As you set out to begin your next contract or teaming opportunity, one of your first tasks will be to evaluate the choices in structuring your business. Entity selection is important, as each type of entity carries its own set of legal and tax attributes. Before you consult with your CPA firm and legal counsel, you will need to give some thought to the following questions:
- How many owners will we have?
- Who will our owners be?
- What type of potential liability will exist for the ownership team?
- How will the business be financed?
- How do we want our business profits to be taxed?
- What is our exit strategy?
These are just a few of the questions that should be addressed before you begin to acquire startup capital, initial loan funding or seek teaming opportunities. Many owners feel overwhelmed with their options: sole proprietorship, partnership, LLC, S Corporation or C Corporation?
Most want to keep things as simple as possible as they begin, however, they very quickly pass by the sole proprietorship due to potential extended personal liabilities. Therefore, let’s discuss a few of the similarities and differences between the other options.
Partnerships
In order to have a partnership, you must have more than one owner. Unlike proprietorships, they are separate legal entities apart from their owners. There is no tax rate schedule for partnerships, as they typically do not pay any tax at the entity level, and in a general partnership the income or loss is passed through to the owners on a Schedule K-1. Each general partner has responsibility for the debts of the partnership. Of course you may have both general and limited partnership interests.
Partnerships have a lot of flexibility when it comes to income allocation. Income or loss allocation does not always follow the ownership of the business, as partnership taxation provides some opportunities for special allocations of income, provided the allocation carries ‘economic substance’ within the terms of the tax code. Partners overseeing specific divisions, contracts or tasks could be rewarded with specific allocations of their department’s financial performance.
Advantages:
- Flexibility in ownership structure
- Collaboration on contracts and moral support from additional owners
- Increased ability to raise capital
Disadvantages:
- Potential disagreements amongst partners
- Sharing profits with others
- Applicability of self-employment tax
S Corporations vs. C Corporations
Many incorporate to have personal asset protection, increased credibility and tax flexibility in their business operations. Below are some similarities and differences between the two corporate structures.
Similarities:
- Both are required to follow corporate formalities including bylaws, shareholder meetings, annual reports, etc.
- Both have shareholders, directors and officers who manage the company
- Both are separate legal entities
- Both offer limited liability protection since owners are typically not responsible for corporate obligations
Differences:
- C Corporations are separate taxable entities, while Sub S Corporations are pass-through entities with their income or losses flowing through to their owners.
- C Corporations have no restrictions on owners, but S Corporations can have no more than 100 owners, S Corporations cannot be owned by a C Corporation
- S Corporations can only have one class of stock, while C Corporation can have multiple classes
- C Corporation income is taxed as ordinary income, with no reduced rate for capital gains
- S Corporations flow capital gains and capital losses to their shareholders
- C Corporations can suffer double taxation of profits at dividend or liquidation payment time
LLCs
LLCs have grown in popularity over the recent years because they generally afford the owners with many of the positive attributes of the both the partnership and corporate structures. They are generally flow through entities taxed as partnerships, however, they may make elections moving forward to be taxed as a C Corporation or an S Corporation. The ability to ‘morph’ the LLC into whatever you desire it be for tax purposes had made this an increasing entity selection for business owners.
Regardless of your entity selection, please be sure to consult your professional advisors to insure that your business is protected in case any of its owners desire to exit the business, sell their interest, retire, or die unexpectedly. Think of your teaming opportunities with that next prime or subcontractor and how structure could play an important role in your organization’s success.
There is a lot of literature available to assist you with this decision, but the experience and guidance of your professional advisors is most helpful in avoiding unforeseen outcomes. If you would like to discuss your current or future business structure, please contact YHB (Yount, Hyde & Barbour, P.C.) Principal Tom Moler at tom.moler@yhbcpa.com or 703-777-7739.
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About the Author
As a principal of the firm in its Leesburg office, Tom specializes in providing accounting, tax and business consulting to closely held companies, corporations, partnerships and limited liability companies. He champions our Professional Services Firm niche and our Government Contracting niche. He is a past Chairman and currently serves on the board of directors, executive and GovCon committee of the Loudoun County Chamber of Commerce.
