The form of ownership you choose for your company can have lasting legal, financial, and tax implications as you consider an exit.
The choice of a business tax structure in the US significantly impacts the sale of a business. In a sole proprietorship or partnership, the sale may be treated as the sale of individual assets, potentially leading to higher taxes. In contrast, a sale of a business structured as a corporation might involve selling shares, offering potential tax advantages like capital gains treatment. Limited liability companies (LLCs) offer flexibility, allowing owners to choose between corporate or pass-through taxation, affecting the sale dynamics based on their decisions. Ultimately, the chosen tax structure influences the tax implications and potential benefits for both the seller and the buyer.
Here’s a review:
~Sole proprietorship — Under this arrangement, one person owns 100% of the business. Taxes are paid using a regular Form 1040, with the addition of a Schedule C to report profits and losses, and a Schedule SE for self-employment tax. While a sole proprietorship is easy to establish, since you and your business are considered the same entity, you potentially face unlimited personal liability if you are sued or become unable to pay your debts.
~General partnership — A partnership is essentially two or more business owners operating under one entity. Ownership can be divided any way the partners see fit, and partners report only their portion of profits or losses on personal income tax forms. As with sole proprietorships, partners can be held personally liable for the debts of the partnership.
~Limited liability company (LLC) — An LLC retains the tax structure and flexibility of a general partnership, but without the personal exposure to liability. Instead, the LLC itself is responsible for company debts and any potential legal claims.
~C-corporation; S-corporation — Corporations also shelter owners from personal liability, but C-corporations get taxed twice — once as a corporate entity and again on the owners’ personal income that is passed through as dividends. In most states, S-corporations avoid the double-tax dilemma by passing profits directly to owners, but they are mired in special rules and regulations that make them more complicated to administer.
All corporations start as a C-Corporation. The founders may elect to receive pass-through treatment by electing an “S-Corp” within a certain number of days (180) from the corporation formation. If the S election is not made in that time, then, upon sale, if the entity has not been an “S-Corp.” for 10 years, then the tax treatment at the sale will revert to the “C-Corp” treatment.