. If the corporate entity is going to utilize real estate often it is best to have the corporation lease it from the shareholder.
e) Tax Basis – Stepped-Up Basis/Carryover Basis. Property which is inherited carries a tax basis equal to its then-fair-market value. Example: Your uncle buys a share of Microsoft stock for $10.00. When he dies and leaves it to you, it is worth $100.00. You can sell it for $100.00 and pay no income tax on the gain. If he had sold it, he would have had a $90.00 gain subject to capital gains income tax.
The stepped-up basis to date-of-death value an heir receives should be compared to the carryover basis one receives as a gift recipient. Gifts of assets take the basis of the donor. Example: your uncle purchases a share of Microsoft stock for $10.00. At the time he gives it to his nephew it is worth $100.00. If his nephew sells the stock, the nephew owes capital gain tax on the $90.00 gain.
In community property states, like Washington, each spouse has an undivided half interest in community property. An heir who acquires the decedent’s half interest from the deceased spouse is entitled to a stepped-up basis. The tax code further states that the surviving spouse is also entitled to a stepped-up basis for his or her half-interest. The practical benefit is that in Washington the surviving spouse obtains a stepped-up basis in the entire value of all community property.
This interplay between a carryover and a stepped-up basis is quite significant in estate planning. It also is relevant to not only your choice of business entity, but the choice of assets owned by the entity. Individual assets owned by a corporation do not receive a stepped-up basis when the shareholder dies. This is another reason why we caution against having a corporation own real estate. As real estate appreciates in value, the owner would want his heirs to receive a stepped-up basis when they inherit the real estate. But if the real estate is owned by a corporation, that tax advantage may be lost. Thus, we sometimes employ leases – the owner of a corporation and of the real estate leases the real estate to the corporation rather than having the business entity own the real estate. This will allow the owner’s heirs to receive a stepped-up basis should they subsequently inherit the real estate. However, in a limited liability company or partnership, the owner’s heirs receive a stepped-up basis of the business assets.