It can be the case that companies are operating under an inferior business classification — an issue that’s more common than many would think.
“They might have chosen a classification as a startup that no longer fits — they don’t have the same goal as they did when they began, so another classification would be better,” says Eric L. Dorenkott, CPA, MT, Director at Corrigan Krause. “Sometimes new shareholders enter the business, and that can change the requirements of who can own the entity. And sometimes an owner made the choice without the guidance of a professional who could have guided them to a better fit.”
Smart Business spoke with Dorenkott about the factors that determine the best classification for a business, and how and why to make a change.
Why is it important that businesses are correctly classified?
Business classification matters in part for liability reasons. For example, a sole practitioner whose company is designated as something other than an LLC can’t shield their personal assets from business risks. Alternatively, if a C Corporation has a loss, that loss is trapped in the C Corp and the loss will only be used against future income the C Corp brings in. But if the company is an S Corp, the owner of the S Corp might be able to take that loss personally against other income generated outside of the company, including personal wages.
In the event of a sale, the entity classification can change the net cash distributed to shareholders. For example, a business designated as a C Corp that enters an asset sale could have those assets taxed twice — once inside the C Corp, and then again when it’s distributed to the shareholders.
Depending on how the entity is structured, there could be a 15 percent difference in total tax to the shareholder between S Corp and C Corp. In a C Corp, the owner or shareholder could pay both corporate income tax and individual taxes. In a partnership, the owner could pay excessive self-employment tax.
Another difference is that a C Corp issues dividends while an S Corp issues distributions, each of which are taxed differently.
What is involved in changing a business’s entity classification?
To ensure the business is properly classified from the start, talk to a CPA or a tax attorney and explain to them the business and its expected trajectory. Give them projections from year one to year five. That could help determine if those losses are better taken personally or should stay in the C Corp to offset future income.
They’ll want to know if the shareholders are all U.S. citizens because the business could have unique filing requirements if they are not. They’ll also want to know the shareholder’s ultimate goal for the company. Is it to build it up and sell it in 10 years? Or is it to build and hold, or pass on to a second generation within the family?
The business should also review its entity designation when significant circumstances change. That could include when a new partner enters the company, if there is a meaningful change in income that would affect the entity’s tax bracket, or tax law changes. The time it takes to make the switch from one entity to another differs. If it’s a change from a C Corp to an S Corp, the time of year is important because such a switch must be done in the same calendar year, and the IRS must be notified by March 15. Unique to a switch from an S Corp to a C Corp is a waiting period a company must go through if it ever wanted to switch back to an S Corp. Additionally, moving either to a partnership structure takes significant planning.
It’s easy to get in the mindset of business as usual, but market conditions change as do tax laws. If the company’s entity classification was last considered when the business began, it’s time to take another look.
INSIGHTS Accounting is brought to you by Corrigan Krause.
