Download Sole Proprietorship Entity – Key Factors Analysis

Sole Proprietorship Entity – Key Factors Analysis
Non-Tax Factors:

Formalities of Existence – Few legal formalities are necessary when forming a sole proprietorship,
since the business and the owner are treated as a single entity under the law. An employment
identification number must be secured if employees will be used in the business.

Limited Liability of Owners – A sole proprietor has unlimited personal liability in regard to
business debts. This is a primary disadvantage of this entity type; creditors can attach personal assets.

Ability to Raise Capital – A sole proprietor may face difficulty in raising capital for the business,
since other owners are not involved. Bringing in partners or incorporating may be the only practical
means of raising additional capital.

Participation in Management – The sole proprietor has total control in managing the business, as
there are no other owners to answer to.

Transferability of Interests – The sole proprietor can easily transfer the business through sale or
exchange. A sole proprietorship may be easily dissolved, with assets converted to personal use.
Tax Factors:

Tax Aspects of Formation – The formation of a sole proprietorship is not a taxable event; the basis
of assets contributed to the business is generally the proprietor’s adjusted basis (unless the fair market
value of converted assets is less than the adjusted basis at contribution).

Taxation as a Separate Entity vs. Pass-Through Entity – The sole proprietorship business and the
owner are treated as a single entity for tax purposes. The net income of the business is determined on
Schedule C, and this amount is included in gross income on the Form 1040. Net losses would
generally be deductible by the sole proprietor unless the hobby loss rules apply. Cash withdrawals
generally have no effect on tax liability. Liquidation of the business by sale or exchange would
involve a single layer of tax, with gains and losses reported on the individual tax return.

Taxation of Owner Compensation – The sole proprietor is always taxed on the net income of the
business (as reflected on Schedule C), regardless of withdrawals. Thus, the designation of a salary as
“reasonable compensation” is meaningless in the sole proprietorship, and any other cash withdrawals
have no effect on the final tax liability. The sole proprietorship is always subject to a single level of
tax at the owner level. As to deferred compensation, a sole proprietor may establish a Keogh (HR-10)
plan that provides benefits similar to corporate plans; immediate deductions for contributions, tax-free
accumulation of income on the trusteed contributions, and deferral of tax until withdrawals
(presumably at retirement). However, employees must be covered under the qualified plan rules.

Ability to Provide Tax-Favored Fringe Benefits – The sole proprietorship entity does not provide a
vehicle for tax-favored fringe benefits. However, in a limited attempt to provide parity with corporate
entities with regard to health insurance coverage, a sole proprietor may deduct for adjusted gross
income 100% of insurance premiums for health coverage for the sole proprietor and his or her family.
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Partnership Entity – Key Factors Analysis
Non-Tax Factors:

Formalities of Existence – A partnership entity generally requires a partnership agreement that
specifies the rights and responsibilities of the partners, including profit and loss sharing ratios. This
agreement would need to be modified each time additional partners are added.

Limited Liability of Owners – General partners (those who participate in the management of the
partnership) have unlimited personal liability. The partnership may also be structured to offer limited
partnership interests, where such partners’ liability is limited to invested capital. However, limited
partners may not actively participate in the management of the business.

Ability to Raise Capital – Partnerships offer increased flexibility as to ability to raise capital when
compared to sole proprietorships. Additional partnership interests may be offered as a means of
raising additional capital; however, this entails changes in the underlying partnership agreement.

Participation in Management – General partners are free to participate actively in managing the
business, but limited partners are prohibited from managing the day-to-day affairs of the business.
Because of this prohibition, limited partners are likely to be subject to the passive activity limitations.

Transferability of Interests – Transfers of partnership interests can be somewhat complex, as other
partners may have to agree to the transfer and the underlying documents will need to be amended.
Transfers of more than 50% in interests will terminate the partnership for federal tax purposes.
Tax Factors:

Tax Aspects of Formation – The formation of a partnership is generally not a taxable event unless
the interest received is compensation for services or the liabilities assumed by other partners exceed
the adjusted basis of the property to the contributing partner. In general, taxable transfers are less
likely to occur with partnership formation; there is no 80% control requirement. Another positive
aspect of a partnership is that a partner’s tax basis includes his or her share of partnership liabilities.

Taxation as a Separate Entity vs. Pass-Through Entity – The partnership is a conduit entity for
federal tax purposes; the single layer of tax is applied at the individual partner level. (The same rules
apply for limited liability entities.) Items of partnership income, deductions, and credits retain their
character and generally flow through to the partners based on profit and loss sharing ratios (this is
also true of losses); however, special allocations having “substantial economic effect” may be made.
Guaranteed payments are deductible in determining partnership ordinary income and are allocated
directly to recipient partners. Distributions need not be pro rata in a partnership entity.

Taxation of Owner Compensation – A partner is always taxed on his or her share of the “ordinary
income” of the business, his or her share of any guaranteed payments, and his or her share of
“separately stated items.” Any cash withdrawals (“other cash payments”) generally have no effect on
the final tax liability. General partners may also establish Keogh accounts for deferred compensation,
and these operate much like the Keogh account of a self-employed individual, described above.

Ability to Provide Tax-Favored Fringe Benefits – The partnership entity does not provide a vehicle
for tax-favored fringe benefits. However, like a sole proprietor, general partners may deduct 100% of
insurance premiums for health coverage for the sole proprietor and his or her family.
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S Corporation Entity – Key Factors Analysis
Non-Tax Factors:

Formalities of Existence – An S corporation is a separate entity for purposes other than tax and, as
such, must conform to various legal and/or state requirements for incorporation. Additionally, strict
election requirements must be met for federal tax purposes.

Limited Liability of Owners – Since the S corporation is a separate legal entity, it offers the regular
corporate advantage of limited liability for its owners. However, this advantage may be somewhat
mitigated by the fact that creditors may require the owners of a start-up S corporation (particularly in
the case of family businesses) to guarantee personally notes for the initial financing of the business.

Ability to Raise Capital – The 100-shareholder limit for S corporation status may cause some minor
problems in raising capital. However, the company can issue as many shares as it desires, as the limit
is stated in terms of the number of shareholders and not the number of shares.

Participation in Management – Because of the limited number of shareholders in an S corporation,
it may be possible for the owners to participate more in company management than in a regular
C corporation.

Transferability of Interests – Transfers of S corporation interests are generally easier to accomplish
than transfers of partnership interests, since the S corporation shareholder can sell his or her shares.
However, care must be taken so that the sale is not to a disqualified shareholder or that the sale causes
problems with the 100-shareholder limit.
Tax Factors:

Tax Aspects of Formation – The formation of an S corporation involves the same tax consequences
as the formation of a regular C corporation. Thus, nontaxable treatment is assured only if the
shareholder receives no boot, performs no services, does not transfer assets with liabilities exceeding
basis, and most importantly, meets the 80% control requirement. Although liabilities are not added to
a shareholder’s basis, the tax basis of any unpaid loans to the S corporation may be recovered.

Taxation as a Separate Entity vs. Pass-Through Entity – The S corporation is a conduit entity for
federal tax purposes; the single layer of tax is applied at the individual shareholder level. Items of S
corporation income, deductions, and credits flow through to the shareholders of record at the end of
the tax year and retain their character. Any distributions must be pro rata. Any operating losses would
also flow through to the individual S corporation shareholders. It is important to note that some states
may not recognize S corporation status for state income tax purposes.

Taxation of Owner Compensation – The S corporation shareholder who is also an employee is
treated as an employee of the separate corporate entity. Thus, such owner/employee is taxed on any
compensation received, is subject to the normal FICA withholding rules, and is treated as an
employee for pension plan purposes. Other distributions to an S shareholder/employee are treated as
nontaxable withdrawals (as long as the amounts do not exceed basis).

Ability to Provide Tax-Favored Fringe Benefits – The normal tax-favored treatment of fringe
benefits available to shareholder/employees in regular C corporations (deduction for the corporation
and exclusion for the employee) is generally not available to shareholder/employees in S
corporations. The only exception is for those S shareholder/employees who own a 2% or less interest
in the S corporation. This seldom occurs in most closely-held family businesses.
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C Corporation Entity – Key Factors Analysis
Non-Tax Factors:

Formalities of Existence – A C corporation is a separate entity for tax and non-tax purposes, and as
such, must conform to various specific legal and/or state requirements for incorporation.

Limited Liability of Owners – Since the C Corporation is a separate legal entity, it offers the
advantage of limited liability for its owners. However, as mentioned earlier with S corporations, this
advantage may be somewhat mitigated by the fact that creditors may require the owners to guarantee
personally any loans used to start the business.

Ability to Raise Capital – The C Corporation offers maximum flexibility in terms of the ability to
raise capital. Different types of stock and securities may be offered as a means to raise such capital;
limitations are not imposed by the Code (other than the possible danger of having some debt
reclassified as stock because the corporation is too “thinly capitalized”).

Participation in Management – In most cases, the stock of a C Corporation is widely held, which
effectively limits the ability of owners to participate in the management of the company. Most major
decisions of the business are in the hands of an independent board of directors.

Transferability of Interests – The C Corporation offers maximum flexibility in transferring
interests. A shareholder may sell his or her shares without any disruption to the ongoing business of
the corporation.
Tax Factors:

Tax Aspects of Formation – Nontaxable treatment in forming a C corporation is assured only if the
contributing shareholder receives no boot, performs no services, does not transfer assets with
liabilities exceeding basis, and most importantly, meets the 80% control requirement. The strict
requirements of Sec. 351 must be satisfied before the entity formation is tax-free.

Taxation as a Separate Entity vs. Pass-Through Entity – The major disadvantage of a C
corporation is the double taxation possibility, since the corporation is treated as a separate tax entity.
Income is taxed once at the corporate level and then again when distributed to shareholders at a 15%
tax rate (unless in the form of deductible salary, rent, or interest). Also, capital losses and operating
losses may not be passed through to the owners; they remain at the corporate level. If losses are
expected for several years after formation, an S election should be considered if at all possible.

Taxation of Owner Compensation – The C Corporation shareholder/employee is treated as an
employee of the separate corporate entity. Thus, such owner/employee is taxed on any compensation
received, is subject to the normal FICA withholding rules, and is treated as an employee for pension
plan purposes. Other distributions to a C shareholder/employee are treated as taxable dividends (taxed
at a 15% rate) unless payments represent deductible rent or interest paid to the shareholder.
Ability to Provide Tax-Favored Fringe Benefits – The tax-favored treatment of fringe benefits
available to shareholder/employees is a major advantage offered by regular C corporations. Such
benefits as health and insurance, group-term life insurance, reimbursement plans, meals and
lodging, child care payments, educational benefits, and other items are deductible by the
corporation and are excludable from income by the employee.
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Choice of Entity – Other Tax Considerations
Choice of Tax Year
Generally, a sole proprietorship and a C Corporation are free to choose a calendar or a fiscal year.
On the other hand, partnerships and S corporations are subject to significant restrictions in the choice of a
tax year. A partnership must generally determine its tax year according three tests, each applied
sequentially until the appropriate year is determined: (1) the majority interest rule; (2) the principal
partners rule; or (3) a tax year determined under a “least aggregate deferral” computation. Generally, an S
corporation must use a calendar year unless a special prepayment election under Sec. 444 is made.
Alternative Minimum Tax
Alternative minimum tax (AMT) considerations are somewhat alike for the sole proprietor, the
partnership, and the S corporation, since all items of income, deduction, and credits flow through the
partnership and S corporation directly to the owners and retain their character. The sole proprietor has the
most control over items that may affect the AMT, since he or she makes all tax elections as opposed to
being one of possibly many owners. The regular C Corporation is also subject to an AMT, but only if
average gross receipts for the preceding three years exceed $7.5 million. The corporate AMT rate is only
20% (as opposed to 26% and 28% for individuals); however, the C Corporation has one major adjustment
that does not apply to the other entities: the adjusted current earnings (“ACE”) adjustment. In general,
ACE is a rough surrogate for financial accounting income, and to the extent this “accounting” number
exceeds alternative minimum taxable income, 75% of the excess is reported as an AMT adjustment.
Multi-Jurisdictional Operations
As a family business grows, the possibility of expanding beyond state (or national) borders may
be a viable business option. This raises a host of tax issues: for example, has the business in the new
jurisdiction established “nexus” (i.e., are there sufficient operations in the new location to justify that
location imposing a tax for goods and services used in the new jurisdiction)? If the answer is yes, then
some type of apportionment of income may be required. The type of entity in the new jurisdiction will
determine the ultimate tax burden; for example, some states do not recognize the existence of an S
corporation. Also, state tax rates, rules, and “tax holidays” may vary in today’s competitive environment.
Transfer of the Family Business
The owner(s) of a family business must constantly give attention to the possible value of the
business at their deaths, who will receive such interests, and who will eventually control the business.
Depending on the size and complexity of the business, useful tax planning tools could include outright
transfers to survivors or simple buy-sell agreements (where the decedent’s ownership interest is
purchased by surviving owners or is redeemed by the business). Leaving the entire interest to a surviving
spouse eliminates estate tax considerations at death of the first spouse, but may create terrible tax
consequences to the family when the second spouse dies. A popular family transfer planning technique
currently used is the “discounted value transfer,” which eliminates post-transfer appreciation from the
decedent’s estate and limits the original amount subject to the gift or estate transfer. Court decisions have
allowed minority interest and lack of marketability discounts when valuing shares of stock (or partnership
interests).
Limited Liability Entities
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Since limited liability entities are taxed as partnerships for federal purposes, many of the same tax
and non-tax considerations apply to these entities. However, complying with the various state statutes
permitting limited liability entities may cause administrative problems for multi-state entities.
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