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Business Valuations

Choice of Business Entity: Corporations and LLCs

W Y Alex Webb

Summary

  • Learn the key differences between C Corps, S Corps, and limited liability companies.
  • There are many other types of business entities beyond LLCs, C Corps, and S Corps, especially for foreign business entities.
  • Choice of business entity is of fundamental and long-lasting significance for any businessperson.
Choice of Business Entity: Corporations and LLCs
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The choice of business entity is of fundamental and long-lasting significance for any businessperson. Elements of asset (or creditor) protection, taxation, ease of governance and operation, and continuity of life are all key considerations. Here, we consider only corporations (both C Corps and S Corps) and limited liability companies. There are, of course, many types of possible entities (especially if you add in foreign entities).

Protection from creditors is the driving force behind using corporations. Corporations are a creature of statute, and the statute must be carefully honored to get iron-clad creditor protection. The debts of the business that were not guaranteed or co-signed by one or more owners can only be collected from the entity or its assets. If the entity cannot pay in a reasonable and timely manner, then the creditors could force it into bankruptcy. But at least the owners’ assets outside the corporation would be safe (unless the creditor sued and won to “pierce the corporate veil,” which is beyond the scope of this article).

In addition to greater creditor protection for the owners, corporations offer at least some tax-planning opportunities, namely, the corporation is a tax-paying body with its own tax-return requirements and its own—often lower—tax brackets. The ongoing problem was getting the net earnings to the owners with the least tax. The classic C corp (under Subchapter C of the Internal Revenue Code) can pay owners and nonowners reasonable salaries and deduct that expense on its tax return (of course, the recipient pays ordinary income tax on their salary so the government is not really harmed). When dividends are paid out of retained “earnings and profits” of the corporation (which has already paid its own tax on these earnings), a second tax is paid by the shareholder on those dividends. This is the proverbial “double tax” problem. It is ameliorated by the “qualified dividend” rule that has been with us since 2001. This second tax is the same rate as long-term capital gains taxes (federal 20%). Although better than two ordinary income tax bites, this is still heavy.

Planners have sometimes opted for paying high (IRS labels such compensation as “unreasonable compensation.” which is an “imputed dividend”) salaries when the result will be a lower overall tax bite. This may occur, for example, if the employee has losses to offset the additional salary income or there is some other credit or device that keeps the salary taxed at a rate below the corporation’s rate. The 2018 tax reform law grants all C corps a flat tax rate of 21% (federal). Max individual rates can be as high as 37% (federal). “Bracket splitting” (pay some corporate tax and some individual tax using the lower end of the personal rate brackets) is an active tax savings arrangement.

Of course, as long as the C corp is paying no dividends (and none are imputed), the corporation can accumulate the net profits inside the corporation and later liquidate the entity, and the shareholders will pay only at capital gains rates on the funds received. This accumulation strategy was recognized many years ago, and Congress has armed the IRS with the “accumulated earnings tax,” which applies a second tax at the entity level to try to force the payment of traditional dividends. This led to many fights over the “reasonable business needs” of the corporation. If such needs are proven by the entity, then the accumulation (and avoidance of the second tax) can continue indefinitely.

Additionally, due to their centralized management and control structure, entity governance and ease of operation are enhanced in a corporation. Finally, corporations can exist forever. Death of any owner has no effect on the existence of the corporation. So, the C corp is the entity of choice for large business structures.

To try to give businesses the benefits of corporations without the second tax burden, Congress enacted Subchapter S of the Code in 1946. “S corps” were born. As opposed to a C corp, there is only (except under special circumstances) one level of tax for S corp owners: the individual tax at the shareholder level and no entity tax. S corps became very popular with small business owners. They cannot be used by large corporations due to limitations on numbers and types of shareholders. Also, S corp status is “fragile” and can be lost if a non-resident alien owns any shares even if only for one second. Finally, the capital structure of an S corp can only consist of one class of stock: common stock (although the law later allowed non-voting common stock as well).

To have the benefits of S corps without all the fragility and odd ways of losing the favorable tax treatment, and to remove the capital structure restrictions, in 1977 Wyoming enacted the first limited liability company (LLC) statute. However, it took 11 years (until 1988) before the IRS allowed LLCs to be treated as partnerships for tax purposes (under Subchapter K of the Code).

LLCs quickly became the entity of choice for small businesses—S corps are still used but much less frequently. In an LLC, there is centralized management (if so elected by the organizer in the filed Articles of Organization (AOO) since a manager-managed LLC can have members (investors) who cannot make any management decisions for the LLC—only the managers have the management powers. This is lost if the AOO states that the entity is member-managed; all members then have the authority as a group (a little like a general partnership).

There is creditor protection in both forms of LLCs (manager managed and member managed). No manager or member is liable to any LLC creditor for LLC debts or liabilities. Of course, if money is borrowed to finance the business, the smart lender gets the necessary LLCs promise of payment but also insists on managers and/or members to guarantee the debt personally.

Importantly, unlike corporation shareholders, when an LLC member has a personal creditor, his ownership interest in the LLC is not (under most LLC laws) subject to levy to pay his personal debt. In both a C corp and an S corp, the shares of the shareholder are subject to seizure and can be auctioned off on the courthouse steps. LLC interests can only be subject to a “charging order,” which does not give ownership of the interest to the creditor but does allow him to get all distributions to the LLC interest holder until the creditor’s debt is paid. If a creditor buys in at an auction of corporate shares and if those shares represent majority control of the corporation, then the creditor can take control of the corporation and sell assets or sell the corporation to a third party to get his debt paid—a very drastic move.

The partnership tax status of an LLC opens up many planning opportunities for the owners. For instance, the capital structure can provide that certain “monied” investor members get their investment back with a certain rate of return before the penniless idea creators get their share. In an S corp, this would violate the second class of stock prohibition and break the S election.

Upon the death of a member (or other transfer of a membership in an LLC), the LLC can make a 754 Election that allows for a special adjustment of the basis of assets inside the LLC to equate to the fair market value of the interest transferred. This has the advantage of allowing the new owner of the interest to get an additional depreciation deduction if the LLC asset adjusted is depreciable or to get reduced gain on the LLCs sale of the adjusted asset. Only the transferee benefits from the 754 adjustments, they can confer be a very valuable tax benefit. No 754 Election is possible in either a C corp or an S corp.

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