Deciding what form of organization to use for a new business enterprise requires the organizers to consider legal and tax issues that relate to the venture. Typically, these considerations translate into cost analyses. The key points of focus are which form provides the lowest overall tax bite and which form lessens the potential liability of the owners from the business risks. Such analyses are appropriate for the organizers of investment operations as well as active businesses.
In the choice-of-entity context, the objectives of tax planning are (1) to lower or defer income taxes on profits, (2) to use tax losses to offset (shelter) other income of the owners, (3) to shelter growth in value from income and estate taxes, and (4) to identify and avoid or minimize other tax costs, such as franchise and intangibles taxes. The current federal income tax environment is highlighted by a tax rate structure in which the top corporate rates are now slightly lower than top individual rates (39.6% vs. 35%) for the first time since 1986. However, distributions of appreciated assets by corporations, whether as dividends or in liquidation, are now subject to double taxation. The result is that it is very difficult for the owners to get the growth in value of a business out of corporations without a significant income tax cost.
The primary business planning objectives involved in selecting a form of business are to identify which form (1) best limits the owners' exposure to the potential liabilities of the business, (2) is most efficient from a management viewpoint, (3) is most flexible for potential transfers of ownership interests, (4) is least restrictive in terms of the types of activities the entity can engage in, (5) is the least burdensome in terms of local law reporting and information complexities, and (6) facilitates equity and capital financing arrangements.
In the past, the legal forms of business that were available choices were sole proprietorships, general partnerships, limited partnerships, regular corporations (C corporations), and Subchapter S corporations (S corporations). Since late 1993, businesses in North Carolina have had the additional choice of limited liability companies (LLC's). Historically, because of the liability issues, most active businesses chose to be organized either as C corporations or S corporations. These were the only forms that afforded limited liability to all owners. While many businesses chose S status before 1986, many more became S corporations when corporate rates moved ahead of individual rates and when it became virtually impossible for the owners to realize the value of a business without double taxation if the business operated as a C corporation.
Historically, organizers of investment entities chose between operating as a partnership or an S corporation because the pass-through tax character of these entities led to lower overall tax costs. If tax basis issues were important, a partnership was preferred to an S corporation. When liability risks to the owners were important, an S corporation, or perhaps a limited partnership, might have been preferred over a general partnership.
Until late 1993, choosing a form of operating a business or investment enterprise in North Carolina frequently seemed to be a "round peg/square hole" exercise. Now that North Carolina has adopted its Limited Liability Company Act, LLC's provide a more flexible entity choice for many situations. The nature of the choice-of-entity analysis may now be more "We'll shape the peg to fit the hole."
Comparison of LLC's to S Corporations
Both LLC's and S corporations offer limited liability to owners and flow-through tax treatment. However, LLC's offer several advantages over S corporations as a business entity. The essence of these advantages is greater flexibility in structuring management and economic relationships among members.
S corporations are subject to a number of restrictions. Affirmative elections must be filed with the IRS within specific time periods. If the election is not filed on a timely basis, the corporation will be treated as a regular C corporation, with all of its double taxation problems. Generally, only individuals (and certain special types of trusts) can be shareholders in an S corporation, and an S corporation cannot have more than 35 shareholders. S corporations cannot own subsidiaries. Although S corporations generally offer the same pass-through tax benefits as a partnership, there are certain circumstances in which taxation at both the corporate and shareholder level can result.
In addition, S corporations can only have one class of stock. Cash distributions to shareholders and allocations of taxable income and taxable loss must strictly follow percentage stock ownership. Distribution of appreciated property by an S corporation to its shareholders will cause the gain in the distributed property to be recognized. The tax basis against which the S corporation shareholder can deduct the shareholder's share of the corporation's taxable losses is limited to the basis in the stock and certain debt owed by the corporation to the shareholder. Numerous other technical tax rules and restrictions apply to S corporations. Finally, for North Carolina tax purposes, stock in an S corporation is currently subject to North Carolina intangibles tax and the corporation itself is subject to North Carolina franchise tax.
In contrast to S corporations, no election is necessary for a properly organized LLC to be treated as a partnership for federal and North Carolina income tax purposes, and there is no restriction on who can be an owner of an LLC or on how many owners an LLC can have. Owners of an LLC might include individuals, corporations, partnerships, or even other LLC's. Subject to some important tax limitations, the tax basis against which the owner of an LLC interest can deduct the owner's share of the entity's taxable losses may include the owner's share of the entity's debt to third parties. LLC's are not subject to North Carolina franchise tax, and ownership interests in LLC's are not subject to North Carolina intangibles tax.
Also, the LLC is a very flexible vehicle in terms of structuring economic sharing arrangements among the owners. For example, in a case where one owner agrees to contribute all of the cash needed for the business, and another owner agrees to contribute services by operating the business on a full-time basis, the parties might want to structure a preferred cash-on-cash return to the money partner. This can be easily done with an LLC, but it would be difficult to do with an S corporation.
The principal disadvantages of an LLC compared to an S corporation include:
All states recognize foreign corporations limitations on the liability of shareholders. However, until all 50 states adopt LLC legislation, there is some risk to N.C. LLC's that do business in non-LLC states that courts in those states would not respect the limited liability rules of the Act in disputes litigated in those jurisdictions. The importance of limited liability in jurisdictions without LLC Acts should be one of the initial inquiries in the choice-of-entity process. Currently, 14 states do not have legislation in place authorizing domestic LLC's or recognizing foreign LLC's. Most appear to have legislation in progress (including California, New York, Pennsylvania, Tennessee, and South Carolina). The ABA's Subcommittee on LLC's predicts that all 50 states will recognize LLC's by the end of 1994.
An LLC must have at least two members on formation, which may run counter to the notions of many entrepreneurs. An S corporation can have a single shareholder.
Although most S corporations will have perpetual existence, an LLC (like a partnership) will be limited in duration.
The taxable income of an S corporation that is allocated to the shareholders (in contrast to salaries and other compensation paid by the S corporation to its shareholders) is generally not subject to self-employment taxes. Although it appears that non-manager members of LLC's will not be subject to self-employment taxes on their distributive share of the LLC's taxable income (by analogy to limited partners in limited partnerships), there is some risk that the IRS might seek to classify some or all of the allocation of income to a member-manager as self-employment income.
Comparison of LLC's to General and Limited Partnerships
Because LLC's, general and limited partnerships are typically treated the same for tax purposes, the principal advantages of LLC's over state law partnerships are non-tax. Clearly, the key advantage of LLC's is the limitation on personal liability for members. General partners in both general and limited partnerships are jointly and severally liable for all debts and obligations of the partnership. Members in LLC's are not liable for the debts and obligations of the LLC. Although limited partnerships offer limited liability to their limited partners, those limited partners can be held liable if they participate in the management and control of the business. Now that LLC's are a recognized business entity form in North Carolina, there is no reason that individuals should continue to operate in the partnership form and expose their personal assets unnecessarily to risk of loss. LLC's provide partnership tax treatment, with the added benefit of asset protection for the owners.
One potential disadvantage of LLC's in comparison to partnerships is that some states (most notably Florida and Texas) impose an entity level tax on LLC's.
Why Shouldn't We Simply Use a C Corporation?
Now that the Revenue Reconciliation Act of 1993 has raised the top individual income tax rate above the top corporate rate, there may be some movement away from pass-through entities such as S corporations, partnerships, and LLC's to C corporations for businesses. However, the rate differential is not a factor unless (a) the individual owners are in fact in a tax bracket higher than the expected corporate rate, and (b) the corporation intends to accumulate earnings without distributing them.
Even if those criteria are met, a C corporation is generally not a good choice for a business that has assets that will appreciate in value over time. If assets increase in value and the business is sold in the future, the result would be both a corporate level and a shareholder level tax on that appreciation in value at the time of sale.
It should be noted that C corporations currently have some advantages over LLC's and similar entities in the area of fringe benefits for owner-employees. A C corporation can pay and deduct the costs of certain fringe benefits, including health and disability insurance premiums, and cafeteria plans. These benefits are tax-free to owner-employees in C corporations. In contrast, owner-employees of LLC's are not eligible to participate in cafeteria plans, and the other benefits are taxable to them. The one exception is that owner-employees in LLC's can reduce their adjusted gross income by 25% of their medical insurance premiums. In the typical situation, the tax savings to owner-employees will be a net deduction of 75% of their medical insurance costs and any applicable cafeteria plan savings. Offsetting these savings would be the costs associated with the typical year-end tax planning for C corporations and the franchise tax applicable to corporations (but not LLC's). For personal service corporations, including professional practices, all taxable income of the corporation will be taxed at the top corporate rate of 35%.
In summary, we believe that, as LLC's become more familiar, they will become the typical entity of choice for most new business formations.