Choice of Entity

Choice of Entity/Significant Tax and Other Considerations

The following is a high level summary of some of the more important federal income tax and non-tax considerations involved in choosing between doing business as an entity taxed for federal income tax purposes as:

  • a C corporation (C Corp);
  • an S corporation (S Corp); and
  • a partnership (such as a multi-member limited liability company (LLC) that hasn’t checked the box to be taxed as a corporation).

C Corporations v. S Corporations

C Corporation Advantages/S Corporation Disadvantages

  • Traditional Venture Capital Investments Can Be Made – C corporations can issue convertible preferred stock, the typical vehicle for a venture capital investment.  S corporations cannot issue preferred stock.
  • Investors Won’t Be Taxed on the Entity’s Income and Receive A Form K-1 – Many investors will refuse to invest in a company if they will be taxed on the company’s income and will receive a Form K-1 reporting such income to them as a result of the investment. This is not the case with C corporations, but it is the case with S corporations.
  • Retention of Earnings/Reinvestment of Capital – Because a C corporation’s income does not flow or pass-through to its shareholders, C corporations are not subject to pressure from their shareholders to distribute cash to cover their shareholders’ share of the taxable income that passes through to them.  An S corporation’s pass-through taxation may make conservation of operating capital difficult because S corporations typically must distribute cash to enable shareholders to pay the taxes on their pro rata portion of the S corporation’s income (S corporation shareholders are taxed on the income of the corporation regardless of whether any cash is distributed to them).
  • Eligibility for Qualified Small Business Stock Benefits – C corporations can issue “qualified small business stock.”  S corporations cannot issue qualified small business stock, thus S corporation owners are ineligible for qualified small business stock benefits, such as the 50% gain exclusion for gain on the sale of qualified stock held for more than five (5) years (for an effective capital gains rate of 14%) and the ability to roll over gain on the sale of qualified stock into other qualified stock.

Until the end of 2013, individuals receiving “qualified small business stock” from C Corps may be able to take advantage of the 100% exclusion from tax (up to $10M in gain), including AMT, under Section 1202 of the IRC, if they hold the QSBS for longer than 5 years. This is a significant potential benefit not available for S Corps. 

  • No One Class of Stock Restriction – S corporations can only have one class of stock; thus, S corporations cannot issue preferred stock.  This restriction can arise unexpectedly, and must be considered whenever issuing equity, including stock options or warrants.
  • Flexibility of Ownership – C corporations are not limited with respect to ownership participation.  There is no limit on the type or number of shareholders a C corporation may have.  S corporations, in contrast, can only have 100 shareholders, generally cannot have non-individual shareholders, and cannot have foreign shareholders (all shareholders must be U.S. residents or citizens).
  • More Certainty in Tax Status – A C corporation’s tax status is more certain than an S corporation’s; e.g., a C corporation does not have to file an election to obtain its tax status.  S corporations must meet certain criteria to elect S corporation status; must elect S corporation status; and then not “bust” that status by violating one of the eligibility criteria.
  • No State Income Tax Complications for Investors. Shareholders of an S corporation may be subject to the income tax of various states in which the S corporation does business. This doesn’t happen to C corporation shareholders.

S Corporation Advantages/C Corporation Disadvantages

  • Single Level of Tax – S corporations are pass-through entities: their income is subject to only one level of tax at the shareholder level.  A C corporation’s income is subject to tax and any “dividend” distributions of earnings and profits to shareholders that have already been taxed at the C corporation level are also taxable to the shareholders (i.e., income is effectively taxed twice).  This rule is also generally applicable on liquidation of the entity.
  • Pass-Through of Losses – Generally losses, deductions, credits and other tax benefit items pass-through to a S corporation’s shareholders and may offset other income on their individual tax returns. These returns are subject to passive activity loss limitation rules, at risk limitation rules, basis limitation rules, and other applicable limitations.  A C corporation’s losses do not pass-through to it shareholders.

C Corporations vs. LLCs

C CORPORATION ADVANTAGES/LLC DISADVANTAGES

  • Traditional Venture Capital Investments Can Be Made – The issuance of convertible preferred stock by C corporations is the typical vehicle for venture capital investments.  Venture capitalists typically will not invest in LLCs and may be precluded from doing so under their fund documents.
  • Traditional Equity Compensation is Available – C corporations can issue traditional stock options and “incentive stock options.”  It is more complex for LLCs to issue the equivalent of stock options to their employees.  “Incentive Stock Options” also are not available to LLCs.
  • Investors Won’t Be Taxed on the Entity’s Income and Receive A Form K-1 – Many investors will refuse to invest in a company if they will be taxed on the company’s income and will receive a Form K-1 reporting such income to them as a result of the investment. This is not the case with C corporations, but it is the case with S corporations.
  • Ability to Participate in Tax-Free Reorganizations – C corporations can participate in tax-free reorganizations under IRC Section 368.  LLCs cannot participate in tax-free reorganizations under IRC Section 368.
  • Sale of Equity or IPO – C corporations can engage in traditional equity financings; it is more complex for LLCs to issue equity.  As a practical matter, an LLC will need to transfer its assets to a new corporation before entering the public equity markets because investors are more comfortable with a “typical” corporate structure.  This preparation and transition will result in additional expense and complexity.
  • Self-Employment Taxes – C corporation shareholders are not subject to self-employment taxes on the corporation’s income.  An LLC’s members are generally subject to self-employment tax on their distributive share of ordinary trade and business income.
  • Retention of Earnings/Reinvestment of Capital– A C corporation’s income does not flow or pass-through to its shareholders; this makes it easier to retain and accumulate capital.  LLC’s pass-through taxation makes conservation of operating capital difficult.  LLCs typically distribute cash to enable members to pay the taxes on their share of the LLC’s income. LLC members are taxed on the income of the LLC allocated to them regardless of whether any cash is distributed to them.
  • Fringe Benefits – C corporations have more favorable treatment of fringe benefits.  LLC members cannot be considered “employees” for federal income tax purposes and therefore must pay self-employment taxes; fringe benefits of LLC members are generally included in income.
  • Qualified Small Business Stock Benefits – C corporations can issue “qualified small business stock.”  LLCs cannot issue qualified small business stock, thus LLC owners are ineligible for qualified small business stock benefits. Such as the 50% gain exclusion for gain on the sale of qualified stock held for more than five (5) years (for an effective capital gains tax rate of 14%) and the ability to roll over gain on the sale of qualified stock into other qualified stock.
  • State Income Tax Return Filing Requirements – Each member of the LLC may be required to a file a tax return in multiple states.  This is not the case with C corporations.
  • Complexity/Uncertainty – The flexible nature of LLCs makes them more complex.  Partnership tax is also substantially more complex than C corporation tax.  The relatively new nature of the LLC form and limited amount of case law make LLC transactions more complex and uncertain than their corporate counterparts.
  • Tax Rates – Individual tax rates can be higher than C corporation tax rates.
  • Administrative Burdens – Partnership tax accounting is more complex than C corporation accounting.
  • Withholding on Foreign Member’s Distributive Shares – An LLC has to withhold taxes on certain types of income allocated to foreign persons, regardless of whether distributions are made.  C corporations are not subject to this requirement.

LLC Advantages/C Corporation Disadvantages

  • Single Level of Tax – LLCs are pass-through entities: their income is subject to only one level of tax, at the member level.  A C corporation’s income is subject to tax, and any “dividend” distributions of earnings and profits to shareholders that have already been taxed at the C corporation level are also taxable to the shareholders (i.e., income is effectively taxed twice).
  • Pass-Through of Losses – Generally, losses, deductions, credits, and other tax benefit items pass-through to an LLC’s members and may offset other income on their individual tax returns (subject to passive activity loss limitation rules, at risk limitation rules, basis limitation rules, and other potential limitations).  A C corporation’s losses do not pass-through to its shareholders.
  • Tax-Free Distributions of Appreciated Property – An LLC can distribute appreciated property (e.g., real estate or stock) to its members without gain recognition to the LLC or its members, facilitating spin-off transactions.  A C corporation’s distribution of appreciated property to its shareholders is subject to tax at the corporate level and possibly tax at the shareholder level as well.  (It is for this reason that entities formed to invest in real estate or the stock of other companies should not be C corporations).
  • Basis Step-Up – Members receive a basis step-up in their LLC interests for income left in the LLC and not distributed.  Because there is no pass-through of income in C corporations, this is not true in C corporations.
  • Tax-Free Formation – Appreciated property can generally be contributed to LLCs tax-free under one of the broadest nonrecognition provisions in the IRC (IRC Section 721).  Tax-free capitalizations for C corporations must comply with the more restrictive provisions of the IRS to be tax-free (i.e., IRC Section 351) (although this is not usually a problem).

S Corporations vs. LLCs

S Corporation Advantages/LLC Disadvantages

  • Sales of Equity and Initial Public Offerings – S corporations can more easily engage in equity sales (subject to the one class of stock and no entity shareholder (generally) restrictions) than LLCs.  For example, because an S corporation can only have one class of stock, it must sell common stock in any financing (and this makes any offering simpler and less complex).  An LLC will often have to define the rights of any new class of stock in a financing, and this may involve complex provisions in the LLC agreement and more cumbersome disclosures to prospective investors. In addition, an S corporation does not have to convert to a corporation to issue public equity (although its S corporation status will have to be terminated prior to such an event).  As a practical matter, an LLC will need to transfer its assets to a new corporation or merge with a new corporation before entering the public equity markets because investors are more comfortable with a “typical” corporate structure.
  • Ease Of Conversion To C Corporation Status – It is typically easier for an S corporation to convert to a C corporation than it is for an LLC to convert to a C corporation.  For example, upon accepting venture capital funding, an S corporation will automatically convert to a C corporation.  For an LLC to convert to a C corporation, it is necessary to form a new corporate entity to either accept the assets of the LLC in an asset assignment or into which to merge the LLC.  Also, converting an LLC to a C corporation may raise issues relating to conversions of capital accounts into proportionate stockholdings in the new corporation that are not easily answerable under the LLC’s governing documents.
  • Traditional Equity Compensation Available – S corporations can adopt traditional stock option plans; in addition, they can grant “incentive stock options.”  It is very complex for LLCs to issue the equivalent of stock options to their employees (although they can more easily issue the equivalent of cheap stock through the issuance of “profits interests”—see below).  “Incentive Stock Options” also are not available for LLCs.
  • Ability to Participate in Tax-Free Reorganizations – S corporations, just like C corporations, can participate in tax-free reorganizations (such as a stock swap) under IRC Section 368.  LLCs cannot participate in a tax-free reorganization under IRC Section 368.  This is a significant reason not to choose the LLC format if a stock swap is an anticipated exit strategy.
  • Simplicity of Structure – S corporations have a more easily understandable and simpler corporate structure than LLCs.  S corporations can only have one class of stock–common stock–and their governing documents, articles and bylaws, are more familiar to most people in the business community than LLC operating agreements (which are complex and cumbersome and rarely completely understood).
  • Self-Employment Taxes – S corporation shareholders are not subject to self-employment taxes.  S corporation shareholders who are employees are taxed as employees and receive a Form W-2, not a Form K-1.  An S corporation structure may result in the reduction in the overall employment tax burden.  LLC members are generally subject to self-employment tax on their distributive share of the LLC’s ordinary trade or business income.  LLC members cannot be employees for federal income tax purposes and thus cannot receive Forms W-2.
  • Fringe Benefits – Only 2% or greater shareholders of S corporations have to include certain fringe benefits in income; generally all fringe benefits of LLCs are included in the income of the members, regardless of their percentage of ownership.

LLC Advantages/S Corporation Disadvantages

Pointer: Filing form BE-605A BE-605 form is required when a U.S. business enterprise is acquired or established by a foreign entity, if that entity owns 10% or more of the voting stock (or equivalent interest).

  • Flexibility of Ownership – LLCs are not limited with respect to ownership participation.  There is no limit on the number of members an LLC may have.  S corporations, in contrast, can only have 100 shareholders. Similarly, LLCs may have foreign members, however upon becoming a member of an LLC, a foreign member may suddenly become subject to the U.S. tax laws and have to file a U.S. tax return filing. Additionally, an LLC will have to withhold on allocations of certain types of income to foreign members). S corporations cannot have foreign shareholders; all shareholders must be U.S residents or citizens.  As a practical matter, however, an LLC is not a viable choice of entity for an entity that will have foreign investors or investors that are themselves pass-through entities with tax exempt partners, because such investors may refuse or not be able to be members of an LLC.
  • Special Allocations of Tax Attributes – An LLC has flexibility to allocate tax attributes in ways other than pro rata based on stock ownership.  An S corporation’s tax attributes must be allocated to shareholders based on the number of shares they own.
  • Debt in Basis – An LLC member’s basis for purposes of deducting pass-through losses includes the member’s share of the entity’s indebtedness.  This is not the case with S corporations.
  • More Certainty in Tax Status – S corporations must meet certain criteria to elect S corporation status; they must then make an election; they must then not “bust” that status by violating one of the eligibility criteria.  LLCs generally do not have to worry about qualifying or continuing to qualify for pass-through treatment.
  • Tax-Free Distributions of Appreciated Property – An LLC can distribute appreciated property (e.g., real estate or stock) to its members without gain recognition to the LLC or its members, facilitating spin-off transactions.  An S corporation’s distribution of appreciated property to its shareholders results in the recognition of gain by the S corporation on the appreciation, which gain then flows or passes through to the S corporation’s shareholders.
  • Profits Interests – It is possible to grant “cheap” equity to service providers through the use of “profits interests” under Rev. Proc. 93-27.  See also Rev. Proc. 2001-43.  It is more difficult for S corporations to issue cheap equity without adverse tax consequences to the recipients.
  • Payments to Retiring Partners – Payments to retiring partners may be deductible by the partnership; payments in redemption of S corporation stock are not deductible.
  • Ease of Tax-Free Formation – Appreciated property can be contributed tax-free to LLCs under one of the most liberal nonrecognition provisions in the IRC.  Contributions of appreciated property to S corporations in exchange for stock must comply with more restrictive provisions of the IRC to be tax-free (i.e., IRC Section 351) (although this is not usually a problem).

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  • Nick Sparagis

    Got a question, we are an LLC.  Currently, we pay payroll tax on the first $110k. My understanding is with an S-corp, you can give can pay yourself through payroll (subject to payroll taxes) and then take a dividend for the remaining earnings.  The dividend/distribution does not incur payroll taxes.  You would pay appr. 15.5% less on the dividend income.  

    • joewallin

      Nick, there is a potential planning opportunity here, but you should consult with your tax advisors. One brake that you should be aware of is the requirement of paying a reasonable salary. But this issue is best discussed in depth with your tax advisor.

  • http://twitter.com/AdviceMarriage James Johnston

    I am a foreigner and I have an LLC registered here in Colorado. My question is can this LLC have an equity in S-corporation?

    • joewallin

      Generally speaking S corps can only have individual shareholders.

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  • Cindy

    You write ” Ability to Participate in Tax-Free Reorganizations – C corporations can participate in tax-free reorganizations under IRC Section 368. LLCs cannot participate in tax-free reorganizations under IRC Section 368.” But that’s only because 368 doesn’t apply to entities taxed as partnerships at all. They can reorganize on a tax-free basis under the Subchapter K rules (assuming they’re taxed as a partnership).

    • joewallin

      Right, but if you have an LLC taxed as a partnership and a big acquiror company (call it “Bigco”) wants to acquire the LLC in a reverse triangular merger in an all stock or majority stock transaction–the typical acquisition structure for tech company acquisitions by big, acquiror companies–that reverse triangular cannot qualify under Section 368 because only corporations can participate in Section 368 reorgs.

      Bigco can acquire a corporation in a reverse triangular for all stock, and recipients of the stock won’t have to pay tax on the stock until they sell that stock (meaning, they get deferral) if the transaction qualifies under 368 as a reorg. But if target is an LLC the stock is taxed on receipt as if it was cash even if it is restricted stock. That is a harsh consequence of being an LLC taxed as a partnership.

  • lanyslinas

    All of your reasons in “S CORPORATION ADVANTAGES/LLC DISADVANTAGES” refer to C corporations. Did you just cut and paste these? What are the actual differences?

    • joewallin

      Thanks for catching this. Not sure how this happened but I will fix it. Thanks.

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  • Patrick Dague

    Excellent article. I will recommend it. Patrick Dague

  • Aaloka Gupta

    Top of Article and good information . i try it.

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