Choice of Entity: US Federal Income Tax Implications
One of the first decisions for an entrepreneur forming a new business is what type of entity to use for that business. There are certain aspects of this decision that are driven by non-tax factors – for example, the founders of a business will likely want to be shielded from personal liability for any debts or obligations of the entity as a matter of corporate law. In many cases, however, the ultimate determination comes down to the differences in US federal income taxation of different types of entities and their owners. The following will provide a high level overview of the tax implications of each type of entity from a variety of perspectives: taxation of the entity, taxation of its owners and employees and concerns of potential investors. The entities to be discussed are C corporations, S corporations and limited liability companies ("LLCs").
New business owners should also consider applicable state, local and non-US corporate and tax implications of each type of entity, which are beyond the scope of this piece.
Overview of Taxation of Different Entities
- Entity Taxation: A C corporation (so-called because the rules governing the U.S. federal income tax treatment of these entities are found in Subchapter C of the Internal Revenue Code of 1986, as amended (the "Code")) generally is subject to tax at the entity level on all of its income at a rate of 21%. All deductions, credits and other tax items are calculated at the entity level.
- Owner Taxation: Shareholders in a C corporation will not be subject to tax on the income of the C corporation until receipt of a distribution. A distribution from a C corporation is treated as a dividend to the extent of the C corporation's current or accumulated earnings and profits, then a return of the shareholder's invested capital to the extent of the amount paid for the shares of the C corporation, and then any amount distributed in excess of that amount is taxable to the recipient as capital gain. Dividends and capital gains generally are taxable at a rate of 20%, with an additional 3.8% "net investment income tax." Any amount distributed that is a return of capital will not be subject to tax for the recipient.
- Employment Tax Considerations: A C corporation will pay salaries (and, if applicable, bonuses) to its employees and such payments will be subject to income tax withholding, as well as withholding for certain employment taxes due from employees. The C corporation will also have to pay its portion of the employment taxes. Typically, a C corporation will engage a payroll service provider to assist with these processes. In addition to paying its employees in cash, a C corporation is also eligible to compensate certain employees in the form of stock and/or stock options.
- Pros: An important advantage of using a C corporation for a new business is that venture capital funds often prefer to invest in companies that are structured this way. This is for a variety of reasons, including that venture capital funds are often precluded from investing in certain other types of entities (such as S corporations which, as discussed further below, can only have certain types of holders) and certain investors in venture capital funds will often require investment in C corporations for their own tax planning purposes. For example, a non-US investor will not want to receive flow-through income from an operating LLC because such income could be treated as effectively connected with a US trade or business, which would trigger tax payment and filing obligations for such non-US investor, and a similar concern would arise for a US tax-exempt investor seeking to avoid income treated as "unrelated trade or business income."
Another advantage to using a C corporation for a new business is the potential availability of "qualified small business stock" ("QSBS") treatment for stock in the entity. Under section 1202 of the Code, gain from the sale of QSBS is excluded from income, subject to certain limitations, for a seller that acquired the stock at its original issuance and has held the QSBS for at least five years.
Lastly, a C corporation is often considered to offer the best options for the seller with respect to exit, as it is typically easier to sell C corporation stock than an entity's underlying assets, and it is typically easier for a C corporation to have an initial public offering, as compared with S corporations or LLCs. This is due, in part, to the fact that C corporation shares generally are freely transferable, while there are restrictions on the transferability of interests in an S corporation or LLC.
- Cons: The primary disadvantage to using a C corporation for a new business has been the "double taxation" that occurs when the income is initially taxed at the entity level when it is earned, and is then taxed again at the shareholder level upon distribution. While this double taxation continues to exist, the impact is lessened to some extent by the reduction in the corporate tax rate (from 35% to 21%) that took effect as of January 1, 2018 as part of the tax reform legislation enacted at the end of 2017. Another possible disadvantage to using a C corporation is that, while a seller may prefer to sell C corporation stock, purchasers often prefer to buy the underlying assets so that they receive a "step-up" in the basis of those assets. However, there are ways to structure a sale such that it will be treated as an asset sale for US federal income tax purposes, even if it was a stock sale for non-tax purposes.
- Entity Taxation: Unlike a C corporation, an S corporation (so-called because the rules governing the U.S. federal income tax treatment of these entities are found in Subchapter S of the Code) generally is not subject to tax at the entity level. In order to become an S corporation, an eligible entity must elect S corporation status within two months and fifteen days after the beginning of the tax year the election is intended to take effect (so, generally, by March 15 of that year), and an entity may only make this election if it is a US corporation with fewer than 100 shareholders, all of whom are US individuals, estates, certain exempt organizations or certain trusts, and all of whom hold a single class of stock.
- Owner Taxation: Shareholders in an S corporation are subject to tax on allocations of income to them, even if no cash is distributed in connection with such allocation. These allocations are subject to different rates of tax based on the character of the income earned by the S corporation (i.e., certain income will be ordinary income, while certain income will be capital gain). In addition, deductions, credits and other tax items are passed on to an S corporation's shareholders. As part of the tax reform legislation passed in December 2017, there is now a new 20% deduction available for certain income received via pass-through entities that are engaged in qualified businesses (generally, not service providers).
- Employment Tax Considerations: Shareholders in an S corporation must pay self-employment tax on income that is paid to them as salary, but not on amounts allocated to them out of the S corporation's profits, as compared with service-provider members of an LLC, who will be subject to self-employment taxes on all of the portion of the LLC's earned income allocated to or received by such member.
- Pros: An S corporation allows its owners to obtain the benefits of flow-through treatment for US federal income tax purposes, while providing limits on personal liability for the entity's debts. Because an entrepreneur who owns and works for an S corporation will receive income from the S corporation in the form of both salary and a share of profits, within certain limitations and reasonableness guidelines, there is flexibility with respect to how that entrepreneur structures the overall compensation package and this can sometimes result in lower employment tax liability for both the individual and the entity, as compared with using a C corporation. Calculations to maximize efficiency with respect to salary versus profits allocations will now also have to take into account the details of how the 20% pass-through deduction discussed above is calculated (as the ultimate amount that is deductible depends, in part, on the amount of wages paid by the entity).
- Cons: As a result of the flow-through nature of an S corporation, an owner will be subject to tax on amounts allocated to such owner, regardless of whether distributions have been made (a phenomenon often called "phantom income"). While it is possible to incorporate the concept of "tax distributions" (discussed further below under "Limited Liability Companies"), this can become complicated for an S corporation because of the requirement that an S corporation must have only one class of stock, which means that any distributions made must always be made pro rata in proportion to the owners' stock ownership. Preferred distributions are not permitted in an S corporation structure. Even though allocations of income must also be made pro rata, depending on other income and losses of the different owners and depending on how much cash the S corporation has to distribute in that year, certain owners could be required to cover their taxes attributable to allocations of income from the S corporation with funds from other sources.
In addition, interests in an S corporation are not eligible for QSBS treatment.
As a practical matter, due to the limitations on eligibility for S corporation status, this entity is often not an option.
Limited Liability Companies
- Entity Taxation: Unless an election is affirmatively filed to treat an LLC as a corporation for US federal income tax purposes (that is, opaque), an LLC is a flow-through entity. This means that the LLC itself is not subject to any tax at the entity level. The LLC is a very flexible entity, without any restrictions on how many members there may be, whether members are US or non-US, or what types of taxpayers the members are (individuals, partnerships, etc.).
- Owner Taxation: As the LLC is a flow-through entity, each member is taxable on allocations to such member of income, even if the LLC does not make any distributions at the time of the allocation. Similarly, items of loss and deduction also flow through to the members. As discussed above under "S Corporations," there is now a new 20% deduction available for certain income received via pass-through entities that are engaged in qualified businesses (generally, not service providers). LLC members are also eligible to receive a portion of their income from the LLC in the form of "profits interests" which, provided the grant of such interests follows all applicable rules and procedures, allow such members to share in the future profits of the LLC.
- Employment Tax Considerations: A member of an LLC who also provides services to that LLC will be subject to self-employment taxes on the portion of the LLC's earned income allocated to or received by such member. It is also important to note that members of an LLC who provide services to the LLC cannot be treated as employees of the LLC. This has various implications, including that the LLC will not withhold tax from such member's distributions (so that the member must make quarterly estimated tax payments) and such member will be ineligible for certain employee programs such as flexible spending accounts for medical, childcare and transportation expenses.
- Pros: The most important advantage of an LLC is that it offers ultimate flexibility with respect to the structure of the entity's economics, while providing limited liability for members for the entity's debts.
- Cons: The downside of the flexibility offered by an LLC is that the accompanying bookkeeping and accounting for members' capital accounts can be complex, particularly in structures where there are many different classes of interests and different allocation/distribution preferences for different members. In addition, interests in an LLC are not eligible for QSBS treatment.
Another consideration is that non-US members or investors may be reluctant to participate in an LLC because the flow-through operating income of an LLC will subject a non-US taxpayer to the US tax system. Such non-US taxpayer will have to pay US tax on certain US-source income and, often more importantly, will need to file US tax returns with the Internal Revenue Service, on which all US-source income must be disclosed.
There are advantages and disadvantages to each type of entity an entrepreneur may consider when forming a new business, from a tax perspective as well as non-tax perspectives. On the tax side, in addition to the analysis that would have been done in the past, there are new factors to consider in light of the tax reform legislation passed in December 2017 that may have a significant impact on the ultimate determination. It is important for anyone starting a new business to consult with the appropriate experts and work together with them to develop the optimal business structure going forward. Please reach out to a member of your Wiggin & Dana team to discuss further.
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