Choose a corporate identity carefully

Choose the corporate identity that makes legal and tax sense for your circumstances.

In the United States, five legal entities are typical among businesses: sole proprietorship, partnership, C corporation, S corporation, and LLC. Each has its tax benefits and hindrances depending on the circumstances of the business.

Sole proprietorships are simple to stand up and easy to incorporate into a person’s existing tax documents. Instead of separate tax preparation, a sole proprietorship adds a Schedule C form to their 1040 ((Clydebank, pg. 188)). The downside to this ease is primarily legal responsibility. Liability extends beyond the company to the owner, so a debt or illegal behavior committed by the company or its employees “passes through” to the owner of the company.

Partnerships are exactly the same as sole proprietorships for the purpose of tax preparation. Legal responsibility is different; however, since it’s shared among the partners. Liability may be equally shared, or certain members may hold greater responsibility than the rest.

C corporations are entirely separate entities for the purpose of taxation. This benefits the owners primarily because liability rests upon the business itself and does not “pass through” to the owner. The downside to the C corps designation as a separate entity is that shareholder (such as the owner) are taxed on the income they receive from the corporation. This means that income generated by the corporation and shared with its shareholders is taxed twice.

S corporations are also separate entities but have “pass-through” liability, which means the shareholders do not need to tax the income they receive from the corporation.

Limited Liability Companies (LLC) grant a separate entity to the corporation and prevent “pass-through” liability for one or more owners.

business taxes are calculated in part by the legal identity of the business. One of the biggest factors to taxation is the liable party. Business entities which exist apart from the owner and which possess full liability are likely to be taxed as a separate entity. When the liability “passes-through,” the taxes levied on that entity merge in part with the taxes of the liable parties.

While it’s possible for an entrepreneur to register their business under any of these entities, legal responsibility and tax savings are important factors to be considered. It is wise for an entrepreneur to select a corporate entity which balances liability with tax savings for their business as it exists today.

A business' legal identity is a purely tax and liability decision and does not change other aspects of the business, such as its brand, so it ought to be made with respect to these factors alone, rather than the sound of the entity. S corporation may sound like an entity type for only the largest corporations but, if the balance of liability and taxes fit your needs, it shouldn’t be overlooked simply because the entrepreneur feels that sole proprietorship sounds more like their business.

The corporation I work for switched its identity from a C corporation to an LLC last year. I don’t know how common this is, but the fact that a corporation with over five hundred employees would change its legal entity indicates that the chosen entity should match the needs of the business today, and that it ought to be changed when another legal entity better suits the evolved business. The only caveat to this advice is when the effort required to switch the business' legal identity is so lengthy that it could hinder the growth of the business.

In other countries, entities may not have so many options as the United States and may face additional tax burdens based on their legal status. It will be important to carefully research the liability and tax requirements of each available entity before advising an entrepreneur on the best one to meet their existing needs.

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