Setting up a new venture as, say, a sole proprietorship, may have made sense initially — but as a successful company grows, an outdated business structure could mean unnecessary tax and other costs.
Ideally, a decision about a business structure will be done before an enterprise is even launched, according to Ted Carnevale, a partner at accounting firm Grassi. “But as the business evolves, the structure should be reviewed at least once a year, or more often if there’s an M&A transaction or other significant change,” he said. “The review should include the owner or owners, and appropriate accounting, tax and legal advisers. There are generally three things to consider: who are the owners, how will profits be distributed, and is the business expected to generate profits or losses in the early stages?”
If one person is the owner and he or she plans to remain the sole owner, then “a sole proprietorship may be the easiest structure. You don’t have to form any kind of entity; just select a business name and register it.”
The downside is that a sole proprietorship doesn’t offer any liability protection, “so we’re not seeing as many these days,” Carnevale added. “More people are starting off as an LLC, or Limited Liability Company, which may limit the risk to the home or other real estate, savings and other personal assets of the owner or owners. However, LLCs are subject to state statutes, so issues like liability and taxes may vary from one state to another.”
Members of an LLC who also actively work for the business are considered owners, not employees, “so they will generally have to pay self-employment taxes on any income they are allocated from the LLC,” said Carnevale. “LLCs, however, do have an option to elect to be taxed as a corporation (in which case the owners can receive salary income as an employee, plus an allocation of net profits): either as a traditional ‘C’ corporation, or as a pass-through ‘Subchapter S’ corporation, where profits or losses flow through to owners and are taxed at their individual rates. There are advantages and disadvantages to both, including a limit of 100 shareholders for a Sub-S Corporation, so it’s a good idea to meet with a tax or other adviser before making a decision.”
Consider the options
Goldstein Lieberman & Co. Chief Executive Officer Phillip Goldstein said business owners should review their company’s structure “every year, and more often if things change, like if the number of owners or shareholders increases.”
Different structures – like a sole proprietorship, an LLC, or a traditional or C corporation – each have their own advantages and disadvantages, he added.
“For example, a Subchapter S corporation, which is a type of PTE, or pass-through entity, is generally limited to no more than 100 shareholders, and generally excludes non-resident aliens from being a shareholder,” he explained. “A C corporation, in contrast, generally allows for an unlimited number of shareholders, but is subject to double taxation — where profits are first taxed at the corporate level, and then taxed again, at the personal shareholder level, when they’re distributed as dividends to owners.”
Goldstein said that “eEvery year we sit with clients who are reviewing their business structure and considering other major decisions, and we bring on lawyers, CPAs and other industry experts to consider their situation and make recommendations. These decisions should not be made in haste, and should be made while considering all of the available information. One of our clients, for example, is a serial entrepreneur, and we’ve recommended different business structures for his enterprises, depending on the particular facts and circumstances. There is never a single answer.”
A business that’s considering a change in structure has to review a lot of issues, noted Rosenberg Rich Baker Berman & Co. tax department chair Joe Caplan. “In addition to tax considerations, the ‘right’ structure will also depend on the goals of the owners, and their respective liquidity or financing needs.”
He recalled a client that was organized as a Subchapter S corporation, “but as it grew, it became clear that the number of shareholders would soon exceed the 100-person limit imposed by the Internal Revenue Service. One option we helped them consider was a tax-free F reorganization, which would enable the business to continue to be taxed as a pass-through entity even though it exceeded the 100-shareholder limit. We also considered restructuring it as a C corporation – which is relatively simple to do – but if circumstances later changed, the owners would generally have to wait five years before being able to re-convert to an S corporation status. Even if the conversion back to an S corporation status is made, the company would have to manage the potentially adverse tax consequences that come with net unrealized built in gains.”
After weighing all the pros and cons, “The client took the option of liquidating the S corporation and relaunching as an LLC,” Caplan said. “This election retained certain liability protections, while offering flexibility along with certain tax advantages. This illustrates the complexity of deciding on an appropriate business structure.”
As companies evolve, “it becomes apparent that there is no ‘one size fits all’ business structure,” noted Eddie Rivera, a partner at Sax. “It’s not uncommon for businesses to start as a sole proprietorship, but the self-employment tax [for an individual, generally, 12.4% Social Security tax on the first $160,200 of self-employment income, plus 2.9% Medicare tax on the first $200,000 of self-employment income, and 3.8% Medicare tax and surcharge on all self-employment income in excess of $200,000], can be overwhelming, especially when the owner reinvests their profits in the company,” he said. “Many instead elect to organize as an S or C corporation. The status should be reviewed at least annually, and more frequently if it looks like an M&A [transaction] may take place, or if the business is growing especially fast.”