BUSINESS FORMATION
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
The greatest federal and state income tax planning benefits, and
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:
How will the income and tax distributions from the enterprise be allocated?
How will the rights for decision making and management in the enterprise be allocated?
What type of liability protection is desired to enable the owners to be protected from the debts of the enterprise?
Who will share in the equity growth of the enterprise, and in what proportions?
What will be the best structure from the federal income tax perspective?
If a family enterprise is involved, what will be the preferred structure from the perspective of assuring the best ownership succession within multiple generations?
What state tax issues will be important, and will these questions necessitate consideration of the tax rules in several states?
What individual income taxation issues might be significant, including, particularly, when differentiating between the treatment of employees and owners?
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:
How can income taxes on the profits of the business enterprise (or the investment activity) be either currently minimized or deferred (or both)?
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?
How can increases in the value of the equity of the business best be protected from future income and estate tax liabilities?
How can assets be transferred into and out of the entity on the most tax efficient basis?
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:
The tax adviser
The business law attorney
The financing and banking experts and
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.
SPECIFIC FACTORS:
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:
FMV Capital:
Corporation $1,000,000 2/3
Investor 500,000 1/3 Total $1,500,000 3/3
PARTNERSHIP/LLC
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
S CORPORATION
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.
PARTNERSHIPS/LLCS
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.
TAX CHARACTERISTICS
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.
S Corporations
No income splitting available due to pass through tax treatment.
Partnership/LLCs
No income splitting available due to pass through tax treatment.
Capital Gain Rates C Corporations
No preferential capital gain rate.
S Corporations
Other than built-in-gains, capital gains pass through to the shareholders, pro rata to their ownership.
Partnership/LLCs
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.
S Corporations
Two percent or more shareholders, and their spouses, have special rules that apply to fringe benefits. Under Section 1372 of the Code, accident and health insurance premiums paid by an S corporation on behalf of a 2-percent shareholder-employee as consideration for services rendered are treated like guaranteed payments under Section 707(c) of the Code. Therefore, the premiums are deductible by the corporation under Section 162, NOT AS WAGES, (subject to the capitalization rules of section 263), and are includible in the recipient shareholder-employee’s gross income under Section 61. The premiums are not excludible from the recipient shareholder-employee’s gross income under Section 106; however, provided all the requirements of Section 162(l) are met, the shareholder-employee may deduct the cost of the premiums to the extent provided by Section 162(l).
Partnerships/LLCs
General Rule: the partners and members are generally not eligible for tax-free benefits.
Accident and health insurance premiums paid by a partnership on behalf of a partner are guaranteed payments under Section 707(c) of the Code if the premiums are paid for services rendered in the capacity of partner and to the extent the premiums are determined without regard to partnership income. As guaranteed payments, the premiums are deductible by the partnership under Section 162 (subject to the capitalization rules of Section 263) and includible in the recipient-partner’s gross income under Section 61. The premiums are not excludible from the recipient-partner’s gross income under Section 106; however, provided all the requirements of Section 162(l) are met, the partner may deduct the cost of the premiums to the extent provided by Section 162(l).
Distributions/Payments to C Corporations
Owners
Payments to C corporation shareholder-employees are deductible by the corporation and taxable as wages to the shareholder-employees, and distributions to C corporation shareholder-employers are taxable as dividends, and not deductible to the corporation.
Taxation of an owner on distributions (cash, property, or debt): Taxed as a dividend to the extent of current and accumulated earnings and profits, then return of basis in stock, then taxed as if from sale of stock.
Taxation of a shareholder on distributions of property: Taxed same as cash. Any gain inherit in distributed property is taxed to the corporation; the basis in distributed property is its fair market value. I.R.C. Section 301.
S Corporations
Payments to shareholder-employees for services performed are taxable as wages. Distributions attributable to a return on capital are taxable as ordinary income, but not subject to employment taxes.
The ability to take S corporation dividend distributions as income not subject to payroll taxes has resulted in shareholder-employees reducing their salaries, some to zero to avoid payroll taxes.
An often unnoticed aspect of this practice is the resulting decrease in Social Security Benefits, for the employee and spouse. The shareholder/employee may be subject to penalties and interest if the shareholder/employee takes less than a reasonable salary.
Taxation of owner on distributions (cash, property or debt): Tax free return of basis in stock, then gain taxed as if from sale of stock.
Taxation of shareholder on distributions of property: Taxed same as cash. Any gain inherit in the distributed property is taxed to the S corporation and passed through to the shareholder; the basis in distributed property is its fair market value. I.R.C. Section 1368.
Partnerships/LLCs
Neither Partners nor members may be an employee of the partnership/LLC. Some tax advisors suggest paying partner/members as employees so that, rather than paying estimates, all of the necessary income taxes may be withheld on the final “wages,” paid in the year. This practice is not allowed and will result in interest and penalties against the partner/member for failure to file and pay estimated taxes.
Taxation of owner on distributions (cash, or debt): Tax fee return of basis in the partnership or membership interest, then gain taxed as if from the sale of the partnership or membership interest.
Taxation of owner on distribution of property: No tax. The partner’s basis equals the partnership basis or the partner’s basis in the partnership, whichever is less. I.R.C. Sections 731(a) and 732(a). The member’s basis equals the lesser of the LLC basis or the member’s basis in the membership interest.
Net Operating Losses C Corporations
Net operating loss deductions are only available to the corporation, and not to the shareholders.
S Corporations
Net operating loss deductions are only available to the shareholders, to the extent of the shareholder basis, and excess is carried forward. I.R.C. Section 1367.
Partnerships/LLCs
Net operating loss deductions are only available to the partners/members to the extent of the partner/member basis, and excess is carried forward. I.R.C. Sections 705(a) and 733.
Step up in Basis of the Assets C corporations of the Entity on the Death of an Owner No step up in basis of the assets of the corporation on the death of an owner.
S Corporations
No step up in basis of the assets of the corporation on the death of an owner.
However, subject to calculations, if a 100% owner dies, the stock, ignoring discounts and assuming a value of $5,000,000, the stock will have a basis of $5,000,000. If the estate liquidates the corporation, assume $5,000,000 in value and a zero basis.
The liquidation is treated as a sale of the property to the estate, resulting in a $5,000,000 gain, and increase in the basis of the stock, due to the gain, by $5,000,000, thus the stock has a total basis of $10,000,000:
Death Step Up $5,000,000
Gain on “Sale” 5,000,000 Total $10,000,000
Because the estate only receives assets of $5,000,000 on the liquidation, there is a $5,000,000 capital loss on the liquidation, with an offsetting capital gain, subject to Section 1239’s provisions that a sale of depreciable property to a related party, the estate, would produce an ordinary gain – the assets have a $5,000,000 step up in basis and the hoped for capital loss on liquidation offsets the capital gain on the deemed sale.
Partnerships/LLCs
An election under Code Section 754 allows a step up, or step down, in basis for the decedent’s interest in the assets. However, the step up is not to fair market value of the assets. The discounted value of the interest is the step up translated into the decedent’s share of the assets.
Voting and Non Voting Interests C corporations Voting and non-voting stock is available.
S Corporations
Voting and non-voting stock is available.
Partnerships/LLCs
Voting and non-voting interests are available.
Asset Protection C Corporations
Assuming the corporation is properly capitalized and operated, the corporation entity law prevents corporate judgments from reaching the shareholder’s personal assets. However, there is no asset protection for the actual shares of the stock held by the shareholder from creditors of the shareholder.
S Corporations
Assuming the corporation is properly capitalized and operated, the corporation entity law prevents corporate judgments from reaching the shareholder’s personal assets. However, there is no asset protection for the actual shares of the stock held by the shareholder from creditors of the shareholder.
F REORGANIZATION: However, there is a legal protection for partnership/LLC interests, referred to as a charging order. It is possible for a corporation, C or S, to become a LLC for state law purposes but elect to be taxed as a corporation, C or S, thus protecting a debtor-shareholder’ shares in a judgment. See I.R.C. Section 368(a)(1) (F corporate reorganization). The shareholder remains taxable on distributable income, the same as a wage earner is taxable on garnished wages.
Partnerships/LLCs
Assuming the entity is properly capitalized and operated, the entity law prevents entity judgments from reaching the limited partner/member’s personal assets. As limited partners require a general partner, the general partner is typically an LLC for asset protection purposes.
As mentioned above, and as in many other states, Virginia permits the creditor a charging order as the sole remedy, granted to the successful judgment creditor of partner/member distributions that would typically be distributed to the debtor partner/member. The partner/member remains taxable on distributable income, the same as a wage earner is taxable on garnished wages.