COMPARISON OF THE MAJOR FACTORS IN CHOICE OF BUSINESS ENTITY
The Issues in Choosing a Business Entity
The organizers of a new business enterprise must decide upon the most beneficial structure for their venture – both from the business law and the tax law perspectives. Multiple planning objectives are often applicable in this context, i.e., to choose that business entity form which provides both
a. The greatest federal and state income tax planning benefits, and
b. Advantages for business law planning (particularly the limitation of any potential liabilities otherwise applicable to the business owners).
The determination of the choice of business entity structure includes various fundamental inquiries:
1. How will the income and tax distributions from the enterprise be allocated?
2. How will the rights for decision making and management in the enterprise be allocated?
3. What type of liability protection is desired to enable the owners to be protected from the debts of the enterprise?
4. Who will share in the equity growth of the enterprise, and in what proportions?
5. What will be the best structure from the federal income tax perspective?
6. If a family enterprise is involved, what will be the preferred structure from the perspective of assuring the best ownership succession within multiple generations?
7. What state tax issues will be important, and will these questions necessitate consideration of the tax rules in several states?
8. What individual income taxation issues might be significant, including, particularly, when differentiating between the treatment of employees and owners?
9. Might state law considerations be important, e.g., might the organizational form dictate (a) when an enterprise needs to qualify for business in a particular state, (b) whether it can sue in the courts of a particular state, and (c) whether its contracts are enforceable through the courts in a particular state?
For income tax planning purposes, a variety of objectives may be examined, including, for example:
1. How can income taxes on the profits of the business enterprise (or the investment activity) be either currently minimized or deferred (or both)?
2. How can any business enterprise tax losses (or investment losses) be used advantageously – particularly to offset other income, including, possibly, the income of the owners of the business enterprise?
3. How can increases in the value of the equity of the business best be protected from future income and estate tax liabilities?
4. How can assets be transferred into and out of the entity on the most tax efficient basis?
5. Do special federal tax rules such as the “at risk” provisions and the alternative minimum tax regime apply differently to certain types of entities, or certain activities of enterprises, so as to encourage the use of one entity form rather than another?
The tax status not only impacts how the business is taxed, but also how the owners can be compensated by the business and the availability of certain employee benefits.
For planning purposes, a mixture of expert advice from a variety of sources often will be important in making the choice of the particular business entity to use, including:
1. The tax adviser
2. The business law attorney
3. The financing and banking experts and
4. Other types of business management and investment specialists
While there are numerous factors involved in the choice of business entity, our time limitations only permit consideration of the major factors that are utilized in the decision to utilize a particular business entity.
Because limited liability companies may operate as a sole proprietorship, disregarded entity, a partnership, or an association taxed as a S or C corporation, they will be dealt with under the partnership category.
Adding a New Owner C or S Corporation
A corporation may only add a new owner, tax-free, if the new owner receives 80% of the voting shares, and 80% of all the other outstanding stock, if any, of the corporation after the contribution. I.R.C. Section (351)(a) . Otherwise, gain or loss is recognized on the contribution of appreciated or depreciated property (different for services) for stock.
Problem: Assume a $1,000,000 value corporation with one owner who needs a capital infusion of $500,000, and an investor who has the equipment that the corporation needs, with a value of $500,000, but a basis of zero. If the investor contributes the equipment to the corporation, the investor will only receive 1/3 of the stock in the corporation. Because the investor doesn’t receive 80%, the investor has to recognize $500,000 in gain.
Solution: The corporation contributes its assets to a new LLC/partnership in return for a 2/3 interest in the new LLC/partnership and the new investor receives a 1/3 interest. So:
Corporation $1,000,000 2/3
Investor 500,000 1/3 Total $1,500,000 3/3
As shown by the above illustration, a LLC/partnership has no limitation on the size of the ownership required for an investor to contribute property. Under I.R.C. Section 721 , no gain is recognized by a member/partner, on the contribution of property to the entity in return for an interest on the entity. There is an exception to the no gain, if securities are transferred to the entity, and an “investment company” is created: most often this is due to too much diversification, in the securities contributed to the entity by the partners/members. If liabilities secured by the contributed property are shifted away and such liabilities, unless shifted back, exceed the basis, gain will be recognized. I.R.C. Sections 721 and 752(b); Treas. Reg. Section 1.752-1(c)
THERE ARE NO LIMITS AS TO WHO OR WHAT CAN BE AN OWNER, WITH THE EXCEPTION OF S CORPORATIONS: NON-RESIDENT ALIENS AND ENTITIES OTHER THAN ESTATES AND CERTAIN QUALIFIED TRUSTS, MAY NOT BE S CORPORATION SHAREHOLDERS.
Cash Flow Flexibility C Corporation
Cash flow flexibility means the ability to freely allocate cash and profit or loss among the owners, depending on the economics of the situation at hand. As an example, if one owner has provided much needed cash, the other owners might want to enable that owner to receive a 10% return on the owner’s cash contribution. Ignoring the 80% requirement, discussed above, what are the rules that apply to a C corporation?
Other than the use of preferred stock, there is no flexibility in the allocation of cash. Even if preferred stock is issued, with a preferred return, it cannot be changed from year to year, as circumstances warrant
There is no flexibility with an S corporation to distribute cash flow other than pro rata according to percentage ownership. Any variation from pro rata distributions is considered a second class of stock and causes a loss of S corporation status.
As long as the economics of the allocations are in accordance with the partnership agreement (Virginia Code Sections 50-73.99 – general partnership; 50-73.34 – limited partnership; or the LLC operating agreement – Virginia Code Sections 13.1-1029 – 1030, there is complete flexibility to allocate cash or profit and loss to take into consideration the economic circumstances at hand. The default is pro rata to contributions among the owners.
Income Splitting C Corporations (Not Personal Service Corporations)
Income splitting refers to dividing a set amount of income between two or more taxpayers to lower the overall effective rate of taxation. Assume the shareholder-employee of a C corporation has $100,000 taxable at the highest rate of individual tax, 35%. If the top $100,000 is left inside the corporation, the first $50,000 is taxed at 15%, or $7,500. The next $25,000 is subject to a 25% rate, or $6,250, and the next $25,000 is subject to a rate of 34%, or $8,750. Thus, the top $100,000 of the shareholder-employee’s income is taxed at $35,000, but if left in the corporation, the combined tax is $22,500 for annual savings of $12,500. While this sounds good, planning must be done to avoid a second tax when the accumulated savings are ultimately distributed to the shareholder-employee.
One method is to prepare annual minutes addressing the need to accumulate cash in the corporation so the shareholder-employee’s salary is deferred for future payments of salary, a form of deferred compensation. However increases the value of the accumulations which may well be subject to a second tax as a dividend, as opposed to deductible wages to the shareholder-employee.
No income splitting available due to pass through tax treatment.
No income splitting available due to pass through tax treatment.
Capital Gain Rates C Corporations
No preferential capital gain rate.
Other than built-in-gains, capital gains pass through to the shareholders, pro rata to their ownership.
Capital gains pass through to the partners/members.
Fringe Benefits C Corporations
An employer’s payment of health and accident insurance on behalf of an employee is deductible by the employer, but not included in the gross income of the employee. I.R.C. Section 106.