Choice of Business Entity for the New Millennium
I. Types of Entities
A. Sole Proprietorship
Business is conducted in owner's individual capacity. Individual uses assets it owns for business purposes. Sole proprietorship is not a separate entity for federal tax purposes. Income and loss reported on individual's income tax return on Schedule C (or Schedule F if the sole proprietorship is a farming operation).
B. General Partnership
An association of two or more persons to carry on a business for profit but excluding an association formed under a non-partnership state statute. A partnership is an entity that is distinct from its partners.
C. Registered Limited Liability Partnership
A registered general partnership is a partnership in which, similar to a limited partnership, owners are shielded from personal liability for debts of the partnership and other partners.
D. Limited Partnership
A partnership formed by two or more persons under state law having one or more general partners and one or more limited partners. Only limited partners are shielded from debts of partnership. General partners are liable for all debts not covered by partnership.
E. Limited Liability Company
An entity organized by one or more persons formed under state law. It is a hybrid entity providing limited liability to its members similar to that of a corporation but still benefits from flow through tax treatment.
F. C Corporation
An entity created by state law that is distinct from its owners. The entity may be closely held, where there are only a few shareholders, or may be publicly held, where there are a large amount of shareholders and the stock is sold on a public market. The corporation is taxed separately from its owners, thus may result in a double tax (one at the corporate level and one at the shareholder level).
G. S Corporation
An entity created under state law that is formed as a corporation but may elect to have only its shareholders subject to tax. Limitations exist as to the type and number of shareholders and the classes of stock.
H. Qualified Subchapter S Subsidiary (QSUB)
An S Corporation wholly owned by a parent S Corporation. Taxed as a division of parent.
II. Considerations in Choosing a Business Entity
A. Corporate Level vs Flow Through Tax Treatment.
- i) C Corporations. C Corporations taxed at corporate level and again on distributions to shareholders. Particularly painful in the event of sale of assets. Sometimes preferred by:
a) venture capitalists. Avoids risk of flow through of income without corresponding cash distribution.
b) tax exempt entities. Avoids risk of Unrelated Business Income Tax in the event of joint venture with for profit entities.
c) governmental agencies. May want losses to carry over to later years.
d) foreign investors. Avoids exposure of nonresident aliens to U.S. income or estate tax. Avoids permanent establishment treatment for foreign corporations.
e) accountants. Deduction for fringe benefits; non calendar fiscal years, graduated rates; eliminate income through year end bonuses.
(f) employee benefit planners. Incentive stock options are only available for C Corporations.
ii) Flow Through Entities. No entity level tax for federal income tax purposes for S Corporations, LLCs and Partnerships. Favored by:
a) family owned businesses. Income and losses flow directly to family members.
b) closely held businesses. Avoid double tax on sale of business; avoid risk of excess compensation issues.
c) estate planners. Ability to take discount on transfers and step-up in basis in the event of death.
d) joint ventures. Large corporations commonly use partnerships and LLCs for joint venture arrangements on projects involving a number C corporations.
III. Comparisons of S Corporations to LLCs.
S corporations and LLCs are both pass through entities that avoid, in most instances, entity level tax. This common attribute has been mistaken by many practitioners for the proposition that both entities are subject to the same taxing schemes. In fact, the similarities start and end here. LLCs offer many tax advantages to S corps and should generally be given first preference in choosing the entity type for your client. As will be discussed throughout this outline, there are still certain advantages to S corps that must be kept in mind when doing tax planning.
A. Recent changes to S corporation rules.
- Pension and Profit Sharing Trusts.
- 501(c)(3) organizations
- ESOPs (however, lose ability to roll over stock) .
- 75 shareholders
- estates for two years.
i) S corporation can have wholly-owned qualified S corporation subsidiaries (QSUB). QSUBs are treated as "tax nothings" for tax return purposes. Treated as a division of parent S corporation.
ii.) S corporation can own any number of stock of C corporation. C corporation subsidiaries can file consolidated return but S corporation parent cannot be included.
iii) Expanded list of eligible shareholders. .
B. Final check the box regulations.
Reg. 301.7701-1 provides that domestic LLCs will automatically be taxed as partnerships unless an affirmative election is made to be treated as a corporation. LLCs can now have limited liability, centralized management, free transferability of interest, and continuity of life, and still have federal tax partnership classification.
C. Advantages of LLCs.
i) Management. Duties and responsibilities of corporate directors and officers based on longstanding case history and state law. Less flexible than LLCs in which because of lack of outstanding case law, may be based more on contractual arrangements.
ii) Ownership. S corporations are restricted as to the pool of owners. No corporations (other than parent S corporations), LLCs or partnerships can be shareholders nor can non-resident alien shareholders. In addition, not all trusts are eligible to be S corporation shareholders. The inability to have C corporation or foreign shareholders effectively cuts off the ability to raise funds from foreign investors. There is no limitation on the other hand on who can be a member of a LLC.
iii) Financing Flexibility. Several restrictions impede the use of creative financing techniques by S corporations:
- a). Single class of stock. S corporations cannot provide a liquidation or distribution preference to a shareholder. Even shareholder agreements must be sanitized to avoid a prohibited second class of stock. For example, cannot set the redemption price at significantly below or in excess of fair market value of the stock. S corporations can, however, enter into the following types of arrangements.
- Qualified straight debt. Qualified straight debt is sum certain debt with interest not contingent on profits and not convertible into stock.
- Non-voting common stock.
- Options (other than "in the money" options), phantom stock or stock appreciation rights for joint ventures with persons or entities not able to be shareholders of S corporations.
- multiple classes of equity interests
- distribution and liquidation preferences
- special allocation of tax items
- equity flavored debt (which may include a debt-to-equity conversion privilege)
b) Debt basis for investment. Members of debt financed LLCs enjoy the benefit of obtaining additional basis for their share of entity level debt. For example, if an LLC member is required to guarantee LLC debt then he will receive additional basis for the amount of the guarantee. Debt basis may be important in the case of highly leveraged entities in which losses exceed investors' cash contributions. In addition, debt basis may allow a member to receive tax free distributions to the extent of a members' share of liabilities. An S corporation shareholder only is credited with basis to the extent of cash contributed and direct loans. It does not include guarantees in basis. Distributions to an S corporation shareholder in excess of basis will be taxable and an S corporation shareholder may not be able to deduct losses in excess of basis. Often tax practitioners will recommend to S corporations that third party financing flow directly to the shareholder who, in turn, reloans the proceeds to the corporation in order to increase the shareholders' basis. This collateralization however could be problematic as a shareholder may be required to expose personal assets to creditors.
c) Type of equity holder.
- S corps exclude foreigners from equity participation which may be a significant impediment to expansion
- S corporations preclude C corporations as investors. It has become common for C corporations to enter into equity arrangements with customers or with suppliers
- a). Allocation of income. LLCs have broad latitude in allocating income and losses among members. An LLC may allocate income and loss to members pursuant to its operating agreement, provided such allocations have substantial economic effect. Not only may preferred returns be provided, but allocations may be tailored to take into account the different tax postures of the individual investors. On the other hand, an S corporation may issue only one class of stock and must allocate income and loss on the per share basis. There is no allowance for preferential returns to investors. In addition, an LLC can ameliorate the potential for a cash contributing member to be charged with the built in precontribution gains attributable to the asset transferred to the LLC. Under partnership rules, depreciation on the built in gain would be allocated to the cash contributing partner and any gain on sale would be allocated to the contributing partner. No such provision however exists for S corporations. A cash contributing shareholder will bear a portion of the tax consequences that are inherent in the properties held by the S corporation.
b).Step up in basis. An equity investor has the ability to obtain a step up in basis in the assets if he pays a premium over the book value when he purchases a membership interest from an existing member. Code § 743 allows the LLC to elect to adjust the basis of its assets for the benefit of the acquiring member. This is of particular importance in light of the ability to take a fifteen year write off on certain intangible assets. On the other hand, there is no ability to step up the basis of S corporation assets unless the purchaser acquires more than 80% of the stock and makes a 338(h)(10) election.
- a) Equity interest received for services. Receipt of a profit interest for services by an LLC member is not taxable provided there is not a certain predictable stream of income from LLC assets and the recipient does not immediately dispose of the interest. A service recipient's receipt of stock of an S corporation however will be fully taxable unless the stock is forfeitable and non-transferable. Such restricted stock however will be taxable when the forfeitability and nontransferability restrictions lapse.
b) Employee incentives. S corporations may enter into certain deferred compensation arrangements, such as phantom stock plans and stock options that will not violate the one class of stock requirements however many prospective employees may demand more of an equity interest. With an LLC, employee may obtain an equity interest based on future profits from a business segment, returns on capital investment or preferred allocations of income.
- a) Pro rata distributions. S corps must make distributions on a pro rata basis to shareholders. No ability to make preferential distributions. An LLC may make preferential distributions to members.
b) Appreciated property. Distributions of appreciated property from S corporations are taxable to the corporation. Distributions generally of appreciated property from an LLC are not taxable to LLC members, other than unrealized receivables or substantially appreciated inventory.
c)Redemptions. An LLC can make an election to step up the basis of assets for remaining members in the event of the redemption of a member. No such election is available for S corporations.
As previous mentioned, LLCs have very desirable tax characteristics. They had the tax attributes of partnerships (which provide tremendous flexibility in the allocation of profits and losses), no double tax on the sale of assets and no potential dividend issues. They also have limited liability for owner. LLCs however are not the natural choice in all cases. Many closely held business continue to operate as S corporation for some of the following reasons:
- i) Sales or Exchanges. Sale of stock by a shareholder of an S corporation results in capital gains treatment regardless of the type of asset in the corporation. On the other hand, on the sale of partnership interest the selling partner may be subject to ordinary income on his portion of unrealized receivables and substantially appreciated assets. Unrealized receivables are accrued income items not yet recognized for tax purposes and income that would be treated as ordinary income under a host of recapture rules, including § 1245. Substantially appreciated assets are inventory whose fair market value exceeds 120% of its basis.
ii) Tax Free Exchanges. Shareholders of an S corporation can exchange their stock in a tax free reorganization under § 368 which is not available to LLC members.
iii) Public offering. Corporate status will facilitate a public offering. A corporate form is the preferred form for public entities and although an LLC can be incorporated prior to a public offering, there is additional expense in converting.
iv) Employment taxes. As long as an S corporation pays a reasonable salary, a shareholder recognizes no self-employment tax or Medicare tax on earnings from an S corporation. Assuming that a shareholder has already reached $68,800 maximum self-employment tax, he can save 2.9% tax on flow through income in excess of $68,800. Active members of an LLC must include in self-employment income all of their share of the LLC's income. An active member of an LLC will include a member that is personal liable for entity debts by reason of being a member; has authority to contract on behalf of the entity; or participates for more than 500 hours in the trade or business of the LLC.
v) Formation of entity. Built in gain on appreciated property contributed to and S corp. does not have to be allocated to the contributing member as in the case of an LLC. In addition, ordinary income type property can be cleansed of their ordinary income taint if contributed to an S corporation under certain circumstances. There is also no tacking on the holding period of contributed property for purposes of taking capital losses. In addition, there is no restriction on the distribution of cash from the S corporation after the contribution of appreciated property which is the case with an LLC.
vi) Complexity. LLCs generally are more complex that S corporations. An S corporation is very simple entity to form. The preparation of an LLC operating agreement can be more flexible and therefore can be more complicated. Secondly, an LLC partnership return is sometimes more difficult to prepare than an S corporation return.
vii) Lenders. Sometimes lenders are more familiar with S corporations than LLCs and may not be fully prepared to lend to an LLC.
viii) Ordinary Loss Treatment. An S corporation shareholder may be entitled to an ordinary loss on the sale of originally issued shares of the S corporation. This however is limited to $100,000 and is not usually something that is planned for when forming an entity.
1. Transfer of LLC interests may be discounted for lack of marketability and for lack of control. Extensive litigation of a variety of fact patterns. IRS has withdrawn rulings that family share ownerships are combined for valuation. Excessive retention of control of the entity by the transferor may cause the transferred interest to be included in the transferor's taxable estate. Excessive diversion of income to the transferor or excessive right to compel accumulation of income may cause the transferred interest to be included in the transferor's taxable estate.
2. Rules relating to LLPs are similar to those of LLCs.
3. S corporations have limits as to who may be stockholders. Certain trusts may be permitted shareholders: (1) grantor trusts; (2) grantor trusts which continue for two years following the death of the grantor; (3) a trust with respect to stock transferred to it pursuant to the terms of a will, but only for the 2-year period beginning on the day on which such stock is transferred to it; (4) a trust created primarily to exercise the voting power of stock transferred to it; and (5) an electing small business trust which may not among other things may not be a charitable remainder annuity trust or charitable remainder unitrust. A qualified subchapter S trust is treated as a grantor trust if during the life of the current income beneficiary there is only 1 income beneficiary of the trust, any corpus distributed during the life of the current income beneficiary may be distributed only to such beneficiary, the income interest of the current income beneficiary in the trust shall terminate on the earlier of such beneficiary's death or the termination of the trust, and upon the termination of the trust during the life of the current income beneficiary, the trust shall distribute all of its assets to such beneficiary. Additionally, all of the income of which is distributed currently to 1 individual must be made to a citizen or resident of the United States.