Now for a report that is a little more technical in nature.
Many start-up business owners are at a loss as to the correct business entity to utilize when starting a new business venture. Most of the business individuals have a very basic understanding of personal liability issues with regard to starting a business with some possibility of the business owner being liable for damages caused to third parties while acting in the course of the business activities. Legal practitioners often have had the responsibility of counseling their clients with regard to the best business entity that would suit their needs. The traditional entity of choice for a small business client has been to incorporate with a subsequent S corporation election through the Internal Revenue Service. Until recently, incorporation with an S corporation election was the typical recommendation.
With the advent of the Limited Liability Company, the standard recommendation of incorporation with an S corporation election has come under scrutiny and reconsideration. With the numerous restrictions of the S corporation it seems that the LLC may be the most desired business entity at the present time with some exceptions. It should be noted that the author of this article is a die-hard S corporation enthusiast notwithstanding the proposed advantages of the LLC.
After its creation in 1958, the Subchapter S corporation provided the only type of limited liability and pass-through taxation entity attractive to small business owners. To qualify as an S corporation, various eligibility rules must be met both at the entity and investor levels. A business must fit within the Internal Revenue Code §1361(b) definition of a “small business corporation,” which means that it is not an “ineligible corporation” as identified in Code §1361(b)(2) and does not have (1) more than a specified number of shareholders; (2) a shareholder who is a non-resident alien; (3) a shareholder who is not an individual, an estate, a permitted trust or a permitted exempt organization; or (4) more than one class of stock. The one class of stock requirement is typically the hardest of the criteria to meet and creates the most significant limitations by requiring that all stock have identical rights to distribution and liquidation proceeds. The rule does, however, allow differences in voting rights and management control among shareholders.
Taxation as an S corporation offers two primary advantages to the small business owner. First, the Code provides that the profits and losses of an S corporation flow through to the owners in a manner similar to a partnership, thus avoiding double taxation. Second, employee-owners may be able to reduce their federal self-employment taxes on a portion of their income by reducing wages and increasing distributions. That tax strategy is still only available to entities taxed as S corporations. Partners (other than limited partners) and owners of disregarded entities may not bifurcate their income between wages and distributions to reduce their self-employment tax. All of their income, whether received as a distributive share, salary or payment as an independent contractor is subject to the federal self-employment tax.
In Revenue Ruling 88-76, the Service classified a Wyoming LLC as a partnership under federal tax law. Any lingering uncertainty about the tax status of LLCs was eliminated when the Treasury Department abandoned its previous rules for determining the tax status of an LLC and adopted “check the box” (CTB) regulations. Effective January 1, 1997, an LLC could simply elect its preferred tax status and choose either pass-through taxation like a partnership, or entity taxation like a corporation, including an S corporation. The underlying premise of the CTB regulations is that state law differences in entity structure and governance should not be controlling for federal taxation purposes.
The primary distinctions between an LLC and a corporation are:
(1) there is no limitation on the number of investors who can participate in an LLC that is taxable as a partnership; in contrast, Subchapter S has always restricted the number or shareholders;
(2) any individual or entity, whether domestic or foreign, can become a member in an LLC; S corporations are subject to rigid shareholder eligibility limitations;
(3) because of the one class of stock requirement, S corporations cannot provide a liquidation or distribution preference to any shareholder; an LLC facilitates the issuance of various types of security interests, without jeopardizing their pass-through tax status;
(4) LLCs, except where limited by state law, can created multi-tiered structures of unincorporated pass-through entities to facilitate combinations of business and investment pools and assets; S corporations are more limited in their ability to combine with other corporations and businesses without jeopardizing their pass-through tax status; and
(5) S corporations may engage in tax-free reorganizations without shareholders recognizing gain or loss on stock exchanges pursuant to a plan of reorganization; an LLC, unlike an S corporation, may not be a party to a tax-free reorganization.
In fact, the CTB regulations only indirectly benefit incorporated pass-through entities, like S corporations, by permitting them to be members of LLCs or limited partnerships and to have wholly-owned LLC tax nothings. Nevertheless, as a result of the CTB regulations, a hybrid LLC business structure may allow the small business owner to combine the benefits of an LLC created by state law with those of an S corporation under federal tax law, assuming that the LLC members can meet and maintain all of the requirements of an S corporation. Indeed, an LLC can provide a useful mechanism for S corporations to segregate different aspects or branches of its business for limited liability purposes while still maintaining control.
The primary benefit of employing the S corporation structure is that corporations are recognized in all jurisdictions and, thus, its limited liability feature is universally accepted, subject to situations where piercing the corporate veil is appropriate on an alter-ego theory. LLCs are creatures of state law that vary from jurisdiction to jurisdiction. Consequently, while an LLC structure may permit greater freedom of contract among LLC members, there is no uniform interpretation of the rules governing the enforcement and interpretation of their contracts. Thus, there is reason for caution in jumping on the LLC bandwagon: unlike S corporations having a single shareholder, because of the difference among the various state laws, single member LLCs may afford an owner less protection from unlimited liability than an S corporation, which generally insures limited liability.
There are, nevertheless, some instances where an LLC structure may prove to be the better choice of entity for the business owners. For example, business owners who intend to acquire appreciating assets for their business, such as real estate, may want to avoid S corporation taxation for two primary reasons: (1) appreciated property cannot be distributed by the S corporation to its shareholders without recognition of the gain; and (2) money borrowed by an S corporation will not increase a shareholder’s basis in his or her stock. Indeed, in the context of high-risk real estate ventures, for example, certain investors or participants may only want to contribute services in exchange for a larger share of the profits later, when the deal becomes profitable.
An LLC may make special allocations reflecting this type of business arrangement as long as the allocations have substantial economic effect. In contrast, all items of an S corporation’s income must be allocated to the shareholders pro rata, based on stock ownership, at the end of the taxable year. Thus, an S corporation cannot allocate a larger share of the profits to one shareholder at a specified time if that allocation does not represent the shareholder’s pro rata share of the profits. Moreover, S corporation shareholders may not contribute services for stock without recognizing immediate gain. LLC participants are permitted to contribute services for an interest in profits without recognizing income until the entity actually earns profits.
As stated previously, the author of this article is a die hard “S corporationist” (I think I just invented a new word but it is appropriate for my position. Lawyers oftentimes make up new words that end up in the dictionary). The LLC makes a lot of sense but with inadequate legal precedence you may find yourself traveling down uncharted waters. The S corporation has been around for an extended period of time and one can give a legally educated opinion with regard to most any legal or tax problem that can arise. Notwithstanding the foregoing, the LLC may eventually dominate and become for some the entity of choice regardless of the legal and tax uncertainties. Only time will tell.
Andrew C. Moler, Esq.