Tax Considerations for Choice of Entity - ABA YLD 101 Practice Series

By Jon D. Seawright

One of the most common questions faced by attorneys handling transactional work is what type of entity to advise a client to form for a proposed business or investment opportunity. More often than not the default response is a limited liability company (LLC). While in many cases that may the appropriate response, there are many factors to consider before determining what type is entity is the best choice for the client.

When analyzing the appropriate entity for a client's venture, tax and non-tax issues should be considered carefully. On the non-tax side, an advisor must discuss with the client the need for limited liability, the desired governance structure, the flexibility needed the arrangement among the equity owners, and the importance of certainty in the governing law. These are significant considerations that should not be discounted in favor of tax issues, and often one or more of these issues will supersede the desired tax result. Nonetheless, advising the client on the appropriate entity for operational purposes cannot be adequately done without at least a rudimentary understanding of the tax rules that apply to the entity options.

"Check the Box" Income Tax Regulations
Generally, entities operating for-profit fall into four categories for Federal tax purposes - C corporations, S corporations, partnerships and disregarded entities. Current Federal tax law effectively permits a party forming an entity to choose how that entity will be taxed, subject to certain restrictions. Under the relevant regulations, the following rules apply:

  • State law corporations must be taxed as corporations
  • Partnerships and LLCs are by default taxed as partnerships, but may elect to be taxed as corporations
  • Single-member LLCs are by default disregarded, but may elect to be taxed as corporations.

Eligible entities may elect a different treatment at any time, except that an entity may not elect to change its classification more than once every five years. A classification election is made by filing IRS Form 8832.

Comparison of Tax Advantages and Disadvantages Among Entities

C Corporations
C corporations are separate taxable entities, and therefore they cause two layers of tax on income earned by the corporation. Income earned by the corporation is taxed to the corporation when it is earned, and then again when it is distributed to shareholders in the form of dividends. Further, because C corporations are treated as taxable entities, distributions from them of appreciated property triggers recognition of the inherent gain. On the other hand, contributions of appreciated property to corporations, if structured correctly, do not trigger the gain. This requires that the contributing shareholder be part of a contributing group that owns, immediately after the contribution, control of the corporation, which the Internal Revenue Code (I.R.C.) defines as at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.

As separate taxable entities, the tax events of C corporations generally have no effect on shareholders, and vice versa. However, to avoid abuse of the C corporation form by closely held entities, certain rules penalize corporations for accumulating earnings in excess of what is necessary for its business operations. See I.R.C. § 531-537 (accumulated earnings tax) and I.R.C. § 541-547 (personal holding company tax).

The benefits to operating as a C corporation include the following:

  • Corporate tax laws are generally simpler and more familiar than partnership tax laws
  • No restrictions on the type or number of shareholders that may own stock
  • Multiple classes of equity allowed
  • No special tax elections when forming the entity and require no minimum contribution in return for the equity received
  • Contributions to a C corporation generally do not trigger any taxable event if after the contribution such shareholders are in control of the corporation
  • Generally have the most flexibility with deferred compensation structures, including the use of qualified employee benefit plans, SEP plans, simple 401(k)s, IRAs, cafeteria plans, stock options or restricted equity
  • C corporations can qualify for tax-deferred reorganizations such as state law mergers, stock for stock exchanges and similar reorganizations
  • Transfers of interest by shareholders generally have no tax effect on the corporation.

Disadvantages of C corporations include the following:

  • Double taxation for earnings distributed to shareholders
  • Accumulated earnings tax and personal holding company rules may force distributions to shareholders
  • Losses are captured at the corporate level and may not be used by shareholders
  • The ability to use losses by another corporation that acquires the loss corporation is severally limited (e.g. I.R.C. § 382)
  • Accrual method of accounting required (although exceptions apply service businesses and small corporations)
  • Distributions of appreciated property cause gain recognition to the corporation.

S Corporations
An S corporation is a corporation that meets certain qualifications and elects to be taxed under Subchapter S of the Internal Revenue Code. The effect of this election, which is made by filing IRS Form 2553, is to cause the corporation to be taxed in many ways similar to partnerships. S corporations are generally not taxed as a separate entity, and the items of corporate income, gain, loss, deduction and credit flow through to the shareholders. Like partnerships, the income of the corporation is taxed to the shareholders, regardless of whether cash is actually distributed to the shareholders. But unlike partnership, a distribution of appreciated property from an S corporation triggers the inherent gain in the appreciated asset.

The use of losses at the shareholder level is limited to the shareholder's stock basis Unlike partnerships, a shareholder's stock basis does not include the shareholder's share of corporate liabilities, but it does include the principal amount of loans made to the corporation. The passive loss rules and at-risk limitations may also apply to losses generated by an S corporation.

To qualify to elect Subchapter S treatment, a corporation must have only one class of stock outstanding (although differences in voting rights do not create a separate class of stock). This eliminates the ability to prefer certain equity owners over others, which both C corporations and partnerships have the ability to do. Another significant restriction applies to S corporations - it may have no more than one hundred shareholders, all of whom must be individuals, certain types of trusts, estates, or certain exempt organizations, none of whom may be nonresident aliens.

Although as a general rule an S corporation is not taxed directly, an S corporation that was previously a C corporation may incur an entity level tax. One type of entity level tax applies to any "built-in gain" recognized by the corporation during the ten-year period after the conversion to an S corporation. A built-in gain generally includes the gain inherent in the corporation's assets at the time of the conversion of the corporation from an S corporation to a C corporation.

The advantages of S corporations include the following:

  • Flow through treatment of tax items;
  • The S corporation tax regime is less complicated than the partnership tax regime;
  • Contributions to an S corporation generally do not trigger any taxable event if after the contribution such shareholders are in control of the corporation;
  • There is no minimum contribution required for equity;
  • S corporations have more flexibility in the use of equity incentives (ISOs available, and NQSOs and restricted equity treatment clear);
  • C corporations can qualify for tax-deferred reorganizations such as state law mergers, stock for stock exchanges and similar reorganizations; and
  • Transfers of interest by shareholders generally have no tax effect on the corporation.

The disadvantages of S corporations include:

  • Limitations on types and number of shareholders
  • Only one class of equity allowed
  • S election must be made within 2 1/2 months of formation for it to relate back to date of formation
  • Tax regime complicated if the S corporation converted from a C corporation
  • Distributions of appreciated property trigger inherent gain
  • Some states do not recognize S corporation treatment
  • Deductibility of losses limited to stock basis
  • Restrictions apply to shareholder qualification for benefit plans.

Partnerships
Entities treated as partnerships are often referred to as "flow-through" entities because they are not subject to federal income tax. Instead, the owners of such entities report their share of items of income, gain, loss, deduction and credit directly on their personal income tax returns. Importantly, the flow-through of tax items occurs regardless of whether the owners actually receive a distribution of cash or property from the entity.

Although tax items flow through to the owners, the ability to use losses generated at the entity level is often limited. Generally, an entity owner may only use losses to the extent that owner has basis in the owner's equity interest. A partner's basis equals the value of contributions made to and income earned by the partnership and the partner's share of partnership liabilities, less the value of distributions from and the partner's share of deduction and losses of the partnership. Further, passive losses may be suspended by the passive loss rules (see I.R.C. § 469) or the at-risk rules (see I.R.C. § 465).

The advantages of being taxed as a partnership include the following:

  • Unlimited number and types of owners
  • Multiple classes of equity allowed (through special allocations)
  • No special tax elections required
  • Contributions of appreciated property generally do not cause recognition of gain
  • Ability to use "profits interest" as equity compensation without triggering income upon issuance of such interest
  • Step-up in the partnership's asset bases upon sale of equity interest
  • Only one level of tax
  • Distributions of appreciated property generally do not cause recognition of gain.

Disadvantages of being taxed as a partnership include the following:

  • Tax rules are much more complicated than corporate tax rules
  • Some minimum contribution is required to avoid being treated as a nominal partner (generally 1% of total contributions)
  • Income taxed to owners regardless of whether distributions are made to pay the tax
  • Accrual method of accounting may be required if corporation is an owner
  • Shift in liabilities can trigger gain
  • Self-employment taxes generally apply to owners participating in management
  • Owner participation in benefit plans restricted
  • Sale of interest generally results in capital gain or loss, but may result in some ordinary income
  • Sale of more than 50% of capital and profits interest in 12 month period causes taxable termination of the entity
  • Tax deferred reorganizations used by corporations are not available.

Single-Member LLCs
Currently, all states allow an LLC to have only one member. This effectively allows a sole proprietor to form an entity to get the liability protection of a corporation, or another entity to isolate a line of business or risky asset in a liability protected entity, while causing no adverse tax consequences. The default treatment of single-member LLCs for federal income tax purposes is to disregard the entity entirely as separate from its owner. This means that all items of income, gain, loss, deduction and credit are taxed directly to the owner as if the LLC did not exist.

Although by default single-member LLCs are disregarded for federal tax purposes, the LLC may elect to be taxed as an association, which are taxed as corporations. Further, a single-member LLC electing to be taxed as an association can then make an S election, resulting in an LLC taxed as an S corporation. These types of elections are fairly unusual, but the forming party may want the flexibility of the LLC governance provisions, while maintaining corporate treatment for federal income tax purposes. However, making an S election for a single-member LLC should be carefully considered due to the single class of stock rule for S corporations. A single-member LLC should file IRS Form 8832 to be taxed as a corporation for federal income tax purposes.

Determining the appropriate choice of entity for a client is not entirely driven by tax considerations, but the advisor must understand the basic tax rules to assist the client in the decision. A careful analysis of the tax implications will provide the client an invaluable service and allow the advisor to direct the client to tax-efficient organizational planning.

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About the Author

Mr. Seawright is an associate at Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C., in Jackson, Mississippi, focusing primarily in the areas of taxation, business transactions and health care. Mr. Seawright is admitted to practice in Mississippi and is a member of the American Bar Association, the Mississippi Bar Association and the American Health Lawyers Association

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