An important, and sometimes overlooked, aspect of tax planning is selecting the appropriate entity structure for a business. While non-tax considerations often play a part, the right structure may make the business more tax efficient or provide long-term tax benefits.
Business owners tend to confront the analysis at two points: when starting the company, and years later, after the business has evolved and plans have shifted, when the question becomes whether a reorganization or tax election would provide benefits not contemplated at founding.
Getting it right at the start
At founding, the right structure usually comes down to two questions. How will you fund the business? And are you building it to keep, or building it to sell?
First, consider funding. Many businesses lose money in their early years. If you’re covering those losses out of your own pocket, some structures let those losses flow through to your personal tax return, where they can offset income you earn elsewhere.
In effect, the tax code shares in your startup costs. An LLC is often the vehicle for this.
Now consider the exit. If you’re building the company to sell it (and you can hold it for at least five years before that), some or all of your gain from the sale can be excluded from tax entirely. That benefit is generally available only to businesses organized as C corporations.
And if you plan to own and operate the business for the long haul, an S corporation enables the owners to take the qualified business income deduction (QBID), which was introduced in the 2017 Tax Cuts and Jobs Act legislation. S corporation profits, unlike partnership profits, are not subject to self-employment taxes.
While these factors may seem straightforward at the outset of the business, things can change over time. When businesses evolve in a direction that clashes with their entity structure, there are usually options.
When the business or the plan changes
Sometimes, owners who set up a C corporation because they expected to sell decide they’re keeping the business after all.
A C corporation’s profits can effectively be taxed twice — once at the company level and again when paid out to owners. For a business that’s now a long-term hold, converting to a different structure can eliminate that second layer of tax.
However, the tax rules include a waiting period after such a conversion. Sell the business’s assets too soon — within five years — and you lose the benefit.
Raising capital is another frequent trigger. A company that planned to self-fund may be looking to raise outside capital and the potential investors may have strong preferences about structure.
S corporations come with rigid limits, including caps on the number of owners and the types of ownership they can offer. The solution may be reorganizing entirely, or building a new subsidiary structure that lets investors come in on terms they’ll accept.
Similarly, founders who chose an S corporation, then wanted to grant ownership stakes to key employees, often discover the structure is too inflexible to do it cleanly. The workaround is often creating a new entity underneath the company where employees can hold their stake while the founders keep their ownership in the original structure because unwinding it would trigger a tax bill.
The lesson in each of these scenarios is the same: Your business structure is not a set-it-and-forget-it decision. It’s a tool, and tools should match the job.
Revisiting the question when your goals shift can be simple or complicated, but in most cases, the headaches of a transition are worth it to have a business structured around where you’re actually going, not just where you started.
Eliot Bassin is a partner at FML CPAs. He leads the firm’s Avon office.
