Orange County Business Entity Formation Attorney
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Entity formation is a service that is commonly offered by attorneys but is well-coupled with the business planning skills that a tax attorney and accountant can provide. At Evolution Tax and Legal, our Orange County business formation lawyers offer the best of both worlds. While many attorneys can inform you of the legal liability consequences and operating structure of a business entity, they cannot thoroughly inform you of the tax consequences of picking a corporation, partnership, LLC, or other type of business entity.
Tax Implications of Business Entity Selection
Here, our team can consult with you to understand your business goals and structure the correct entity and operating format that best meets your needs in the most tax efficient manner. There are a number of items that should be considered when undertaking a business venture:
- Organization’s operational format
- Start-up capital, debt financing and investor structuring
- Exit plan
- Legal agreements and controlling operating documents
- Agreements and contracts with 3rd parties such as customers, vendors, and other suppliers
- Limitation of legal liability and insurance
The various considerations that go into each one of these points will affect your overall operating structure and the legal entity of choice (corporation, partnership, etc.). This, in turn, affects the tax consequences of your venture, which should be mitigated from the outset of any business.
Entity Selection Overview
You have various choices of entities to select from when beginning your business. Most taxpayers select one of the following entities—
A C corporation is a separate legal entity, distinct from its shareholders, that is created under state law. A properly structured C corporation will protect its shareholders from the debts of the business yet enable them to control both day-to-day operations and corporate acts such as redemptions, acquisitions, and liquidations
Since the corporation is taxed as a separate entity, all items of income, credit, loss, and deduction are computed at the entity level in arriving at corporate taxable income or loss.
An S corporation is a small business corporation that has made an election to be taxed as an S corporation and satisfies certain statutory requirements. An S corporation is a tax vehicle only, and in all other respects, the S corporation is a regular corporation for state law purposes. The key difference between a regular corporation and an S corporation for tax purposes is that the income, losses, deductions, and other tax attributes of the S corporation flow through to the shareholders rather than being taxed at the corporate level. From a nontax perspective, the shareholders of an S corporation, like a corporation, enjoy the aspect of limited legal liability. Several states, however, do not recognize S corporation status for state income tax purposes. In most cases, the S corporation may be required to pay tax at the corporate level, similar to a regular corporation.
The following statutory requirements must be met for a corporation to elect to be taxed as an S corporation:
- The corporation must be a domestic corporation.
- It must have 100 or fewer shareholders.
- All shareholders must be individuals, estates, or qualified trusts.
- There must be only one class of stock.
- The corporation cannot have a shareholder that is a nonresident alien.
Limited Liability Companies
Limited liability companies (LLCs) are statutory creatures that combine the corporate characteristic of limited liability for all investors with the income flow-through attributes of an S corporation. The basic characteristics of limited liability companies are as follows:
Management authority may be vested in all, some or none of the members, thereby providing absolute flexibility with regard to designing the allocation of authority and decision making.
The owners are not liable for the debts of the entity.
The entity may continue or dissolve upon the happening of specified events identified in the operating agreement giving the entity complete structuring flexibility as to dissolution, limited only by the goal of obtaining the desired outcome for federal income tax purposes.
The transfer of an interest in the LLC and/or admission of new members to the LLC may be prohibited or allowed pursuant to any agreed-upon criteria set forth in the operating agreement, thereby providing for absolute flexibility in structuring the business arrangement among the owners.
A partnership is a pass-through entity that does not pay tax on its income. Instead, the partnership passes along its income or loss, gains, deductions, and credits to the partners. Each partner reports a percentage of the partnership income and other items on the partner’s own tax return.
A partnership is formed when two or more people or entities join together to carry on a business or other financially-motivated venture and split the profits from it. There must be two or more participants in order for a partnership to exist. It is not necessary for the participants to have a formal written agreement in order to have a partnership for tax purposes. However, most partnerships will be formed under particular state laws and the rights of the participants will be carefully outlined in a written partnership agreement.
The four entities typically taxed as partnerships have the following basic characteristics:
- General partnership: Has two or more general partners who are fully liable for all partnership debts. Creditors have access to personal assets of all of the owners.
- Limited liability partnership (LLP): All owners are treated like general partners and are personally liable for the partnership debts. However, partners are not liable for malpractice committed by other partners
- Limited partnership (LP): Has at least one general partner and many limited partners. The general partner is personally liable to creditors, but the limited partners can only lose their investments in the partnership.
- Limited liability company (LLC): Has all of the characteristics of a corporation under state law except for the double layer of tax. All members have limited liability just like corporate shareholders.
Legal Liability Considerations
In addition to considering the tax implications of an entity to operate through, the owner of the business should consider what types of protections they are afforded from a legal perspective. Each entity provides its own unique form of protection. The type of protection afforded depends on the state the entity is formed in, however, it generally remains the same from state to state on a high level. Below is a high-level overview of the types of protections afforded to owners of the various entities to choose from.
Stockholders are generally not liable for any debts of a corporation; rather, shareholder liability is limited to their investment in the corporation unless loans or notes are guaranteed by the shareholders.
Like a C corporation, stockholders in an S corporation are generally not liable for any debts of a corporation. Liability is limited unless loans or notes are guaranteed by the shareholders.
A member’s liability is limited to the amount of his contribution unless the member has guaranteed a debt of the LLC.
In a general partnership, all partners are liable for the full amount of the partnership’s debts. In a limited partnership, only the general partners are fully liable for the partnership debts and the limited partners are liable only to the extent they invested in the partnership.
After considering the tax and legal consequences of each entity, attention should be closely paid to the management format of each type of entity. Once again, the default rules surrounding the management of an entity varies from state to state, but generally remains the same. Additionally, these default rules can be modified through the operating agreement put into place by the owners of the entity.
In a large corporation, control is often in the hands of top management. In a closely-held corporation, management is often exercised by the owners.
The management of an S corporation is fairly flexible. Active participation is usually present since the total number of shareholders cannot exceed 100.
Management of an LLC is largely dependent on state statute. A member is generally eligible to participate in the management of the LLC’s business, but management may also be elected.
All general partners will actively participate in management activities. The partners can grant management control to certain partners in accordance with the partnership agreement.
Exit Considerations – Transferability of Interests
Most business owners do not have their eyes set on an exit from a business when they are just starting it. It, however, is an important consideration to be taken when forming an entity. The ability to sell and transfer your interests of an entity needs to be considered so you are not restricted in how much, who, and/or when you can sell your ownership interests.
Stock is easily transferable unless the bylaws of the corporation provide a restrictive right.
The same rules apply as for a C corporation.
NOTE: The corporate charter should provide that a transfer cannot be made to an ineligible shareholder unless agreed to by other shareholders so as to not jeopardize the S corporation status upon a transfer of ownership interests in the entity.
A membership interest consists of two classes of rights: financial rights and management rights. In order for a transferee of a membership interest to become a full member, unanimous consent is required in some states.
Normally, the transfer of an interest will require the approval of all partners and may cause termination of the old partnership and the creation of a new partnership. Limited partners may be allowed to freely assign their interests.
Tax Return Due Date Considerations
While we briefly discussed the tax consequences of owning each different type of entity, an owner should keep in mind their tax return due dates.
C corporation returns (Form 1120) are due on the 15th day of the fourth month after the close of the tax year. Until 2026, however, C corporations with a June 30th fiscal year-end will have an original due date of the 15th day of the third month after the close of the tax year, or September 15th.
For tax years before 2026, the extension for calendar-year C corporations is five months, resulting in an extended due date of September 15th. However, the maximum extension period for corporations with a June 30th fiscal year-end is seven months. For later tax years, a six-month extension to file Form 1120 is available.
S corporation returns (Form 1120S) are due on the 15th day of the third month after the close of the tax year. A six-month extension of time to file is available.
LLC returns (Form 1065) are due on the 15th day of the third month after the close of the tax year. A six-month extension of time to file is available.
Partnership returns (Form 1065) are due on the 15th day of the third month after the close of the tax year. A six-month extension of time to file is available.
Accounting Method Considerations for Choice of Entity
Generally, most owners are not aware (or maybe don’t care) of the accounting methods that are applicable to various entities formed. For the most part, entities can utilize the “cash” method of accounting (e.g. record income and expense when income or expenses are actually received or paid) versus the “accrual” method of accounting (e.g. recognize income and expense when all events have occurred to establish your legal right to receive income or be obligated to pay an expense, even though not yet received or paid). After the passage of the 2017 tax act, only entities with average gross receipts over $25 million are subjected to using the “accrual” method of accounting.
For tax years before 2018, a C corporation is restricted to the accrual method unless the average gross receipts for the previous three tax years are less than $5 million.
An S corporation is generally not restricted to the accrual method unless it is required to maintain inventory.
An LLC may be restricted to the accrual method if it has a corporate partner.
A partnership may be restricted to the accrual method if it has a corporate partner.
Considering Who is Taxed on the Income of an Entity
In addition to the normal tax attributes of the various entities discussed, it is also worth considering who will be taxed on the operations of the business for the year (e.g. the owner of the business or the business itself).
A C corporation is taxed on its income at the entity level, regardless of any distributions to shareholders.
An S corporation generally does not pay tax at the entity level (but see the built-in gain tax and tax on excess net passive income); rather, the income or loss is allocated among the shareholders, who report the income and pay the tax at the shareholder level. Losses may only be deducted by the shareholders to the extent of the shareholder’s basis in the stock and debt of the S corporation.
An LLC does not pay tax at the entity level; rather, the income or loss is allocated among the members, who report the income and pay the tax at the shareholder level. Losses may only be deducted by the partners to the extent of the shareholder’s basis in the stock and debt of the S corporation.
A partnership does not pay federal income tax at the entity level; rather, the income, gain, loss, or deduction of the partnership is allocated among its partners, who report the items and pay any corresponding tax in their separate capacity. The partners must report their share of the partnership’s income, even if the income is not distributed.
Free Consultation With an Orange County Business Formation Lawyer
If you are looking to form an entity, and would like to consult with an Orange County business formation attorney regarding the entity’s operational format, the legal protections it will provide you in a business context, and additionally understand the tax impact of one entity over another, please contact our team for more information.