|EXECUTIVE SUMMARY |
| When advising clients on the choice of business entity, CPAs should consider the advantages and disadvantages of each type. If more than one entity is involved, CPAs should also determine whether clients can deal with the complexity of the resulting structure.
The many issues to consider can be organized into four categories: capitalization, compensation, allocation of profits and losses, and distributions.
From the standpoint of capital structure, C corporations and LLCs offer more flexibility than S corporations, which are subject to statutory restrictions.
Compensation within corporations is affected by the number of shareholders and their involvement in the corporation’s business. Consider whether there are one or multiple shareholders, whether the shareholders each own the same amount of stock, whether they perform services and how fringe benefit plans are set up.
For both C and S corporations, reasonableness of compensation is an issue. For C corporations, the question is whether a shareholder/employee’s salary is too high relative to any dividends paid. For S corporations, the question is whether the salary is too low in relation to distributions.
The ability to use losses is often critical in the choice of a business structure. In general, because third-party debt may create basis for members, LLCs provide better opportunities for passing through losses than do S corporations for their shareholders.
The tax treatment of distributions may vary, depending on the type of entity making the distribution, the type of entity receiving it and the type of property being distributed. Property distributed from a C corporation is generally taxed to the recipients; distributions to S shareholders are subject to rules that follow a specified order. For LLCs, cash and property distributions are generally tax-free (to the extent of basis), but there are many exceptions.
Gregory A. Porcaro, CPA/ABV, MST, is with the firm Otrando, Porcaro & Associates Ltd. in Warwick, R.I. His e-mail address is email@example.com.
Selecting the right entity for its operations is an important issue for every business—and every CPA who’s called on to help clients decide. Whether a corporation or a limited liability company (LLC) is the better choice is not always obvious. The selection involves numerous legal and tax issues and should involve the client’s or employer’s attorney. CPAs must consider all the facts and alternatives and, above all, understand the client’s objectives. This article highlights key differences between types of corporations and LLCs that are treated as a partnership for tax purposes.
THE RIGHT CHOICE
Fortunately, the choice-of-entity question does not have to be answered absolutely. The majority of closely held businesses engage in more than one business activity, and it’s possible to use a different entity for each. Owners of closely held businesses often ignore the structural barriers between entities (and sometimes between their business and personal activities); they tend to treat all the businesses as one entity. This can have significant negative repercussions, particularly for limited liability protection and income taxes.
Issues CPAs need to consider when helping clients choose an entity, listed in Exhibit 1, can be organized into four categories: capitalization, compensation, profit and loss allocation, and distributions.
|| Selected Issues Affecting Choice of Entity |
||Nontax issues |
|Sale of business/liquidation
||Limited liability protection |
|Tax rate exposure
||Capital structure |
|Use of losses
||Stockholder and buy-sell agreements |
||Type of business/investment activity |
||State law |
|State tax issues
For a corporation, the contribution of property solely in exchange for at least 80% of the corporation’s stock generally is tax-free under IRC section 351. From the standpoint of capital structure, C corporations and LLCs offer more flexibility than S corporations, which are subject to statutory restrictions on their classes of stock and the number and type of stockholders. Depending on the client’s objectives and goals, these restrictions can have a critical effect on the choice-of-entity decision. For example, if the organizer of a new business plans to raise equity capital that provides a fixed rate of return and limited liquidation rights, an S corporation would not be appropriate.
The basis of property contributed to a corporation under section 351 is equal to the contributor’s basis at the time, plus any gain recognized from excess liabilities or the receipt of property other than stock (such as a note). In certain situations, the corporation’s basis can be limited to the property’s fair market value. If the assets are encumbered by liabilities that exceed their basis, the contributor must recognize gain equivalent to that excess under IRC section 357(c). This gain recognition may be avoided if the contributing stockholders also contribute a bona fide note (with a fair market value equal to the difference) to the corporation. The important point is that the issue must be addressed when the initial capitalization takes place.
Sometimes, to attract or retain a key person, a corporation must issue stock in exchange for services. That normally results in taxable income to the recipient equal to the stock’s fair market value—unless the stock is subject to a substantial risk of forfeiture, as described by IRC section 83(a)(1). If IRC section 351 applies, it may be possible to avoid this result if the recipient exchanges some form of property for the stock, such as a customer list or other intangible asset. In general, revenue procedures 2001-43 and 93-27 state that an exchange for a profit-only interest in an LLC does not give rise to taxable income. However, in May 2005, the IRS issued proposed regulations that treat the exchange of a profit-only interest for services similarly to an exchange of corporate stock—see proposed Treasury Regulation 1.761-1. And for S corporations, the basis of the assets contributed becomes the basis of the contributor’s stock for purposes of using losses that may pass through in the future. In many situations, capital is contributed with a loan to the corporation. When advising organizers whether to receive stock or debt, CPAs should consider:
Will there be more than one stockholder?
Will all the stockholders be equal?
Will stockholders contribute property of equal value?
Will the entity be an S corporation or a C corporation?
Will stockholder distributions be made?
The answers to the first three questions revolve around the difference in rights between a stockholder and a creditor. For example, if three individuals intend to be equal stockholders but one of them contributes $100,000 more in cash than the others, that stockholder should receive a note for the excess, possibly secured by corporate assets. The decision to make an S corporation election does not change this conclusion.
Because of the S corporation basis rules under IRC section 1366, the debt-vs.-equity question carries important tax ramifications. S corporation stockholders can use debt basis for deducting losses, but subsequent repayment of the debt results in the recognition of taxable income, which in many cases comes as a surprise. On the other hand, C corporation stockholders are better served by holding debt, because generally they can receive nontaxable loan payments, regardless of the corporation’s profits or losses. In general, barring any legal issues, S corporation stockholders should choose to receive stock in exchange for capital.
Dividend distributions to stockholders of a C corporation represent after-tax corporate earnings and are subject to tax at the stockholder level (generally at a 15% rate). A C corporation may be the appropriate entity in situations involving a complex capital structure designed to provide investors with a specified rate of return. If preferred stock is issued, the rate of return will not include appreciation in the value of the company, unless it is convertible into common stock. In general, distributions to S corporation stockholders are not taxable. However, S corporation distributions must be made on a pro rata basis to all stockholders, including liquidating distributions (see “Distributions” below).
How compensation is structured can have both tax and nontax effects on the choice of entity. Members of an LLC cannot be treated as employees. Therefore, to design a compensation plan other than one based solely on ownership, an LLC’s operating agreement must provide for guaranteed payments. (Other issues regarding LLC members’ exposure to self-employment tax on their share of allocated earnings are still evolving and beyond the scope of this article.) Corporate stockholders can be treated and compensated as employees and are subject to payroll tax withholding. In a corporate environment, many nontaxable fringe benefits (such as health insurance and retirement plans) can be offered only to employees; therefore, it is critical that stockholder/employees’ compensation is properly reported on form W-2.
At the most fundamental level, the structure of compensation is affected by the number of stockholders and their involvement in the corporation’s business. Typically, a sole-stockholder C corporation structures compensation to reduce taxable income on the corporate level, thereby reducing the stockholder’s future exposure to double taxation. This is true despite the fact that qualifying dividends are currently subject to a 15% federal tax rate.
But a sole stockholder of an S corporation may structure compensation to increase corporate taxable income that will pass through to him or her, thereby reducing exposure to Social Security taxes. Due in part to a Treasury Inspector General Report issued in 2002, the IRS has increased its focus on S corporation compensation vs. distributions to shareholders. Overall, a C or S corporation provides a familiar compensation structure.
In a multistockholder corporate environment, the following issues affect compensation vs. distribution:
Do all stockholders own the same amount of stock?
Are all stockholders performing services to the corporation?
How are fringe benefit plans designed?
C corporations offer more flexibility, such as a deferred compensation benefit and stock option plan. In general, as a pass-through entity, an S corporation cannot offer deferred compensation; the fact that the salary is not currently deductible increases the amount of income that flows through to shareholders. S corporations can offer stock options, provided they do not create a second class of stock.
In both C and S corporations, CPAs also must be concerned about the reasonableness of compensation. For C corporations, the question is whether the stockholder/employee’s salary is too high in relation to any dividends paid. For S corporations, the question is whether the stockholder/employee’s salary is too low in relation to distributions. Exhibit 2 lists relevant factors for each type of entity.
|| Factors in Determining Reasonable Compensation |
||S corporations |
|Compensation paid in proportion to stock ownership
||Services performed in relation to salary |
||Number of employees |
|Corporation’s capital structure
||Degree of control over corporation |
|Year-end increases in salary
||Undocumented loans receivable |
|Existence of employment agreement
||Existence of employment agreement |
|Statistical reasonableness of compensation based on the company’s sales
||Compensation level of other employees |
||Industry guidelines |
||Loan covenants |
ALLOCATION OF PROFIT AND LOSSES
Another decision is whether to create a flow-through entity such as an S corporation or LLC. C corporations are subject to corporate tax rates on the first $75,000 of taxable income, which are lower than an individual would pay with a flow-through entity. Individuals considering organizing a C corporation, however, should be aware that:
Personal service corporations, such as medical practices, are subject to a flat 35% tax rate.
Multiple C corporations, commonly owned by up to five persons who own more than 50% of the corporations’ voting stock and value, must allocate the C corporation tax brackets among the corporations.
Except for personal service and farming businesses, C corporations with gross receipts exceeding $5 million cannot use the cash-basis method of accounting.
An S corporation’s profit and loss is allocated to its stockholders on a per-share, per-day basis, based on stock ownership. In general, LLCs offer greater flexibility in allocating profits and losses among members, provided the allocation has substantial economic effect (as defined in IRC section 704). This is a complex topic, but basically, profits and losses must be allocated in a way that mirrors the economic risk of each LLC member.
The ability to use losses generated by a pass-through entity often is a critical consideration when choosing a structure. In general, S corporations do not offer as great an opportunity to use losses as LLCs.
Both S corporations and LLCs limit interestholders’ ability to use losses that pass through to their basis in the entity. CPAs must help clients or employers properly document their basis in either form of entity. For example, if an individual has a stock basis of $50,000 and allocable losses of $75,000 in an S corporation or LLC, only $50,000 of losses can be used to offset other income, assuming the at-risk (IRC section 465) and passive activity loss (IRC section 469) rules do not apply.
The distinction between S corporations and LLCs turns on the definition of basis. In an S corporation, basis is defined as capital in the form of stock and direct stockholder loans. Third-party debts, personally guaranteed or not, do not create basis. But many forms of third-party debt do create basis for an LLC member. If, in the example in the preceding paragraph, the entity borrowed $25,000 from a personally guaranteed business line of credit, an S corporation stockholder could still deduct only $50,000 of losses. But an LLC member could deduct the entire $75,000 loss, because his or her basis would include the personally guaranteed debt.
The entity’s stockholder or operating agreement should specify the amount and timing of distributions of property or cash. This is particularly important to a minority interestholder. The tax treatment of a nonliquidating distribution is determined by the type of entity making the distribution, the type of entity receiving it and the type of property being distributed. Property distributions from either C or S corporations trigger a recognized corporate-level gain to the extent the fair market value of the property distributed exceeds its basis.
The value of the property distributed from a C corporation is included in the gross income of the recipients (possibly subject to a 15% tax rate) if the 90-day holding period for individuals and the dividends-received deduction requirements for corporations are met. This inflexible structure is one of the principal reasons corporations generally are considered the wrong type of entity for owning appreciable property, such as real estate.
The income-tax treatment of S corporation distributions of cash or property (at fair market value) to shareholders, on the other hand, follows a specified order. First, distributions are not taxable to the extent of the corporation’s undistributed earnings (its accumulated adjusted account); then they are considered a return of capital, to the extent of the recipient’s basis in the S corporation stock; and finally, any excess is treated as a capital gain.
At first glance, the ability to make nontaxable distributions appears attractive. However, CPAs must caution clients that their exposure to taxation is based on their allocable share of profits. It is possible to have income allocated to a stockholder and reported on a schedule K-1 without a corresponding distribution of cash or other property. This problem can be eliminated (or at least mitigated) with a well-drafted stockholder agreement.
The distribution rules for LLCs, meanwhile, are deceptively simple. In general, cash and property distributions are tax-free to the extent of the member’s basis in the LLC. However, there are numerous exceptions, as shown in Exhibit 3, depending on factors such as the type of property being distributed, to whom it is being distributed, when it was contributed to the LLC and by whom. In addition, subchapter K, which governs the tax treatment of LLCs, provides various rules for determining the basis of distributed property as well as the property retained by the LLC.
|| LLC Distributions—Exceptions to the General Rule |
|Distributions of marketable securities—IRC section 731(c). |
|Disproportionate distribution of unrealized receivables or appreciated inventory—IRC section 751. |
|Distributions of property within two years of a contribution to the LLC—Treasury Regulation 1.707-3(c)(1). |
|Noncash distributions to a member within seven years of contributions—IRC section 737. |
|Contributed property distributed to another member within seven years—IRC section 704(c). |
One significant advantage LLC/partnerships enjoy over corporations is the ability to adjust the entity’s basis in assets retained if a gain or loss is recognized due to a distribution from the LLC (IRC section 734) or a sale of an LLC interest (IRC section 743). A partnership can make this election, which applies to all subsequent transactions and cannot be revoked without the IRS’s consent. The election is provided by section 754. However, the American Jobs Creation Act of 2004 requires a mandatory basis adjustment if the built-in loss amount exceeds $250,000.
| If an entity wishes to offer a deferred compensation benefit and stock option plan, consider a C corporation.
In a common transaction involving the purchase of real estate using personally guaranteed debt, recommend the client form an LLC.
A well-drafted stockholder agreement can eliminate or at least mitigate the problem that arises when income is allocated to a stockholder and reported on a schedule K-1 without a corresponding distribution of cash or other property.
A PATH TO THE FUTURE
When CPAs are helping their clients or employers through the maze of entity selection options, they must consider numerous issues. Some involve what the client is planning to do in the immediate future; others require looking into the distant future. This decision also may be dramatically affected by future changes in business and tax law.