What Entity Type Is Right for Your New Construction Business?
When starting a new construction company, the owners have several key factors to consider when selecting the entity structure. These factors should take into account not only the company’s immediate goals, but the longer-term outlook as well. Key considerations might include whether the company plans to work with labor unions, maximizing liability protection, ownership transferability and tax implications.
A company’s status as a union or non-union shop can be contingent upon the chosen entity. This is important since unions act as a creditor and can make claims against the company. Below are the most common types of entity structures used and the impact of the factors above on each:
1) C Corporation
Operating as a C corporation provides legal benefits as it is considered a separate legal entity. This means the company’s debts, obligations and liabilities are its own, and creditors must rely on the company to satisfy its debt obligations, not shareholders. The shareholder’s exposure to loss is limited to their investment in the corporation. Additionally, transferring ownership in a C corporation is convenient and easy, and the entity has a perpetual existence.
The Tax Cut and Jobs Act (TCJA) brought significant changes for C corporations, including a flat income tax rate of 21% and the corporate Alternative Minimum Tax (AMT) elimination. However, owners may find removing profits from a C corporation difficult since entity/owners are subject to double taxation. This is because the profits are taxed once at the corporate level and a second time at the shareholder level upon distribution. Additionally, C corporation earnings are not eligible for the qualified business income (QBI) deduction under Internal Revenue Code Section 199(a), which the TCJA established. Instead, C corporations benefit from the lower tax rate.
2) S Corporation
Another common entity type is an S corporation. An S corporation elects to be treated as a pass-through entity for income tax purposes. Essentially, as a pass-through entity, the company’s profits and losses are passed through to its shareholders based on the percentage of stock ownership they hold. Each shareholder is then taxed at the appropriate individual income tax rate. To be eligible for the election, the corporation must meet specific requirements, such as not having more than one class of stock and no more than 100 shareholders. Additionally, nonresident alien shareholders are not allowed, and only individuals, estates, certain trusts and tax-exempt organizations may be shareholders.
From a legal standpoint, S corporation shareholders are not personally liable for the entity’s obligations. However, a shareholder who personally guarantees a debt may lose this protection. Like a C corporation, an S corporation has a perpetual existence, and ownership can be sold among eligible shareholders. As previously mentioned, the profits and losses of an S corporation are taxed by the shareholders based on individual income tax rates, with the highest bracket being 37%. While S corporation income is exempt from the self-employment tax (15.3%), it may be subject to the net investment income tax (3.8%) in addition to the corresponding individual income tax rate. The earnings of an S corporation are eligible for the QBI deduction, as established by the TCJA, which allows for a deduction of 20% against qualified business income through 2025 in many situations.
3) General Partnership
A general partnership is another type of pass-through entity that allows the pass-through of income and loss for tax purposes. Legally, each partner in a general partnership is jointly and severally liable to creditors for the partnership’s debts and obligations and has a default obligation to contribute to any of the partnership’s losses. A significant benefit worth noting is that a partnership provides flexibility in terms of ownership, as special allocations can be made for income, gain, loss, deductions, and credits. The ownership of a partnership can be transferred, and there are minimal limitations to the types of owners. However, since a partnership interest is considered a capital asset, its value can fluctuate, resulting in complex calculations when selling or exchanging it.
For tax purposes, a partnership is terminated when none of its partners are carrying on any business of the partnership. Unlike an S corporation, income from a partnership is subject to the self-employment tax (15.3%) in addition to the appropriate individual income tax rate, with the highest bracket being 37%. The earnings of a partnership may be eligible for the 20% QBI deduction on qualified business income through 2025.
4) Sole Proprietor
A sole proprietorship refers to a business owned and operated by one individual who is directly liable for any debts and obligations of the company. All income and expense items are passed through to the owner’s personal income tax return, where both self-employment and personal income taxes are applied. Since the sole proprietorship is not a separate legal entity, ownership cannot be separately transferred or exchanged. However, the assets of the entity can be. The earnings of a sole proprietorship may be eligible for the 20% QBI deduction on qualified business income through 2025.
5) Limited Liability Company
As reflected in the name, a limited liability company provides the owner or owners with limited liability protection from the debts associated with the trade or business. If an LLC has a single owner, it is not treated separately for tax purposes, leading to the owner being responsible for self-employment and income taxes related to earnings. However, if an LLC has multiple owners, it has the option to be taxed as a partnership, corporation, or S corporation. The elected classification would distinguish how the entity’s profits and losses are taxed. Ownership of an LLC can be transferred, and the tax treatment will depend on the entity classification.
When deciding on a business structure, there are many factors to consider. The above information highlights only a portion of the items that must be taken into account before starting a new company. We highly recommend consulting with the tax professionals at Dannible & McKee, LLP, or your current tax advisor, to assist you when navigating the options for entity structure.
Contributing author: Kaitlyn L. Mariano, CPA, is a senior tax manager at Dannible & McKee, LLP. Kaitlyn has over 11 years of experience overseeing tax engagements for a variety of the firm’s clientele, focusing on contractors, manufacturers, multi-state taxation and high-net-worth individuals. For more information on this topic, contact Kaitlyn at email@example.com or (315) 472-9127.