Entity Selection

Entity Selection - Business man and business woman working on computerThe selection of an appropriate entity through which to conduct business must be made in context of the income tax, reporting, banking or personal requirements of the investors. In many cases a business structure becomes complex as a result of the various needs of investors, bankers, members, shareholders or partners.

A business beginning operations must decide on the most advantageous form of legal entity in which to conduct its operations. Many factors will affect this decision. Among them are the following:

(1) taxation;
(2) protection from personal liability;
(3) ease versus complexity of operating and organizational procedures; and
(4) ability to raise capital.

Among the more common types of entities from which to choose are the following:

(1) Sole proprietorship.

(2) Partnership. Partnerships are generally divided into limited and general partnerships. They are pass-through entities—that is, they are generally not taxed at the entity level.

(3) Limited liability company (LLC). LLCs are generally treated as partnerships for tax purposes, but offer limitations from personal liability similar to C corporations.

(4) C corporation.

(5) S corporation.

(6) Trust.

In Canada, an entity assumes its form upon registration or incorporation.  So an entity which is incorporated either federally or under the laws of a province is considered a corporation, and a partnership or sole proprietorship registered under provincial law is considered a partnership or sole proprietorship.

In the United States, most entities can be classified after registration according to an entity classification system.

The check-the-box regulations establish a regime for entity classification. The rules provide a mandatory classification for federal tax purposes for some organizations and a procedure for electing a classification for other organizations. The general approach of the regulations is that a business entity with two or more members is classified as either a partnership or a corporation, and entities with one member are either classified as a corporation or are disregarded altogether. Thus, a single-owner limited liability company (LLC) will be treated as a sole proprietorship, unless it elects to be treated as a corporation. Numerous courts have held that the check-the-box regulations are reasonable and are a valid exercise of the IRS's authority. Thus, if a single-owner LLC does not make an election to be treated as a corporation, the owner may be liable for taxes that have not been paid by the LLC.

A corporation is defined as an entity organized under a federal or state statute, or a statute of a federally recognized Indian tribe, that describes or refers to the entity as incorporated, as a corporation, as a body corporate, or as a body politic, and certain other entities, including entities classified as associations under the rules. By contrast, a partnership is defined as a business entity that is not a corporation under these rules and has at least two members. A business entity that has a single owner and is not a corporation is disregarded as an entity.

The question of classification is made easy by the default rules, which classify an entity as either a partnership or as a corporation and allow entities to change their classification by election if they so desire. The first question in classifying an entity is whether it is a business entity, which is an entity recognized for federal income tax purposes (including an entity with a sole owner that might ultimately be disregarded for tax purposes) that is not properly classified as a trust or other special entity under specific provisions of the Code. If an entity is properly classified as a trust or as a special entity under the Code, those rules will apply to classify the entity, rather than the check-the-box rules. For example, if the single owner of a business entity is a bank, the special rules that apply to banks continue to apply to the single owner as if the wholly owned entity were a separate entity.

Several types of business organizations specifically are classified under the regulations as corporations and are thereby denied the option of electing their classification. These entities include all incorporated entities; heavily regulated entities, such as joint-stock companies, insurance companies, and banks; entities wholly owned by a state or municipality or a foreign entity; and a variety of specific business entities listed in the regulations that are organized in a foreign country or the European Union. For example, a business entity organized in Belgium as a Societe Anonyme or in the European Union as a Societas Europaea, or a Bulgarian Aktsionerno Druzhestvo must be classified as a corporation for purposes of U.S. federal tax law.

Business operations which may be local, or which involve activities in many countries must be considered carefully to ascertain an appropriate structure which satisfies both the needs of the investors, and the requirements set out by taxing authorities, banks or other third parties.  Please contact us for a review of your business plans.