Incorporation and Business Transactions
Legal and Tax Considerations for Choosing a Business Entity
Educational Overview by Zaher Fallahi, Attorney at Law, CPA
Los Angeles & Orange County, California
Tel: 310-719-1040 | 714-546-4272
Email: taxattorney@zfcpa.com
Disclaimer: The following material is provided for general educational and informational purposes only and should not be construed as legal, tax, accounting, or investment advice. Business formation and taxation involve complex federal and state laws, including the Internal Revenue Code (“IRC”), Treasury Regulations, and applicable state statutes. Readers should consult qualified legal and tax counsel regarding their specific circumstances.
Choosing the Proper Business Entity: Legal and Tax Considerations
Selecting the appropriate legal entity is one of the most important decisions for entrepreneurs, investors, professionals, and closely held businesses. The choice of entity may affect liability protection, taxation, succession planning, management rights, investor relations, employment taxes, and long-term business strategy.
The most commonly used business entities include:
- C Corporations
- S Corporations
- Sole Proprietorships
- Partnerships
- Limited Liability Companies (LLCs)
Each structure carries unique legal and tax consequences under federal and state law.
I. C Corporations
A C corporation is a legal entity formed pursuant to state corporate statutes for the purpose of conducting business activities. Properly formed and maintained corporations generally provide shareholders with limited liability protection against corporate debts and obligations. See IRC §11; Cal. Corp. Code §§100 et seq.
However, corporate officers and directors may still face personal liability for breaches of fiduciary duties, including the “duty of care” and “duty of loyalty.” Additionally, under IRC §6672, responsible corporate officers may be held personally liable for unpaid payroll withholding taxes through the Trust Fund Recovery Penalty (“TFRP”).
Taxation of C Corporations
For federal income tax purposes, a C corporation is treated as a separate taxable entity under IRC §11. Corporate earnings are taxed at the corporate level, and shareholders are taxed again upon receiving dividends. This is commonly referred to as “double taxation.” See IRC §§301 and 316.
The Tax Cuts and Jobs Act (“TCJA”) reduced the federal corporate tax rate to a flat 21%, creating new planning opportunities for certain businesses. Depending on projected earnings, reinvestment strategy, and shareholder tax brackets, a C corporation may produce tax advantages in selected circumstances.
Piercing the Corporate Veil
Courts may disregard the corporation’s separate legal status under the doctrine commonly known as “piercing the corporate veil.” Factors may include:
- Inadequate capitalization;
- Failure to observe corporate formalities;
- Commingling of assets;
- Fraudulent conduct; and
- Failure to maintain corporate separateness.
See associated judicial doctrines and state corporate case law. Small closely held corporations are particularly vulnerable when owners fail to seek timely legal and tax guidance.
II. S Corporations
An S corporation is generally formed under state corporate law but elects pass-through taxation under IRC §1362.
Unlike C corporations, S corporations generally do not pay federal income tax at the entity level. Instead, profits, losses, deductions, and credits pass through to shareholders and are reported on their individual tax returns pursuant to IRC §1366.
Requirements for S Corporation Status
To qualify for S corporation treatment, the corporation generally must:
- Be a domestic corporation;
- Have no more than 100 shareholders;
- Have only one class of stock;
- Have only eligible shareholders, including certain individuals and trusts; and
- Not be an ineligible corporation under IRC §1361.
Non-resident aliens generally may not be S corporation shareholders. See IRC §1361(b)(1)(C).
Qualified Business Income Deduction
Eligible S corporation shareholders may qualify for the Qualified Business Income (“QBI”) deduction under IRC §199A, potentially allowing a deduction of up to 20% of qualified business income, subject to limitations.
Shareholder Basis Limitations
Shareholders generally may deduct losses only to the extent of their adjusted stock and debt basis. See IRC §1366(d).
III. Sole Proprietorships
A sole proprietorship exists when an individual conducts business without forming a separate legal entity.
Many sole proprietors operate under a fictitious business name or “Doing Business As” (“DBA”). Registering a DBA does not create a corporation, LLC, or other legal entity.
Liability Exposure
Unlike corporations and LLCs, sole proprietors generally remain personally liable for business debts, lawsuits, and obligations. Personal assets may therefore be exposed to creditors and litigation claims.
Although insurance may provide partial protection, insurance coverage does not eliminate exposure to lawsuits, judgments, or potential damage to creditworthiness.
Taxation of Sole Proprietors
Sole proprietors generally report business income and expenses on Schedule C attached to IRS Form 1040. See IRC §61.
They also may be subject to:
- Self-employment taxes under IRC §1401;
- Quarterly estimated tax requirements under IRC §6654; and
- Personal liability for payroll and sales taxes.
Under IRC §172, eligible Net Operating Losses (“NOLs”) may potentially offset future taxable income subject to statutory limitations.
Qualified taxpayers also may qualify for the IRC §199A Qualified Business Income deduction.
IV. Partnerships
A partnership generally exists when two or more persons join together to carry on a business for profit. See IRC §761(a).
Partners may contribute money, property, labor, or expertise as partnership capital.
Allocation of Profits and Losses
Partnership allocations are often governed by the partnership agreement and Treasury Regulation §1.704-1, including the “substantial economic effect” rules under IRC §704(b).
The partnership agreement typically addresses:
- Profit and loss allocations;
- Capital contributions;
- Management authority;
- Indemnification provisions; and
- Dissolution procedures.
Liability of Partners
General partners may be personally liable for partnership obligations. Limited partners generally enjoy liability protection limited to their invested capital, provided statutory requirements are met.
Taxation of Partnerships
Partnerships generally file informational returns on IRS Form 1065 under IRC §6031. Although partnerships generally do not pay income tax directly, taxable items pass through to partners via Schedule K-1.
Partners report their distributive shares on their personal returns and may also owe self-employment taxes depending on their level of participation.
Eligible taxpayers may qualify for the IRC §199A deduction.
V. Limited Liability Companies (LLCs)
A Limited Liability Company (“LLC”) is a legal entity created under state statute that combines selected liability protections of corporations with the operational flexibility of partnerships.
Owners are commonly referred to as “members.”
Liability Protection
Generally, LLC members are not personally liable for LLC debts solely by reason of being members. However, managers or managing members may still face liability for unpaid employment taxes, sales taxes, or wrongful conduct.
Flexible Tax Treatment
For federal tax purposes, LLCs may elect to be taxed as:
- Disregarded entities;
- Partnerships;
- C corporations; or
- S corporations.
See Treasury Regulation §301.7701-3 (“check-the-box regulations”).
Passive Activity Rules
Under IRC §469, LLC losses may be limited by passive activity loss rules depending on member participation and structure.
Charging Order Protection
Many state statutes provide LLC members with “charging order” protection, limiting creditor remedies against membership interests.
California LLC Considerations
California imposes annual franchise taxes and LLC fees under Cal. Rev. & Tax Code §§17941 and 17942, including:
- Minimum annual franchise tax;
- Gross receipts LLC fees; and
- S corporation entity-level taxes.
Certain licensed professions, including law, medicine, and public accounting, generally may not operate as California LLCs under California law.
International and OFAC Considerations
International investors and foreign-owned businesses may also face federal sanctions compliance issues administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”). Counsel advising international clients should evaluate applicable sanctions programs, anti-money laundering (“AML”) obligations, and related federal regulations.
Conclusion
No single business entity is ideal for every situation. The appropriate structure depends on multiple factors, including:
- Liability exposure;
- Tax objectives;
- Investor expectations;
- Estate planning goals;
- Employment tax considerations;
- International ownership issues; and
- Long-term succession planning.
Careful legal and tax planning at the entity formation stage may significantly reduce future disputes, tax exposure, and operational inefficiencies.
Zaher Fallahi, Attorney at Law, CPA
Los Angeles & Orange County, California
Tax Controversy • Business Formation • International Tax • Asset Protection • OFAC Compliance • Estate Planning
