Question

A&B (two individuals) wants to organize an entity to combine their two businesses. Assume the business will average $1 million of taxable income from the combined businesses. What entity would you advise your client to form? Please include in your discussion a compare and contrast of the different forms of business regimes including a discussion of a corporation, an S corporation, partnership and a limited liability company. Also, include in your discussion the different tax consequences between the different types of entities including which of these regimes requires the business entity to pay tax on the income earned and which of these regimes requires the entity owners to pay tax on the income earned by the entity.

Discuss the short term vs. long term benefits / detriments of each form of business regime.

Answer 1

Partnership

Since in the given scenario, there are two individuals involved and the business is going to be owned and operated by more than one individual, they can structure their business as Partnership. There are two forms of partnership : The General Partnership and Limited Partnership. Assuming both the partners would be actively managing the organization, the General Partnership would be a better choice. With respect to the tax treatment enjoyed by the Partnership Firm, it does not pay taxes on its income but "passes through" any profits or losses to its individual partners. Here each partner is required to report his or her share of income in the prescribed schedule to the IRS (Inernal Revenus Service) . One of the major concern of structuring a business as General Partnership is Personal Liability. As General Partners are personally liable for the Partnership's debts, obligation and other liabilities.

Coporation

Another way of Struturing a business is Coporate structure, though it is complex to form. It enjoys the benefit of Seperate Legal Entity i.e. seperate from its owners. Due to which the business owners gets the advantage of Liability protection. As the Corporation Debts and obligation would not be considered as of its owners and their personal assets would not be at risk anymore. Additionally the corporation can retain some of its profits without paying tax on them. Another advantage is that it is easier to raise funds when business is structured as Coporation.

The downside the corporate structure faces are Higher cost to form and requries more tax praparation and accounting services. The major downside is that the owners end up paying double tax on their business earnings. As Corperations are subjuct to corporate income tax both at federal level and state level but if any earning is distributed in the form of dividend to the shareholder, then such dividend is taxed at individual level i.e. at individual tax rates on their personal tax returns.

S Corporation

Small Business owner can form as S Corporation rather than a regular corporation. As It enjoys some appealing tax benefits and also provide the Liability Protection to the business owners. Here in S Corporation income or losses are passed through to the shareholder and included on their individual tax return. Additionally when owners in S corporation does not have any inventory, then they can follow the cash method of accounting instead of accrual method. Which mean income is taxable when received and expenses are deuctible when paid.

The downside of S corporation are higher cost to structure. and at the same time subtect to many rules and regulation.

Limited Liability Company (LLC)

LLC is basically a Hybrid entity which has the best features of Parnership and Coporation. The main purpose of Structuring the business as LLC is to provide the owners with the benifit of Liability protection which is enjoyed by the Corporation but without double taxation. As earnings or losses are passed through to the owners which are to be included in their personal or individual tax returns. It may sound similar to S corporation but unlike S Corporation any one can become the member of LLC whether it is an individual or Partnership Firm. Also it does not have any restriction on maximum number of members or shareholder unlike S Corporation.

Since the LLC is formed by filing the document with the state. If the owners intend to operate LLC in different states then one has to determined how one state is going to treat the LLC in another State. For doing that a Professiona service w.r.t. accounts and taxation would be required.