The Basics of the Entity Alphabet©
By Thomas F. Jurney
Has anyone told you something that sounded like "I folded my S-Corp into a C-Corp, then transferred the shares to an LLC that was the GP of an LLP"? It used to be easy. You were either a corporation, partnership, or if only one owner, sole proprietorship. Nowadays, the proliferation of choice of entities for even small, single-owner businesses can be daunting. While it can all be very confusing, all of this alphabet jargon boils down to two basic issues: taxation and liability.
In the old days, you could only have limited liability if you were taxed as a corporation and could only be taxed as a partnership if you had full liability. Now the two issues have been separated, giving modern business owners the full range of possibilities. Let's take a look at how these two issues have been dealt with and what concessions business owners have wrestled out of the IRS in the last 20 years with the introduction of the Limited Liability Company (LLC).
In essence, there are two ways to be taxed. The first is to be taxed as a corporation, which means a double taxation. The entity is taxed on the income it earns, and then the income it distributes in the form of dividends is taxed again in the hands of the shareholders. The second way to be taxed is called flow-thru taxation, which means the entity is ignored and the income is only taxed once in the hands of the owners. This is called partnership tax if there is more than one owner or sole proprietor if there is only one. The main difference between the two flow-thru options is a partnership has to report its income to the IRS on an information return, while the sole proprietor income is reported only on the single owner's individual tax return, usually on schedule C. (It should be noted here that if you do nothing, you are automatically a sole proprietor or, if more than one owner, a partnership. These are the default entities.)
As you can see, flow-thru taxation, especially for the small business, is usually the ideal choice. Not only is their no taxation at the entity level, but in most cases the owner(s) can deduct expenses against nonbusiness income, whereas a corporation must retain those losses until it actually has income to deduct them against. So why do you see vans marked Joe Blow's Vacuum Repair, Inc.? Why would sole proprietor Joe Blow incorporate?
There are two answers. The first is that Joe wants to be protected in case of litigation. If one of his workers crashes the company van, he doesn't want the claimant in the accident to go after his home. In a corporation there is limited liability. If the company was liable for damages or debt, Joe is only liable up to the amount he has invested. Now with a sole shareholder or small corporation there are much more complex legal issues regarding liability, but in an ideal world, i.e. with a properly drafted and operated corporation, Joe's liability is only the company assets, not his personal assets. This is why Joe is incorporated-to protect himself from personal liability. It must be noted that Joe will always be personally liable for his own actions, on or off the job, no matter how many corporations he has.
The second answer of why Joe incorporated goes back to the alphabet. Joe may have what is called an S-Corporation. Business owners were fed up with having to pay double taxation in order to have limited liability, so Congress created the S-Corporation. (For reference, a normal corporation is called a C-Corporation; the letters refer to separate sections in the Internal Revenue Code). An S-Corporation has the best of both worlds. It gives limited liability, but it is taxed as a partnership or a sole proprietorship.
Sound too good to be true? Well, as with most gifts from the IRS, it was. The regulations governing S-Corporations made it very difficult to maintain the 'S status,' with minor faults, such as failing to have a corporate meeting or transferring the shares to more the 35 people, causing the S-status to go away and all the double taxation be owed. While good advise and careful planning avoided these pitfalls, it required much more work and time than most small business owners thought it worthwhile to waste on legal formalities.
In comes the last entity we will be talking about, the Limited Liability Company, or LLC. An LLC gives the owner(s) limited liability just like a corporation. More importantly, with the new 'check the box' regulation, owners can choose to have their LLC taxed with either flow-thru or corporate status, something no other entity can do. Why would anyone want to face double taxation? Suffice it to say, sometimes it makes sense tax-wise and having the choice if the situation arises is very helpful. So that is a short tour through the alphabet of business entities. With the new entity of an LLC, small business owners, consultants and solo professionals can benefit from limited liability, and can choose to be taxed the best way they can, with a minimum of legal formalities, allowing them to get to work at what they do best.
Thomas Jurney is an attorney who practices general business law and estate planning. He gave up trying to rationalize the law years ago, and has resigned himself to trying to explain it as simply as possible. Thomas can be reached at firstname.lastname@example.org. As with all legal articles, an attorney should be sought before applying any of this information to your own situation.