Introduction
Did you know that your business can receive the coveted S Corp tax status without actually being a corporation? Many business owners conflate tax classification with entity type, believing that they are one and the same. However, these are distinct concepts with different legal and tax implications. This article explores the difference between tax classification and entity type, focusing on how entities like LLCs can have different tax classifications, including S Corp status.
DISTINGUISHING ENTITY TYPE AND TAX CLASSIFICATION
A: Entity Type
Entity type refers to the legal structure of a business. Different entity types come with various legal rights, obligations, and protections. Here’s an overview of common entity types in Georgia:
- Sole Proprietorship: Owned by one individual, no legal distinction between the owner and the business. I would never recommend that someone operate as a sole proprietorship because there is no liability protection, and your only tax classification option is as a disregarded entity.
- Partnership: Owned by two or more individuals, partners share responsibilities and liabilities. An additional election must be properly filed to receive liability protection from the acts of a partner. Partnerships are naturally taxed under the partnership classification.
- Limited Liability Company (LLC): Combines features of corporations and partnerships, provides limited liability protection. As discussed below, LLC owners often have the most flexibility in choosing its tax treatment
- Corporation: A separate legal entity owned by shareholders, offering strong liability protection.
B: Tax Classification
Tax classification, on the other hand, pertains to how a business is taxed by the Internal Revenue Service (IRS) and should be selected after consultation with a CPA. A default classification will apply unless you file the correct paperwork with the IRS. Here are the primary tax classifications:
- Sole Proprietorship/Disregarded Entity: Taxed at the individual level.
- Partnership: Pass-through taxation, profits/losses pass to individual partners.
- C Corporation (“C Corp”): Taxed at the corporate level, and then shareholders are taxed on dividends (double taxation).
- S Corporation (“S Corp”): Pass-through taxation, avoiding double taxation, but must meet specific requirements.
THE RELATIVE FLEXIBILITY OF AN LLC
An interesting aspect of tax classification and entity type lies in the flexibility of LLCs. Before discussing this flexibility, it’s important to discuss the limited options for the other entity types:
- If you are a sole proprietor or a partnership, you are automatically taxed under a particular classification, which may or may not be advantageous. A sole proprietor is taxed as a disregarded entity, and a partnership is naturally taxed as a partnership.
- If you choose a “corporation” as your entity type, your two options are to be taxed as a “C Corp” or an “S Corp.” If you don’t file the right form within two months and fifteen days of becoming incorporated, the IRS will automatically tax you a C Corp, which means double taxation. C Corp status makes sense for certain large corporations, but for almost all of the small business clients that we serve, C Corp status is the least desirable. S Corp status, on the other hand, is preferred for most close corporations.
- Here’s where we get to LLCs. Single-member LLCs can be taxed as a disregarded entity, an S Corp, or a C Corp. Multi-member LLCs can elect to be taxed as a partnership, an S Corp, or a C Corp. The default tax treatment for LLCs is either disregarded entity or partnership, depending on the number of owners/members. So, it’s important to consult with your CPA about filing the right paperwork to get the most advantageous tax treatment.
MAKING THE RIGHT CHOICE
Choosing the right entity type and tax classification is crucial for optimizing legal protection and tax benefits. Factors to consider include:
- Legal Entity Selection: Corporations and LLCs offer more substantial liability protection than sole proprietorships and general partnerships. If your business is not operated formally under a corporation, LLC, or limited liability partnership, your personal assets are vulnerable to your business liabilities. Choosing the right legal entity is a matter to discuss with your attorney.
- Tax Classification: The tax classification can significantly impact the business’s tax liability. S Corp status often appeals to those looking to avoid double taxation while also maximizing deductions and limiting self-employment taxes for an operating business with employees. However, being an S Corp may not be the best for a business where the main purpose is to own and rent real estate. Making the right choice can be complex, and therefore discussing this matter with a CPA is essential.
- Complexity and Costs: Corporations, including those with S Corp status, generally have more stringent reporting and compliance requirements. LLCs are a little bit easier to manage on the legal side than Corporations. In any case, complexities must be balanced against the benefits, and accountants and lawyers can help you with this.
- My Preference for Entity Type: Although it’s not absolute, I usually recommend LLCs for my clients because 1) LLCs are a little easier to manage than a corporation and 2) LLCs give clients the flexibility to choose the tax classification that best fits their business. Many people ask me to form a corporation because they heard they needed an S Corp, but it turns out that an LLC can elect to be treated as an S Corp. Conversely, if your entity type is a corporation, you cannot elect to be treated as a disregarded entity or partnership which would probably be better for owning real estate.
CONCLUSION
Understanding the distinction between tax classification and entity type is vital for business planning. However, if any of this is still confusing, please don’t feel discouraged. It has taken me years of dealing with these concepts to get to my current understanding, and I continue to learn new things to help my clients. Even the most experienced business owners use accountants and lawyers to navigate these issues.
At Bryant & O’Connor Law Firm, we guide both new and experienced business owners through these complexities, providing legal advice to complement tax advice provided by your CPA. Whether you are starting a new venture or considering a change in your existing structure, our experienced team can help you navigate these decisions to find the most beneficial arrangement for your specific needs.
Feel free to contact us at Bryant & O’Connor Law Firm for more information or to schedule a consultation. As always, our blog articles provide general information to make you think about the planning you need to do. However, blog articles are not legal, financial, or accounting advice tailored to your specific situation, so you may not rely on this or any article we produce as professional advice. Please consult with the appropriate professional for your needs.