Alphabet Soup: Tax Guidelines In Choice Of Entity DecisionsPasquale Amodeo
September 7, 2006 — 1,671 views
In 1997, the U.S. Treasury Department greatly simplified the rules associated with the tax treatment of non-corporate entities by issuing the “check-the-box” regulations. While the name of these regulations suggests a simple decision process, the actual decision of which type of entity to select for a particular business is actually fraught with highly technical and complex issues that can significantly impact a business. A comprehensive discussion of the tax issues involved in such a decision are well beyond the scope of this article; nevertheless, certain guideposts are discussed herein that will serve as valuable guidance for business owners. The basic choices to consider when forming a new business are limited liability companies (LLCs); limited partnership (LPs); S-Corporations and C-Corporations.
This alphabet soup of choices breaks down into two general categories of tax treatment: (i) “passthrough” entities (e.g. LLCs, LPs and S-Corporations) and (ii) entities subject to double taxation (C-Corporations). Pass-through entities are business associations that do not actually pay taxes but, instead, serve as reporting vehicles that flow tax items down to their owners. Within this category of pass through entities important differences exist that can cause drastically different results on the ultimate tax liability of the entity and its owners.
While businesses formed as LLCs or partnerships are presumptively treated as pass-through entities, corporations will only be treated as pass through entities (i.e. S-Corporations) if an election (on Form 2553) is made by the corporation and its shareholders. Through my years of practice, I have been contacted countless times at year-end by new business owners who formed corporations themselves without filing an S-Corporation election and discovered that both their corporation and the individual owners will pay tax. Fortunately, the Internal Revenue Service (IRS) will grant S-Corporation status retroactively in many cases, provided, that the entity was run as a de facto S-Corporation from the time of its formation until the formal request is made for retroactive S-Corporation treatment. For those year-end callers not fortunate enough to have operated their corporation as a de facto S-Corporation, the reality is that the business is subject to double taxation. Since LLCs and partnerships are not required to file an election, new business owners can avoid this inadvertent double tax status by forming an LLC or partnership instead of an S-Corporation.
Another important difference between LLCs/partnerships and S-Corporations are the restrictions placed on ownership. Generally, no “disqualifying” restrictions are placed on the ownership of LLCs and partnerships. In contrast, S-Corporations will lose their pass through tax status and be subject to double taxation if the rules of Section 1361 of the Internal Revenue Code are not strictly followed. These rules provide that an S-Corporation may not have more than 75 shareholders or have as a shareholder any (i) C-Corporations, (ii) non-resident aliens or (iii) certain trusts. These rules may seem simple enough but, in reality, they can be easily violated. For example, a shareholder may file for bankruptcy and have his or her shares transferred to an institutional creditor that may be a C-Corporation. Not only will this type of transfer invalidate the entity’s S-Corporation status but it will trigger a tax on “built- in gain.” While “built in gain” is a fairly complex concept, the essence of the tax is a surcharge at the highest corporate tax rate on the difference between the fair market value of the entirety of the business’ assets less the adjusted basis of those assets.
In addition to the restrictions placed on ownership, LLCs/partnerships and S-Corporations differ significantly with regard to the treatment of corporate debt and the sharing of certain tax attributes of the business. While a debt owed by an LLC or partnership to a third party will increase the basis of the members or partners (allowing additional loss deductions), the debt of an S-Corporation will not increase the shareholders’ basis. In order for debt to increase an owner’s basis in an S-Corporation, the individual shareholder himself or herself must be the debtor. Accordingly, whereas a mature LLC or partnership could borrow against its assets to raise money and thereby increase the basis of its owners, shareholders of an S-Corporation need to be the actual borrowers of the money (and accept personal liability) to achieve the same result. Because of this disparity in the treatment of entity level debt, businesses that typically engage in secured lending transactions (such as real estate) are rarely formed as S-Corporations. Moreover, in a situation where owners agree that certain tax attributes should be allocated disproportionately to certain partners, the partnership rules, unlike S-Corporations, allow “special allocations” to be made in a disproportionate manner. For example, partners may decide that a single partner should be allocated all the depreciation deductions related to a real estate investment (thereby allowing him or her to claim a losses on his or her individual tax return) because that individual contributed the entire down payment for the investment. Provided that the disproportionate allocation has “substantial economic effect,” this special allocation will be honored by the IRS. On the other hand, S-Corporations are not allowed to make any disproportionate allocations.
The second major category for the tax treatment of business entities is entities subject to double taxation. These entities are typically referred to as C-Corporations. The phrase double taxation describes the fact that these entities themselves pay tax and a second level of tax is applied (at the shareholder level) to any distributions made to the owners of the entity. Many businesses, including banks and insurance companies, must be formed as C-Corporations for regulatory purposes. In other circumstances, businesses may be formed as C-Corporations by investors seeking to avoid taking into account income or losses on a current basis. For example, an investment fund may prefer the accumulation of losses at the corporate level in the form of “net operating losses” or NOLs because these losses may be attractive to potential acquirers that could use these NOLs to offset income after a merger. Also, C-Corporations allow their owners to facilitate capital markets transactions by creating preferred stock (these preferred shares typically provide preferred liquidation rights and dividend payments) that is attractive to investors seeking to balance risky investments with these preferred rights. During the late 1990’s, this type of C-Corporation capital structure was the preferred investment vehicle for venture capital investment in internet and other emerging technology companies. The creation of preferred stock is prohibited by the single class of stock requirement of S-Corporations. Lastly, business entities that plan on offering shares in the public markets generally chose to become C-Corporations since the vast majority of publicly traded entities are C-Corporations.
While this article only outlines some of the basic tax characteristics of the various types of business entities, the foregoing should demonstrate that there is no “one size fits all solution” to choosing which type of entity is best for a particular business. In addition to the items outlined above, business owners should be aware that there are potential tax advantages to forming LLCs or partnerships versus S-Corporations or C-Corporations when appreciated assets are contributed to a new business, there is a small payroll tax advantage to forming an S-Corporation as opposed to an LLC or partnership and that there could be advantages for businesses with international operations to using entities that can “check-the-box” (i.e. LLCs, partnerships and foreign equivalents) to avoid some complex double taxation rules provided in “Subpart F” of the Internal Revenue Code. Accordingly, the best approach to a choice of entity decision is a detailed discussion with a trusted tax and legal advisor of the likely capital structure of the business, whether or not the entity will borrow significant amounts, the profile of both current and future owners and whether the business will invest or manufacture items abroad. Only after such a careful discussion can a business owner discover which letters in the alphabet soup will spell success for the business and its owners.