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Accounting - Entity Selection and Changes

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HOUSTON - Whether you set out to build a construction empire or started picking up odd jobs in your spare time, at some point, you made a decision about the type of entity you wanted for your business. What you chose when starting out may not be the best option for you now, but the good news is you are not locked in.

 

 

     There are four basic types of entities for tax purposes: Subchapter C Corporations, Subchapter S Corporations, Partnerships (General or Limited Liability), or Sole-proprietorships.  Below are some key characteristics of each:
Subchapter C Corporations
•    C-Corps are formed at inception or when an S-Election is terminated.
•    C-Corps offer limited liability to directors, officers, and shareholders.
•    The primary advantage of C-Corps is the ability to “grow” your business through the sale of stock to an unlimited number and type of investors.
•    The most notable tax disadvantage is the double taxation that occurs when earnings within the C-Corp are taxed at the entity level and taxed again as shareholders take dividends from the corporation.  In addition, because income is taxed at the entity level, there is no deduction on each shareholder’s individual return for any losses realized within the corporation. 
•    Ownership transfers when stock is sold and produces gain or loss at the individual-level for the related shareholder.  Other shareholders are not affected in most cases.   
Subchapter S Corporations
•    An S-Corp is formed when either a C-Corp or an LLC timely files Form 2553 S-Election, choosing to be taxed as an S-Corp.   
•    S-Corps offer limited liability to directors, officers, and shareholders.
•    The primary advantage to an S-Corp entity is the ability to limit the amount of income that is subject to self-employment tax for closely-held businesses.  Owners can pay themselves fair wages, subject to payroll taxes, but can also take tax-free distributions of earnings, subject to certain limits. 
•    Though the S-Corp is required to file its own income tax return, income is not taxed at the entity level, but at the owner/shareholder-level.
•    Use caution when selecting S-Corp status since the entity does not allow for special allocations of income, loss, or distributions; certain types of owners are prohibited; and the number of shareholders is limited to 100.  Violation of any of these may terminate the S-Election.
•    Losses are limited to each individual shareholder’s at-risk investment. 
Partnerships
(General or Limited Liability)
•    Partnerships are formed when multiple individuals or entities come together with a profit motive.  This is also the default entity selection for multi-member LLC’s. 
•    General partners are personally liable, but limited partners have limited liability.
•    Partnerships are also pass-through entities where income is taxed at the owner/partner-level rather than at the entity level. 
•    The primary advantage of partnerships is that income, loss, and/or distributions may be specially allocated.
•    General partners are subject to self-employment tax on all income or on income designated as guaranteed payments if applicable.  Limited partners who have no role in management will recognize their share of partnership income, but do not earn income subject to self-employment tax. 
•    Losses are limited to each individual partner’s at-risk investment.
Sole Proprietorships
•    This is the default entity selection for unincorporated businesses, single-member LLC’s, or multi-member LLC’s owned by husband and wife filing jointly. 
•    LLC’s have limited liability, but for other sole-props, there is no separation of business assets from personal assets for liability purposes.
•    The primary advantage of reporting as a sole-prop is that there is no additional tax form required.  All activity is reported directly on the individual tax return.
•    The most notable disadvantage is that all income earned by a sole-prop is subject to self-employment tax. 
Losses are generally not limited and are deducted at the individual level.
    Entity selection depends on a variety of characteristics specific to each business, so contact a tax professional and legal counsel to make an informed decision based on your particular situation whether just starting out or growing your business.
    Leann Ussery, CPA is tax manager of corporate/partnership returns and focuses on the tax needs of small-to-mid sized entities, including entities with multi-state tax issues.  Leann joined Armstrong, Vaughan & Associates, P.C. in 2008 after graduating from Angelo State University with an MBA in Accounting.  She can be reached at 210-658-6229.


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Tanya Erickson houstoneditor@constructionnews.net