U S Taxation: Choosing most appropriate entity to start business: Is it sole proprietorship, LLC, LLP, or C Corporation?
In U.S.A., with the announcement of historical tax concessions for business, being reportedly released in the future, though the legal approvals have already been obtained, not a day passes when someone would not ask me what type of business he/ she may start in USA. Even in the world book fair 2018, being held in Delhi, currently, I discussed the issue with some brilliant young people, one of them a would-be writer or publisher or both. This also includes some Indian nationals who have some business interest in USA. India being the most promising emerging country is ready to look at various legal options to grow its industry.
Now, the intellectual discussion on how to choose an entity keeping in view of the client’s objectives, how to choose a particular one with its advantages and disadvantages, its tax and ton-tax considerations, and other information required for successful running of the business unit.
You may recollect how in one of my earlier articles, I narrated the incident of a curious would-be entrepreneurial child’s enquiry about a legal entity to do business but with control with himself. Now taking the logic more elaborately to all types of legal entities, the basic question would be what could be the expected objectives of the client and how to coordinate and develop a strategy to give suitable professional guidance.
AICPA’s Statements on Standards for Tax Services(SSTS) No. 7, Form and Content of Advice to Taxpayers guides that tax advice be communicated in writing for “important, unusual, or complicated transactions.” However, if the client is interested in only knowing the details, a personal meeting along with professional advice in writing can be given. However, the client’s objectives such as the tax considerations, the ease of doing business with various details of submissions of relevant legal forms, periodical submission of statement of accounts, legal liability of owners/ the management or submission of tax deducted at source may require detailed study and professional guidance.
Correspondingly, we shall discuss the above facts related to the following profit-making entities:
Tax consideration or savings
Considerations such as reduction of employment tax, income tax, payroll tax, estate tax exposure or other related matters constitute the basis for selecting an entity for business. Individual tax position constitutes a major starting point for discussion.
General partnership or sole proprietorship offers no liability protection to owners. However, S Corporations, LLPs, LLCs, or C Corporations may provide limited liability obligations depending upon he owners’ personal involvement, lenders’ requirements of personal guarantees or the application of professional service malpractice statue applications. However, illegal actions or fraudulent actions may pierce through the legal shield of protection and involve the owners towards liability.
One of the most resonant decision taken for business for any owner is to be fully involved in running the business by taking decisions as the manager. Management options are not available for limited partners; the position takes different positions in other forms of entities depending upon the involvement of members with the capital contributed for running the business.
Motivation and ownership transition
One of the common attributes of starting a business with experienced and wealthy professionals is basically fulfill their passions towards certain objectives. I have come across many executives who had golden periods of service with multinational companies, either in public or private, with the burning desire to own a company and serve the set objectives which may be in art, teaching, business or travels. The booming startups stand testimony to this fact in all countries including India, USA and others.
The nature of the entity to be recommended changes drastically if the principle is to keep business alive even if the owner passes away peacefully. Recently, I had gone to conduct last rites for my beloved dog ‘Yumaji” to a cremation ground where the owner of the enterprise is a non-profit organization run by the trustees but started by a rich person with great love for animals, particularly, towards honorable conduct of their last rites. Amazing instance of noble service but with great business sense to survive the organization even after the death of the original owner who created it. This is an instance of a great professional service given by some brilliant Chartered Accountant or a Lawyer. (This happened in India but the same analogy has been drawn in following paras for U.S.A.)
Similarly, instead of having a sole proprietorship, other forms of entities, depending upon the circumstances, advice may be given. Moving ownership to successor may involve gifts, installment sale, stock redemption, bequest or a combination of methods. The exact entity that will meet the required client’s objective may differ.
Let us discuss the advantages and disadvantages of the entities under the lenses
In any discussion, the easiest form of doing or creating an entity which attracts an individual is sole proprietorship which unfortunately is not a legal entity and is not separate from its owner. The owner does hold the title to the property, conduct business for profit (even if a loss is incurred), and is hence directly and personally liable for all obligations. An example. i.e., Jim Rah owns a fast food restaurant which incurs huge losses far exceeding its assets. Can Jim own the assets in the name of his enterprise and escape the losses? The answer says “no” and it sinks the owner.
Why not put it in writing the advantages as well its distinguishing negative features?
Easy to fill the forms, get the registration and good to do business in any state without requiring to file, register or qualify to do business in that state.
The owner manages the firm, takes good/bad decisions and sinks or swims the currents of business. He can be a multi-millionaire with huge assets or gets losses due to wrong decisions.
Filled with very few administrative burdens, owner is free to sell the business at the flick of a coin.
Expectedly, the business profit or loss passes through the owner and dealt with at his personal level only.
Disadvantages, distinct, though
To expand, except his close relatives, friends or admirers, no chance to raise the capital.
Closely chasing his personal assets are his/her liabilities in the business, most unwanted though in nature.
With self-employment tax solely directed at the owner, the business is orphaned if the owner peacefully demises. Yes, legal process continues for his estate matters.
The second nature of business, popularly known as “general partnerships”, the known entity to devour simple persons. Easy to form by two or more persons, even by verbal agreement, it just comes alive. The most inconvenient caveat is each partner is jointly and severally liable for partnership’s obligations. “miseries like, father had burnt the properties by joining xyzzy partnership “abounds the history of the world. But due to increasingly complex rules, they are facing difficulties.
Let us put in writing the advantages.
More sources of capital than the sole proprietorship. Who does not want to be an owner?
Obviously, more managerial persons to manage and with few administrative burdens as compared to corporations.
Partnership owns the properties and hence individual partner can’t legally assign or transfer the properties at his/her whims.
Pass through entities, income and loss allocations being flexible in nature, the entities are however continuous in nature, if properly provided for.
Transfer of ownership is cumbersome. Each partner is personally liable for all partnership obligations. Even, minority partner can’t escape the legal obligations.
Being inactive by any partner does not entitle avoidance of self-employment tax. Furthermore, tax deductible fringe benefits are very few for partners.
A joint venture easily formed by business ventures from various countries is treated as a partnership at international level. Due to complex rulings and instant obligations, such ventures nowadays take distinct legal shapes. Yes, husband and wife may form a joint venture with distinct items of income, gains, loss, deduction and credit based on sharing his or her share of these items.
With at least one limited partner, this type of entities engulfs the general partners with all liabilities with complete control of the operations and the profits/losses proportionate to their capital and other details written in the partnership deed. Yes, limited partner subjects himself to the losses limited to the investment made in the business.
These types of entities created under state laws for conducting business, may be characterized as artificial persons with powers to hire employees, enter into contracts, get assets and obviously earn profits/losses. The world over, American corporations have given millions of jobs to professionals, created technology booms and given millions as dividends or capital gains to their shareholders who invest capital in them. Popularly known because of their listing in stock exchanges.
Popularly known as C Corporations, these have helped capital raising through sale of capital stock.
Owners have limited liability.
With unlimited lives unless the articles of incorporation limit them, they have survived even centuries of endurance by sheer transfer of ownership rights.
With the management functions, even owner-employees may receive full array of employer provided tax-free fringe benefits.
Expected double taxation, both at corporate level as well as shareholder level.
More administrative burdens and invite many state/federal laws on operation.
Borrowing invites stock holder permission resulting in stockholder guarantees.
Loss on sale of stock normally results in capital loss resulting tax implications for shareholders in their tax returns.
Tax advantages of partnership with liability protection of a corporation-a serious advantage to consider.
A pass-through organization avoiding double taxation-obviously, members to bear taxation.
Owners escape full responsibility with limited liabilities.
The expected tax rate may be lower than the one for a corporation since the tax rate of the member is surmised to be lower than the corporation.
Presuming S corporation pays sufficiently for its members towards professional services, payroll tax system may exempt this corporation.
Limits its membership to only 100 and family members get numbered as one only.
Only one type of stock and less jealousy among the members.
Normally calendar year has been the chosen one instead of a fiscal year.
Employees owning more than 2% entail more tax towards availing of fringe benefits.
Owners can not be C corporations, partnerships, certain trusts (qualified trusts exempted though), or non-resident alien shareholders.
Limited Liability Companies
Since all the states have enacted legislation towards creation of a LLC which beautifully combines the advantage of a partnership and limited liability of a Corporation, LLCs have become very popular.
Interesting and truthful in nature
A Limited Liability Company with one member can choose itself to be treated as a sole proprietorship. With membership more than one, it can become a corporation or a partnership. Many formed at the state level have opted to be tax driven as S Corporation. For our discussion, it is presumed that they do not consider themselves as corporations.
Let us narrate the advantages as well as the disadvantages in short.
With limited liability and number of members not curtailed, the members can be corporations, trusts, other LLCs, or other types of entities.
Double taxation is definitely avoided and members do participate in administration.
Distributions not in tune with ownership percentages.
With more than one class of stocks, it is not surprising that this type of entity is a hit among investors.
Transfer of interest is difficult and the new member may not enjoy the attributes of a member
With laws pertaining LLCs varying from state to state, expect guidance is required. In some states, if one owes as a LLC some tax dues and not paid in time or filed the tax returns, the penalty or interest burdens are very high.
Professionals are not eligible to use LLCs but may use LLPs.
With multiple operations in states, tax liabilities may be complex inviting expert guidance.
For tax purposes, complex partnership rules do apply.
Expectedly, members do invite employment tax, since these entities are pass-through entities.
Limited Liability Partnerships
Many professionals are not allowed to form LLCs and have to apt for LLPs with limited liabilities,
With pass-through taxation status, they do have flexibility towards structure of ownership interests.
In some states, the partners are liable for debts but mostly the members do enjoy similar protection like those in LLCs.
Now let us discuss nontax considerations too.
Formation of entity
How nice is it to create a sole proprietorship since I constitute the entity and can create, use it to run the business and also pay the tax in my tax return and pay self-employment tax too. But to do the business under a fictitious name as “d/b/a or “doing business as” registration is a must with state authorities.
Yes, limited partnerships, LLC, LLP or Corporations need completion of verifying the name, initial filings and finally registrations and of course, after payment of required fees with state authorities.
For a corporation, verification of a name, preparation of articles of incorporation and adoption of corporate laws are some of the formalities. It is always a lengthy road for any corporation with following all the laid down procedures of the required state where it would get registered.
S Corporations do require an election with IRS in addition to complying with all state corporation rules.
Any business without capital either in the form of cash, property or debt is unrealistic. Some more interesting facts about capital in various types of entities.
Sole proprietor can have his/her own consent to bring cash, property or raise loans with friends or relatives but with personal guarantees meaning involving all the risks with himself which engulfs his/her cash, property or other assets.
For a limited partnership, general partner or limited partner with attendant risk or benefits set the tone. For LLCs or LLPs, the canvas widens and more capital can be arranged with limited liability but the situation becomes complicated when debts are raised with involving personal properties as mortgage or loans with others with intendant liabilities.
Corporations can get substantial capital internally from investors, venture capitalists or raise debts by issuing bonds, or term loans with or without mortgage. They can easily go on a spending spree with self-destruction or create enormous wealth with proper course of action. They invite humongous paper work and face various state/federal charges if proper procedure is not followed.
As the discussions have indirectly indicated, sole proprietorship is nonexistent after demise of the owner. General partnership, Limited Partnership, LLCs, LLPs or Corporations are perpetual if created with proper legal knowledge and guided with the best CPAs or legal minds.
The purpose of this article is to draw your minds to various types of entities one can create in USA and understand the advantages, disadvantages, some of the legal formalities to be followed and finally a sketchy discussion on their longevity. You will agree with me that USA with virtual difference in almost every rule, regulations or political parties who control the affairs, the creation of any business entity requires the assistance of a good CPA, lawyer or both for successful functioning.
Now that a glimpse of the formation of any entity has been briefly touched, it is time to approach an experienced CPA, a lawyer or both to have them practically established and run successfully to create more wealth and live happily with more profits.
From IRS web site,
Any of my earlier article on some of the entities may also guide the reader.
About the author : Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in international tax, auditing, IFRS etc. He can be reached at [email protected]. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi.