When assisting clients in their pursuit of a new business venture, we often get questions like: Should I be using an LLC or an S-Corporation? Questions like these highlight a common misunderstanding that selecting the type of legal entity for your business automatically dictates what tax classification that entity will receive from the Internal Revenue Service. The way a business is structured can have long-lasting tax and legal consequences. Therefore, understanding the potential effects of your selection of legal form and tax classification is crucial to finding the appropriate structure for your business.
One of the first steps in developing your initial business plan is deciding the legal structure for your venture. If no formal designation or registration is made for a business, it will be treated as either a sole proprietorship or partnership, depending on whether the business is being operated by one individual, or together with business partners. Typically, a business owner desires the liability protection afforded by corporations and limited liability companies (“LLCs”) and elects to make a formal filing with the State to operate under one of those designations. Corporations and LLCs are provided for and governed by State law and allow the owners to protect their personal assets from any claims or actions brought against the business. Additional entity structure options such as professional associations, close corporations, and limited partnerships can also make sense depending on the type of business being conducted, and the way owners are investing in the venture.
In addition to deciding the legal form of your business, you must also consider what tax status is the most appropriate and efficient for your venture. Starting out, each entity is given the default tax classification used by the IRS for the legal structure that was chosen. For example, LLCs are treated as disregarded entities and will either be taxed as a partnership or as a sole proprietorship depending on whether it has one or more owners. Similarly, a corporation will, by default, be classified as a C-corporation and taxed accordingly. However, both LLCs and corporations may make a subchapter S election (“S-Corp”) provided that certain qualifications are met in the structure and ownership of the business. With S-Corp status, your business may be able to take advantage of certain tax benefits such as avoiding self-employment taxes. As you can imagine, these tax incentives may be more beneficial to some businesses and less so to others depending on the profitability of the business. While very popular among small business owners, S Corps also have some limitations and drawbacks. Therefore, it is important to not only conduct a thorough analysis of your options at the outset but also revisit your business’s tax classification periodically with a qualified accountant.
In summary, it is important for every new business owner to understand that determining the form of your business entity, and how that entity should be registered with the IRS, are choices independent of one another, not one and the same. While your legal structure will likely remain unchanged, your tax classification may be worth changing as your business evolves and expands. Having a reliable team of attorneys and accountants to advise you on the different considerations when starting your business and throughout its life is critical to taking advantage of the various laws and regulations that apply at the State and federal level.
Here at Liff, Walsh & Simmons, my colleagues and I have helped many business owners determine their best course of action in choosing a legal structure and tax classification. If you have questions about a particular employment law issue or would like more information, email me at jmcgowan@liffwalsh.com or call me direct at (443) 569-7389.
About Liff, Walsh & Simmons
Liff, Walsh & Simmons is a business law firm. We provide expert, responsive legal services to middle-market businesses, their owners, operators, and investors across the mid-Atlantic region. Our attorneys are subject matter specialists in business counseling, contracts and transactions, commercial and civil litigation, real estate, employment, banking and finance, real estate, land use, zoning, and estate planning and administration.
