There are a number of variables that will suggest appropriate entity selection. In my experience three factors are most considered: limited liability, governance (control and compensation), and tax treatment.
The primary factor is limited liability. An individual should not do business unless it is through a limited liability entity. Limited liability protects the business owner from the claims of outside creditors of the entity and also protects from the liability that could accrue to an owner from the actions of another owner. Generally the choice of limited liability entities is between a corporation and a limited liability company (“LLC”).
The next factor is governance. With respect to the number of owners, recent court decisions suggest that a single owner of an LLC will not have as much liability protection as the single owner of a corporation. Moreover, the governance and compensation issues are different between an LLC and a corporation. For example in a corporation each owner would vote shares of stock on ownership issues (electing a board of directors and officers) and typically an owner would exercise one vote as a director on the board of directors (setting compensation) and receive compensation as an officer (employee) of the corporation. With a limited liability company the member is not an employee of the company and profits of the company are allocated to the capital accounts of the owners (members) in the proportion of their capital contributions. A member will not have control unless the member is designated a manager by the member or members contributing the most capital. The number of owners and the amount they invest will influence control and compensation issues of the entity.
Tax treatment generally involves three choices: corporate (“C corporation”), S corporation, and LLC. A C corporation is taxed as a separate taxpayer on the money it earns (filing a form 1120). Money in a corporation can be transferred to a shareholder in three ways: compensation (salary and bonus), dividends, and loans. Often the warning is given that the C corporation shareholder will incur “double taxation.” While this can happen, well-run C corporations are able to utilize the deduction for wages and bonuses, along with other benefits regarding fringe benefits and retirement planning to reduce or eliminate this effect. The shareholder of an S corporation is liable for tax on the income of the S corporation but the S corporation does not have to pay tax (filing an informational form 1120s with a k-1 to the form 1040 of the shareholder). Since much of the profit of the S corporation can come to the shareholder as a dividend without additional tax, advisors frequently recommend that S corporations pay small salaries to shareholders to limit amounts paid to withholding and government trust accounts. The owner (member) of an LLC receives in the member’s capital account an amount from LLC earnings in proportion to the balance of that owner’s capital account to all other owner’s capital accounts. (An LLC files a partnership form 1065 with a k-1 to the manager’s form 1040.) This entire amount will be subject to self employment taxes. S corporations and LLCs can “pass through” losses incurred by the entities to the extent of basis (the money invested). Entity selection involves a complex decision tree.
Hopefully this answer has convinced you to do a thorough analysis involving all the owners with accounting and legal advice before the selection is made.
