Question: Can you provide some guidance from a tax perspective to my business partner and I on the best structure for a new business we are starting?
Answer: The myriad of factors that must be considered in choosing the proper business structure requires a careful evaluation of the available alternatives. In today’s business environment, most closely-held businesses operate as conventional C corporations, S corporations or limited liability companies.
From a tax perspective, C corporations are treated as entities separate and apart from their owners. Income earned by a C corporation is taxed to the corporation while dividends paid by a C corporation are taxable to the shareholders. This can result in a dual layer of taxation, a tax at the corporate level on income and a tax at the shareholder level on dividends. The considerable flexibility in permitting multiple classes of stock and foreign ownership makes C corporations the optimal business structure for publicly-traded and other large corporations. The C corporation structure can nevertheless be advantageous for a smaller corporation with owners seeking to reinvest earnings in the business. The 21% flat Federal income tax rate imposed on C corporations generally permits the accumulation of funds at a lesser tax cost than would result if earnings are taxed at the individual level and then reinvested in the business. C corporations can, however, be particularly burdensome when businesses are sold to third parties as most buyers prefer to buy the assets of a corporation rather than the corporation’s stock, thereby triggering a potential double tax on the sale proceeds.
S corporations are generally not subject to income taxation as business income, gain and loss flow through to and are reported by the corporation’s shareholders on their personal income tax returns. The absence of a tax at the corporate level is attractive although it comes with a cost. Only individuals, other than non-resident aliens, estates and certain trusts are permissible S corporation shareholders. S corporations can have only one class of stock which restricts some of the financial flexibility other entities enjoy by offering preferential rights to distributions to some owners but not others. A S corporation cannot have more than 100 shareholders which prevents a corporation with a large number of shareholders from enjoying S corporation status. S corporations do, however, offer payroll tax savings in that only the salaries paid to S corporation owners are subject to payroll taxes; any dividends or distributions S corporation shareholders receive in their capacity as shareholders are not subject to payroll taxes. While a S corporation can readily revoke its S corporation status and become a C corporation, a five-year period must lapse before a C corporation can reelect S corporation status.
A limited liability company or “LLC”, like a corporation, is formed in accordance with a State statute but can be treated as a partnership for Federal income tax purposes. In many cases, LLCs offer the best of both worlds, the opportunity to avoid Federal income tax imposed on C corporations and freedom from the statutory restrictions on S corporations. Because LLCs permit owners or members to share in company distributions without regard for each member’s ownership interest in the company, differing distributions to members are commonplace in governing LLC documents which permit the holding of preferred and common interests. LLCs are permitted to have to a variety of owners as corporations, partnerships and non-resident aliens are permitted owners as are individuals, estates and trusts. In cases where a business entity is borrowing funds from a third party, a LLC may be the entity of choice if losses are anticipated as LLC members can deduct their share of company losses not only to the extent of their capital contributions but also to the extent of their share of loans taken out by the company. In contrast, S corporation shareholders can only deduct losses to the extent of their capital contributions and any loans they have personally made to the corporation. One disadvantage of the LLC structure is that income reportable from operations by the members will be subject to payroll taxes.
While the specifics of your situation need to be carefully analyzed by your professional advisors who are most familiar with your business, the vast majority of closely-held businesses are formed as S corporations or LLCs. Unless you are in an expansionary phase where you intend to accumulate earnings for future use of the business or need to maintain a structure which is more widely recognized for institutional investors, the S corporation or LLC structure would appear to be best suited for your needs.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.