Natural Entrepreneur: Forming Your Business Type- Taxation

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Business Entity Types

Though there are a great number of entity types from which to choose, operating businesses are most commonly (by far) either a corporation or a limited liability company. The corporation and the limited liability company offer many of the same benefits to the business owner: limited liability (for the owners), transferability of ownership (by transfer of the ownership interest in the entity), and business continuity (the entity survives after the death of the owner(s)). Though these factors are generally the same for both the corporate and limited liability company form, there are a variety of other factors that must be analyzed to determine which entity form is most appropriate for a particular business.

In addition to the business entity characteristics mentioned above, an entrepreneur must consider other important factors, including tax treatment, exit strategy, jurisdiction of formation, equity compensation matters, and the number of potential owners.

Taxation

One important consideration when choosing between the corporate form and a limited liability company is the manner in which they may be taxed. The difference in tax treatment is most pronounced between the C corporation and the limited liability company. For federal tax purposes, the profits of a C corporation are taxed at the entity level first, and then distributions paid to the shareholders are taxed as dividends. This is commonly referred to as “double taxation”, and generally results in the corporation’s shareholders netting less of the corporation’s profits.

A corporation may elect to be taxed as a so-called S corporation. The S corporation is formed in the same manner as a C corporation, but then also files with the Internal Revenue Service an election to be taxed as a S corporation. As a S corporation, the corporation’s profits are generally not taxed at the entity level; instead all of the company’s income flows down to the owners’ tax returns and is taxed as income of the owners. Because this generally results in a lower overall tax burden to the shareholders, treatment as a S corporation has certain tax advantages over the C corporation. However, in order to qualify as a S corporation, the corporation is subject to certain restrictions, including the corporation (a) cannot have more than 2 classes of stock (though having voting and non-voting stock is not considered having 2 classes of stock), (b) cannot have more than 100 shareholders, and (c) can have only very limited types of entities as shareholders. Because of these restrictions, the S corporation form is not appropriate in many cases, despite its tax advantages over the C corporation.

The limited liability company may elect to be taxed as a C corporation or as a partnership (which benefits from flow-through taxation in much the same way as a C corporation). As a practical matter, limited liability companies most often (by far) are taxed as partnerships. This means that at the federal level, the limited liability company is generally not taxed at the entity level; instead all of the company’s income flows down to the owners’ tax returns and is taxed as income of the owners. Though very similar to the tax treatment of the S corporation, there are subtle differences between the two that are important to understand before selecting an entity type.

Finally, one important note: This tax discussion is accurate only for federal income taxes. New Hampshire does not recognize the pass-through tax treatment of the S corporation or the limited liability company, and therefore both are subject to the New Hampshire Business Profits Tax and the New Hampshire Business Enterprise Tax.

This is the first article in a multi-part series. In the next installment, we will discuss how your exit strategy and the state of jurisdiction impact your decision of business formation entity.

Matthew Benson is an attorney with Cook, Little, Rosenblatt & Manson in Manchester, NH. He can be reached at (603) 621- 7115 or via email at mbenson@clrm.com

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