By Karl, Peter A., III
The CPA Journal , Vol. 69, No. 8
The Choices in Entity Formation
The author provides a comprehensive guide to choosing a legal entity for business operations. The question-andanswer format highlights the pros and cons of each type of entity, from the traditional professional corporation through to the new limited liability company.
No one entity is perfect for every business venture; there are a number of different factors that would favor the selection of one entity over another. For example, the extent of legal liability may be crucial to some, and several questions deal with the entities' degree of protection. Special attention is paid to the LLC and how it measures up to the limited partnership and the C corporation. The tax benefits of pass-through entities in general as compared to corporations are discussed; so are the effects of selfemployment taxes and income taxes on S corporations.
The business entity's purpose-such as providing retirement benefits, income splitting, or holding real estatewill have a large effect on the decision process. When all factors are considered, however, the author believes the LLC is the best all-around entity choice, especially if liability protection is paramount.
1. Why is the unincorporated form preferred by some in entity selection?
For many business proprietorships and partnerships there is adequate insurance available to cover tort liability exposure. Included in this analysis would be the availability of additional insurance coverage (excess liability) for a nominal premium.
In addition, the legal insulation of operating as a corporation is often offset by factors such as the following:
Under tort the theory, the agent is always liable for personal negligence. This is best illustrated by the one-shareholder professional corporation (PC), in which the professional (acting as both stockholder and employee) cannot escape personal liability merely because of the existence of the corporation. In a similar fashion, the sole proprietor without any employees does not benefit from creating a separate corporate entity for a personal service business (e.g., as a consultant or a realtor). In other words, there is no entity available that can shelter an individual from personal torts.
With respect to contracts, the owner may be required to personally guarantee the transaction (e.g., a bank loan).
The IRS can always "pierce the corporate veil" of a corporation and personally hold liable any shareholder involved in a decision-making capacity as a responsible party with respect to any unpaid "trust taxes" (such as employee income tax and FICA withholdings).
2. Besides unlimited legal liability, are there other disadvantages to the sole proprietorship as a form of conducting business?
Two other inherent disadvantages of the sole proprietorship are
the inability to split income among family members with respect to the business unearned income (for the benefit of children age 14 or over) as discussed in Question 3. However, a child employed by a parent's proprietorship does generate FICA and Ft TA savings if under age 18.
the unavailability of certain estate planning techniques such as valuation freezing (as a result of transfers of a portion of the ownership) because of indivisibility of the ownership of a proprietorship.
3. What are the tax benefits in using "pass-through" entities?
Pass-through entities such as S corp Family income splitting of the business` earnings for income tax purposes can be accomplished provided that the entity's income is derived mainly from the fruits of capital as opposed to labor (e.g. a personal service enterprise). Estate splitting of the business' value among family members. Distribution of the losses that many start-up businesses incur (though the deduction at the individual owner's level is subject to such restrictions as the passive activity rules). …
Family income splitting of the business` earnings for income tax purposes can be accomplished provided that the entity's income is derived mainly from the fruits of capital as opposed to labor (e.g. a personal service enterprise).
Estate splitting of the business' value among family members.
Distribution of the losses that many start-up businesses incur (though the deduction at the individual owner's level is subject to such restrictions as the passive activity rules). …