With changing tax rates and pending legislation, choosing the right type of entity for your business is becoming increasingly more difficult.
“It is much less clear now in what form you should operate your business from a tax standpoint,” says Mark Klimek, chair of the Tax Practice Group at McDonald Hopkins LLC. “With the changes in tax rates, does it still make sense to set up your business as a limited liability company? The analysis used to be pretty straightforward, but it has become much more difficult.”
Smart Business spoke with Klimek about how to determine which type of entity will work best for your business and how having an exit strategy can simplify that decision.
How can a business owner begin to determine which type of entity to select?
The ideal option is one that allows you to maintain flexibility and operate your business in a form that would allow a change in the future, if needed. For example, if you operate as an S corporation and it turns out that a C corporation would be more advantageous, you can generally terminate the S corporation election without tax consequences. If the business is an LLC or a partnership, you can usually convert the business to a corporation on a tax-free basis. You normally cannot convert a C corporation to an LLC or partnership without it being a fully taxable transaction.
It is also important to accurately forecast and plan for what is likely to happen with the business in the future. If you know you will keep the business during your lifetime and simply draw a salary, that is one analysis. But it is a different analysis if you plan to build the business up to its maximum value and then sell it in five years. For the exact same business, those different exit strategies might dictate a different type of entity.
Should you plan your exit strategy before you start your business?
If possible, yes. If a business owner could predict with certainty what was going to happen with the business from start to finish, it would be very simple to determine which entity type would best suit it. And although predicting with certainty is impossible, a business owner should engage in the process of planning for the life cycle of the business and keep the end in mind. You do not have to determine an exit strategy to make a choice on entity type, but it does help.
How have recent changes in the tax law impacted the choice of entity?
First, the individual income tax rate will be going up in 2011; 2010 is the last year of the Bush tax cuts. Without any legislation — and none is expected — these rates will increase. So for businesses that are LLCs or S corporations, which pass through income to their owners, the owners’ tax bill will be higher next year.
Another factor is that dividend rates are potentially more than doubling in 2011 for some taxpayers, because without further legislation, dividends will be taxed as ordinary income, increasing from 15 percent to nearly 40 percent for higher income individuals. If the business is a corporation that puts all of its profits back into the company to stimulate growth, then increased dividend rates will not have as much of an impact. For a corporation that does not have cash needs and instead distributes its profits as dividends, the increased dividend tax rates will have a significant impact.
