BASIC TAX CONSIDERATIONS IN CHOOSING AN ENTITY FOR A NEW BUSINESS

by Jack Wilk

Every time an individual or entity establishes a new business or expands a business into a new location, one of the first decisions to be made is choosing the type of legal entity for the new business or location. The types of entities most often used are corporations, limited liability companies, corporations and limited partnerships. This article will briefly describe them and their basic advantages and disadvantages. The main considerations are minimizing taxes and minimizing the owners’ liability.

I. Corporations
The main reasons to use a corporation are: (i) a corporation’s owners generally are not liable for the debts or other obligations of the corporation, and (2) the rules and regulations that apply to corporations are well established, so there is some certainty about governance issues. Once the corporate form is chosen, the next decision is whether, for tax purposes, the corporation should make a Subchapter S election. Corporations that do not elect Subchapter S treatment are referred to as Subchapter C corporations. (Subchapter S and C are parts of the Internal Revenue Code.)

Generally, corporations looking to expand their businesses into different jurisdictions or into different types of business most often establish Subchapter C corporate subsidiaries, while individuals establishing or expanding their businesses quite often establish Subchapter S corporations or limited liability companies. Also, entities that expect to issue their shares to the public usually either start as Subchapter C corporations or convert to Subchapter C later.

A. Subchapter C Corporation
A Subchapter C Corporation is a corporation that has not elected to be taxed as a Subchapter S Corporation (as described more fully below). Subchapter C Corporations and their shareholders are subject to two levels of income tax: first, the corporation pays income tax (federal, and usually State and local income or franchise tax) on any income it earns, and then, if it pays a dividend to its shareholders from this income, the shareholders also must pay income tax on the dividend. Recently, this second level of tax has been somewhat mitigated because of the reduction of the Federal tax rates for both dividends and capital gains to 15%.

In our experience, for most closely held corporations, the principal negative impact of double taxation does not occur until the corporation disposes of its entire business. Closely held businesses usually pay out most of their earnings to their owners and/or key employees in bonuses or salaries, leaving the corporation with little, if any, taxable income. Also, even when closely held corporations do not pay out all of their income in salaries or compensation, they usually do not pay dividends to their shareholders. But, when a corporation seeks to dispose of its business, a potential buyer of the corporation’s business usually insists on buying the assets of the corporation (rather than its stock), which means that the selling corporation experiences a taxable gain on the sale. The shareholders would then have taxable income when the proceeds get distributed to them. So the gain on the sale is taxed twice. We have seen many transactions fall apart because the seller of the business gets too little money after taxes to make the sale of the assets of the corporation economically sensible.

Subchapter C corporations do have advantages. They can file consolidated tax returns with 80% owned corporate subsidiaries. There are no limitations on the types or number of shareholders or classes of stock that can be issued. Subchapter C corporations may also be advantageous if the owners’ individual tax rates are significantly higher than corporate tax rates. Also, as a general rule, owners of C corporations are not subject to certain restrictions on certain employee benefit plans that apply to S corporations and limited liability companies.
The state and local taxation of corporations should also be studied because the taxation of Subchapter C corporations varies among jurisdictions.

B. Subchapter S Corporation
As mentioned above, a key negative of a Subchapter C corporation is the potential for two levels of tax on the same income. This is the principal reason that many individuals who start businesses elect to have their corporation taxed under Subchapter S of the Internal Revenue Code. If a Subchapter S election is made, all of the corporation’s income is subject to only one level of federal income tax -- at the shareholder level – and, subject to certain restrictions, losses generated by the Subchapter S corporation that pass through the shareholders can offset certain of the shareholder’s other income. In other words, the S Corporation itself is not subject to any federal income tax, and so the corporation’s income and losses pass through to the owners, who pay tax on that income or can deduct the losses.

The key negative of a Subchapter S corporation is that the Internal Revenue Code imposes many restrictions on these corporations. For example, there is a limit on the number of shareholders (currently 100) and, more important, there are many restrictions on the types of shareholders. For example, corporations and non-resident aliens cannot be shareholders of Subchapter S corporations. Accordingly, if there is a corporate owner involved in the transaction, a Subchapter S corporation is not an alternative. The other restriction that most often causes a problem is the “one class of stock” rule. Under this rule, except for potential differences in voting rights, all of the stock must have the same economic rights. This prevents shareholders from having preferences, and the corporation from issuing preferred stock.

One notable advantage of Subchapter S corporations (versus limited liability companies) is that the earnings of the S corporation not paid out as a salary are not subject to employment taxes such as social security tax. In our experience, Subchapter S corporations are often the entity of choice if there are only one or two shareholders and their relationship is an uncomplicated one.

Extreme care must be given to analyze the state and local tax treatment of Subchapter S corporations. Not all jurisdictions respect Subchapter S elections, and will treat Subchapter S corporations the same as Subchapter C corporations. New York City, for example, does not recognize Subchapter S elections, and imposes a corporate level tax. We often recommended that taxpayers doing business in New York City not use a Subchapter S corporation.

II. Limited Liability Companies
Limited Liability Companies (“LLC”) are a relatively new statutory creation that has become quite popular. LLCs offer the owners (who are called “members”) protection from the entity’s liabilities. This limited liability of the entity’s owner is similar to the limited liability shareholders of a corporation enjoy. Absent an election to be treated otherwise, LLCs are taxed like partnerships: there is only one level of federal income tax, and all of the income and losses pass through to the members.

A significant advantage of LLCs over Subchapter S corporations is increased flexibility for its owners. For example, there are no limitations on the types of persons who can be member (owners) of LLCs: individuals, corporations and other LLCs can all be LLC members. Also, LLCs can draft their operating agreements to include special allocations of income and loss, provided the allocations meet certain requirements imposed by the Internal Revenue Code, or to provide for preferred ownership interests.

Another advantage of LLCs is that the members (owners) get tax basis as a result of borrowing at the entity level. This means that if the entity borrows money for which the owners are not liable, and the entity generates losses, the taxpayers can (subject to certain restrictions) use the losses on their personal tax returns. (This is not true for owners of Subchapter S corporations.) However, the losses that result from entity level debt will in all likelihood be recaptured for tax purposes when the property is sold or the debt is otherwise satisfied. Because of this potential for recapture, LLCs that own real estate often seek to dispose of their holdings by like-kind exchanges rather than outright sales.

Unlike Subchapter C or S corporations, LLCs usually can distribute appreciated property to their owners without any current tax consequences.

As a general rule, LLCs offer all the tax advantages of Subchapter S corporations without the restrictions (except for the possible FICA savings available to Subchapter S corporations described above). One possible disadvantage of using LLCs is that, because they are relatively new, there is not much case law interpreting the LLC laws. Also, if a single person or entity establishes a LLC, absent an election to the contrary, the entity will be ignored for tax purposes, which means that all of the income and losses of the LLC will be reported by the owner on the owner’s tax return.

As with corporations, care must be taken to evaluate the state and local tax treatment, fees and rules applicable to this kind of entity. For example, New York imposes a per member annual fee of $100, and requires LLCs to publish in local newspapers when they are formed. In some jurisdictions, LLCs may be subject to entity level tax. New York City, for example, imposes unincorporated business tax on many LLCs.

III. Limited Partnerships
Limited Partnerships are treated for federal income tax purposes the same way as LLCs (i.e., as pass-through entities). It is differences in local law that usually affect whether a limited partnership or an LLC is a better choice. The most significant difference is that limited partnerships must have a general partner who is personally liable for all of the debts of the limited partnership. Individuals who use limited partnerships usually have a corporate general partner in order to shield them from liability. However, in order to make sure the corporation is respected and that its shareholders are not liable for its debts, care must be taken to ensure that all of the corporate formalities of the corporate general partner are followed. As is the case with LLCs and Subchapter S corporations, local law must be evaluated to see how limited partnerships are treated in a particular jurisdiction.
Our experience in recent years is that the use of limited partnerships has been greatly reduced and that taxpayers more often use LLCs.

IV. Non-U.S. Taxpayers
Please note that the above analysis does not apply to non-U.S. taxpayers who have many different considerations than U.S taxpayers. (As stated above, non-resident individuals cannot be owners of subchapter S corporations.)

Conclusion
This very brief summary should make it clear that there are many different factors to consider before choosing the type of entity to use for a business venture. Careful evaluation at the outset is critical because it is quite often difficult and costly to change from one type of entity to another type of entity and if the wrong type of entity is chosen it can have a significant financially impact its owners.

If you have questions about the foregoing article or any other tax related issues, please feel free to contact Jack Wilk at (212) 981-2333.

**This article was prepared as a service to our clients and friends. This article does not constitute legal advice and should not be relied upon as legal advice by the reader or any other party.

To ensure compliance with requirements imposed by the IRS, we inform you that any US federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed within.