Recently, I have come across a number of articles on the topic of entity formation and taxation. A lot of it has been indigestible hash. Here’s my quick attempt to make some sense out of these important subject areas frequently appearing side by side.
“Entity Formation” is what you’re talking about when you ask what kind of “company” your business should be. What you’re really talking about is the state law format your company should have. We’ll refer to this concept as the type of “legal entity” that your business should be.
Most states recognize the following business entity types: corporation, partnership (also known as a “general” partnership), limited partnership (LP), and limited liability company (LLC). These are the four most common legal entities. Many states also recognize additional legal entity types such as limited liability partnership (LLP), professional corporation (PC), and professional limited liability company (PLLC). These additional types of entities are treated similarly to one of the other common four, so we’ll ignore them for purposes of this discussion.
In each state, the business organization laws of that state determines what type of legal entity your business will be treated as and its legal attributes: how the entity is to be formed; the rights of owners amongst themselves; the required internal decision making rules and formalities to be followed by the officers and managers of the business; and the protections afforded the owners against the claims of creditors of the business are, among others, very important characteristics.
The secretary of state’s office for your state administers the legal procedures for forming or creating entities doing business in its state. These procedures must be carefully followed if you want your business’ chosen legal entity type to be respected by your state and to be certain your business has the particular attributes and characteristics you’ve chosen.
Yes, this can be a little complicated, and yes, that’s why in all but a few situations, you should consult an experienced advisor, such as a business attorney, in deciding which legal entity is best for your business.
Important: If you haven’t gone through the legal procedures and filed the proper paperwork with your state’s secretary of state office, and you’re the sole owner, by default your business is a sole proprietorship. If you and someone else own the business and haven’t filed with the state, the default may be a partnership, but you’ll need an attorney to figure that out definitively.
Your business’ type of legal entity is a different concept than how your business is taxed. How your business is taxed is determined by your business’ “tax status”. Federal and state tax law determines your tax status. State law often follows federal law when determining a business’ tax status, but not always. In Texas, most small businesses, roughly defined as businesses with revenues under $1 million, do not pay state taxes on their operations. So for simplicity, in Texas we’ll ignore state law in this discussion. But you should be aware that it is possible for state and federal tax law to differ as to how a particular legal entity is treated for tax purposes. This is a topic for your business attorney or your tax advisor.
The most common types of tax status for businesses are C Corporations (C Corp), S Corporations (S Corp), partnerships and sole proprietorships. Important: there is no separate tax status for limited partnerships or LLCs. So it’s not hard to see the confusion that can be created by the different concepts of legal entity and tax status since both concepts have vocabulary in common – both concepts use the word corporation, for example.
Worse, a given type of legal entity can have more than one possible type of tax status. Here’s some fun examples: It’s possible for a legal partnership to be taxed as a C Corp (this would most likely be a publicly-traded master limited partnership – not that common but the Boston Celtics are an example); a state law legal entity corporation can be taxed as either a C Corp or an S Corp with very different results; and a state law legal entity LLC could be taxed variously as a C Corp, S Corp, partnership, or sole proprietorship – again, all with very different results.
Note: there is no such thing as a “Texas S Corporation”, a phrase I’ve seen on the internet. S Corp status is conferred by federal tax law. Texas business organization law treats all corporations the same. Texas tax law treats all S Corps the same regardless of whether it’s a Texas S Corp, a Delaware S Corp, or a Nevada S Corp.
Another reason for the confusion between legal entity and tax status is that these two separate decisions are frequently made, and generally should be made, when the business entity is created. Further, these two concepts also tend to exist side by side in many discussions throughout the life of your business.
Tax status can be specifically chosen by the owner of the legal entity. If the owner doesn’t choose the tax status, the IRS will determine the entity’s tax status. For example, the IRS and federal tax law will say all corporations are C Corps unless the owner specifically and formally elects to have the corporation taxed as an S Corp according to their detailed rules. The IRS’ choice for your entity may not be the one most advantageous you. So not thoughtfully choosing your company’s tax status in advance and letting the IRS do it is a dumb move. Don’t do that. Consult your business attorney or tax advisor.
And remember that tax status has no bearing on legal liability – only tax liability.
Hopefully now you understand that “should my company be an S Corp or an LLC” is a nonsensical statement. Your business can be both or neither. S Corp and LLC are separate concepts: type of tax status vs. type of legal entity. Your LLC could be taxable as an S Corp or as a partnership. If you have elected S Corp tax status, say, “My LLC has elected S status” or “is taxable as an S Corp.” Or “I have a Subchapter S LLC” or an “S Corp LLC.” If your LLC is taxable as a partnership, say “I have a partnership LLC” or “my LLC is taxable as a partnership.” This will help you follow both the legal rules and the tax rules. Both are important, and they are not the same.
How you go about choosing your business’ type of legal entity and which tax status is right for your situation are topics for another day.
John H. Walker