Accountants often face a difficult task when approached by clients who want to start a company. The clients have business plans and dreams but may have no clue how to structure a company, and they likely don’t know how this important structural decision can affect them down the road.
That’s why CPAs need to help clients figure out their choice of entity—be it a sole proprietorship, limited or general partnership, limited liability company (LLC), S corporation, or C corporation.
So how do they help their clients figure out which entity is best for them? The first step, sources say, is simply to ask a lot of questions before any paperwork is filed.
“Ultimately, you have to listen to the client and hear what they want to do and how they expect things to go—and then you react accordingly,” said Mark Schneider, J.D., principal for Deloitte Tax LLP and an adjunct professor of law at Georgetown University.
Keep it simple for clients
The challenge is in simplifying things for clients and “figuring out what is relevant to them, without overwhelming them,” added Daniel Rowe, CPA, a principal at Green Hasson Janks in Los Angeles who specializes in partnership and S corporation taxation. Rowe said there is not a one-size-fits-all approach, and the difficulty in explaining the various structures lies in the fact that there are so many variables, including number of owners, state laws, financing, tax rules, and future hopes or plans. Clients also need to consider the tax, legal, and operational impacts each type of entity will have on its respective business.
CPAs first need to find out where their clients plan to do business. Each state has its own rules when it comes to entities, and these rules can impact the bottom line. For example, Rowe said, “California has an entity-level tax on S corps. at 1½% of income, and the state has an LLC fee that is based on gross revenue.”
Practitioners need to be prepared to help clients understand both the tax and nontax considerations of each choice. Nontax considerations include ease and cost of formation; flexibility of structure (and whether it can change as the business grows); who is liable for the business’s debts; compensation arrangements; and, if outside investors are needed, what structure will be most attractive to them.
Tax considerations include, of course, whether the entity will be taxable, but also whether the owners will be liable for self-employment tax on all distributions, and the availability and impact of check-the-box elections.
LLCs allow for more flexibility in determining the type of governance of the company. Flexibility is also a key point when comparing S corporations and partnerships. Simply put, Rowe said, “If you are comparing an S corp. and partnership, the S corp. is the simpler choice, but it has less flexibility. The partnership offers a lot more flexibility, and with that comes a lot more complexity.”
Determine the economics
Accountants should also determine the economics of the business—such as how the company will deal with profits and losses, how earnings will be funneled back to the business, and how the owners plan to be compensated.
CPAs also need to find out how the business will be financed. Will the owners finance it, or will they seek outside investors? In general, C corporations are the most attractive to investors, such as venture capital firms or angel-backed companies, due to tax and administrative reasons. Also, accountants should assess if the clients will finance the business through debt or put in capital. “Do they expect to be profitable initially, and if not, then when?” Rowe added.
While tax decisions may not drive the choice-of-entity decision, CPAs should make sure clients are clear on the tax impacts and explain the differences. “S corps. are simpler than partnerships in taxation,” Schneider added. “An S corp. is very straightforward.”
Self-employment tax liability can be a surprise for new business owners. “In an S corp. the income that flows through to the owners is not subject to self-employment tax, but in a partnership it could be,” Rowe said.
Additionally, if the company plans to do business abroad, a number of tax and nontax issues need to be considered to ensure that the entity chosen is the best from a global perspective.
CPAs should also address liability, explaining for each type of entity who will be liable for business debts.
Finally, accountants should ask about plans for the future. “You just can’t look at this year,” Rowe advised. “You have to look at your clients’ ultimate plans for the company. Do they expect to bring in foreign investors? Do they want a second class of ownership later? Is this a company that they plan to grow and sell? Transition it to family?” If clients may want to convert their company to a different type of entity later, for example, they may want to consider an LLC, which offers more flexibility in transitioning to a new entity.
CPAs—and a client’s counsel, as well—should ask these probing questions, and the answers will help them figure out the best entity to choose for their clients and the tax and legal impacts of each choice.
Cheryl Meyer is a freelance writer based in California.