Choice of Entity & Business Tax Status

Business Law for Entrepreneurs Series

By Adrienne B. Haynes, Esq.

Managing Partner, SEED Law

At SEED Law, we have helped hundreds of businesses to establish a firm foundation, and provided complimentary consultations at entrepreneurial centers across the region, including for the City of Kansas City’s KCBizCare, the one stop shop for business resources, advocacy and information for new and existing businesses.

In doing that work, we understand the most common questions for startups and early stage businesses, including choice of entity, governing documentation, and selecting a tax status.

MAKING YOUR CHOICE OF ENTITY

One of the most important early steps after the decision to start a business will be to decide which entity type makes the most sense for your company. The choices of entity options available will depend on your venture’s purpose, ownership structure, service or product offerings, anticipated funding sources, and other business and legal considerations.

The most common types of business entities available in most states include a sole proprietorship, a partnership, a limited liability company, a for profit corporation, or a not for profit corporation. Some state laws do allow for hybrid entities such as benefit corporations, and L3Cs, and other variations, but the focus of this article will be on the most common types we see. For each entity type below, we’ll share information on how to create the entity type, how liability is assessed, required documentation and tax statuses available for each entity.

The most common types of entities available are as follows:

· Sole Proprietorships are organizations where one person owns all the assets, is liable for all the liabilities, and operates in his or her personal capacity (instead of within a formalized entity).

· Partnerships are associations of two or more people as co-owners of a business for profit. If filed, this entity type provides limited liability protection to all owners, but also requires that owners are jointly and severally liable for all obligations and liabilities created by the business, unless they contractually agree to different arrangements.

· Limited Liability Companies are the most common type of filed legal entity. This entity choice provides the limited liability protection of a corporation and the ease of a partnership for ongoing corporate formalities (learn more about Series LLCs here).

· Corporations offer a liability protection and have significantly more formalities than the above-mentioned entity types. For instance, most states require corporations to have annual shareholder meetings, a board of directors, and annual filings.

· Nonprofits are entities created for a charitable purpose and public benefit. This does not mean that the business does not intend to or should not make a profit, but that the money generated will be used solely in pursuit of the mission and not for the benefit of any organizers.

PREPARING YOUR GOVERNING DOCUMENTATION

After narrowing down options for one’s entity choice, the organization should be formalized with the Secretary of State’s office in their home state and the required governing documentation should be prepared.

The documentation necessary will depend on your entity type. If you have a sole proprietorship, no documentation is required because this business is usually not filed. Some choose to create a fictitious name, but this is not the same as filing a business. If you choose a limited liability company, you’ll need an operating agreement. If you have a partnership, it’ll be a partnership agreement. For both nonprofit and for profit corporations, the required governing documentation are bylaws.

Once the key terms and decisions have been identified and documented, seal it with a signature and store it where your business partner, financial agent or power of attorney would be able to easily access when if needed. Because of changes in law, circumstance, and succession plans, governing documents should be reviewed every 2–3 years.

DETERMINING YOUR TAX STATUS

After the choice of entity has been made and the governing documentation has been drafted, the founders should determine the entity’s tax status. There are four primary classifications- a disregarded entity, partnership, corporate options, and tax exempt.

· Pass Through, or Disregarded entity: The disregarded entity (or pass through entity) tax status recognizes that although a business entity is separate from its owner, for federal tax purposes, it is disregarded as separate. This means that a disregarded entity does not file its own tax return but instead, it’s profits and losses are recorded on the owner’s income tax return.

· Partnership Status: The partnership tax status is the default for business entities that are owned by more than one person, and this tax status allows the profits and losses of the business to “pass through” to the partners. A partnership must designate a tax matters partner and file an annual information return with the IRS. but “passes through” any profits or losses to its partners

· Corporation: A corporation is taxed at two levels- at the corporate level on taxable earnings, and then again when the money is distributed to its owners or shareholders. There are two types of corporate tax status, C Corp (traditional) and S Corp (Subchapter-S small business election). Learn about the distinctions, see this article on the conditions and qualifications needed to be eligible for the Subchapter-S small business election.

· Tax Exempt: This term generally means that the organization is exempt from federal income tax under Section 501 of the Internal Revenue Code. To be exempt from paying state or local business sales, income, and property taxes, the organization must receive a separate tax exemption from the government involved. In most cases, receiving federal tax exemption automatically gets you state income tax exemption and makes it much easier to receive sales and property tax exemptions from state and local governments.

This article is an overview of choice of entity considerations, including formation requirements, corporate documentation, and tax status distinctions and does not cover every legal right or obligation, consideration, exception, or restriction. These decisions are complex, and should be well researched and discussed with a professional before being made.

To schedule a consultation with a SEED Law attorney, you can give us a call at (816)945–4249 or schedule your consultation today here.

Additional Resources:

Limited Liability Company (LLC), https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc (last visited Apr 22, 2020).

LLC Filing as a Corporation or Partnership, , https://www.irs.gov/businesses/small-businesses-self-employed/llc-filing-as-a-corporation-or-partnership (last visited Apr 22, 2020).