One of the most important decisions that new business owners make is selecting their ownership structure. When determining what type of entity will fit your business best—limited liability company (LLC), partnership, S corporation, or C corporation—consider such factors as raising capital, control, legal liability, and tax benefits. Also, establish a back-up plan because once you have made your decision regarding which entity to choose, changes in ownership, tax law, or the economy may make it necessary to convert to an entirely new type of entity.
An essential job for every new business owner is raising capital. S corporations and C corporations allow for the sale of stock, which can be a quick and effective means of raising capital. Unfortunately, S corporations have a number of constraints, including being limited to one type of stock, having at most 100 shareholders, and restricting the type of shareholders they can have. For partnerships and LLCs that are taxed as partnerships, they raise capital by admitting additional partners or having current partners put more capital into the partnership. While there is no limit on the number of partners a partnership can have, from a tax perspective, having a partner buy into a partnership generally is more complex than a stock transaction.
Another significant consideration for new owners is the amount of control they want to retain in their business. No matter the entity, with the right amount of planning and proper organizational documents, it can be controlled as desired. A single-member LLC or sole shareholder of an S corporation provides 100 percent control over your entity, but if you were to bring in new members to an LLC or add shareholders to an S corporation, you may dilute your control. Arrangements can be made to help you retain majority ownership. S corporations sell not only voting shares, but also nonvoting shares, which can help to mitigate any loss of control as new members join the S corporation. Also, partnerships can write their partnership agreement in any number of ways to ensure the control stays with the desired parties. Partners can be brought in with a profits interest or as an equity partner.
Having legal protection within your new entity is a necessity and can make a business more attractive for investors as most require some form of legal liability protection. S corporations, C corporations, limited partnerships, and LLCs are popular because they have limited personal liability for debts and other actions undertaken against the entity. Even though true sole proprietorships and general partnerships expose owners to liability, it can be prevented through proper planning.
Tax benefits should not be overlooked or underestimated when organizing a new business since each entity type has tax opportunities as well as consequences. For example, a multimember LLC can choose to be taxed either as a partnership or as a corporation, while a single member LLC can choose to be taxed as a C corporation, S corporation, or as a disregarded entity. S corporations, partnerships, and LLCs taxed as partnerships are pass-through entities, which mean they "pass through" taxable income, interest, dividends, deductions, and credits to the shareholders or partners responsible for paying tax. This avoids the double taxation associated with C corporations that pay entity-level taxes and then distribute dividends that are subject to individual taxes. The following illustrates using the highest marginal federal tax rates:
|C corporation||S corporation|
|Entity level tax (35%)||(350,000)||0|
|Shareholder income tax (35%)||0||(350,000)|
|Qualified dividend tax (15%)||(97,500)||0|
|Total taxes paid||447,500||350,000|
Though both provide pass-through taxation, S corporations and LLCs taxed as partnerships have slight differences in the advantages and disadvantages they offer. S corporation income is not subject to self-employment tax because it is limited to wages that are subject to withholding, FICA, and Medicare. This gives S corporations a small advantage over guaranteed payments from partnerships and other partnership income subject to self-employment taxes. However, the IRS has challenged positions where the S corporation did not pay “reasonable compensation."
Partnerships provide tax advantages by allowing more freedom with distributions, whereas S corporation distributions are pro rata, based on ownership percentages. Partnerships also provide flexibility to specially allocate income and loss to its members; S corporations must allocate on a per-share, per-day basis. Partnerships and LLCs taxed as partnerships allow their partners to treat debts in the partnership as basis, unlike an S corporation. Partners in a partnership have the ability to use IRC section 754 to take a step-up in basis on assets when partners transfer in and out. Using a 754 election allows new partners to have more basis in their share of partnerships assets, thus more deductible expenses.
Converting from one type of entity to another can have varying tax consequences depending on the beginning entity and the ending entity. Some conversions may be tax-free to the owners and the entity, but others may trigger income tax consequences. In practice, there are three main conversion strategies: (1) converting a C corporation to an S corporation, (2) converting an LLC to an S corporation, and (3) converting a corporation (C or S corporation) to an LLC.
Converting from a C corporation to an S corporation
Often owners of C corporations will consider converting to an S corporation. The main reason for converting is changing from a double layer of tax to a single layer. If the corporation meets all the requirements to elect S status described above, all shareholders must agree to change. Although, infrequent an S corporation can become a C corporation, either because they lose their S status or by choice.
Unlike some entity conversions, a change from a C corporation to an S corporation is not generally subject to immediate taxation. However, the newly converted S corporation will be subject to two different taxes: the built-in gains tax and the excess net-passive income tax. The built-in gains tax is tax on the sale of corporate property. If you sell property in 2012 or beyond, the built-in gains recognition period will be within 10 years of conversion. The measuring point is the fair market value on the date of conversion less the adjusted tax basis on the date of conversion. It is highly recommended that a corporation electing to S status obtain a valuation of its tangible and intangible assets and have adequate documentation of its basis records. The excess net-passive income tax applies to S corporations with earnings and profits and that have income derived from passive sources, such as interest, dividends, and rentals. Through proper planning, the S corporation conversion taxes often are minimized.
Converting from an LLC to an S corporation
Unlike converting from a C corporation to an S corporation, converting an LLC to an S corporation does not create any built-in gains or excess net-passive income tax issues. It is generally a tax-free exchange. The main advantage of converting to an S corporation relates to the self-employment savings.
To convert to an S corporation, LLC members are recommended to contribute their LLC units to a newly formed S corporation rather than creating a corporation underneath the LLC and then distributing the stock or distributing operating assets to the members. This strategy helps insulate the owners from liabilities from the business because they never had direct ownership of the LLC assets. Additionally, this strategy eliminates the possibility of an ineligible shareholder owning the S corporation stock (i.e., an LLC taxed as a partnership).
Converting from a C or S corporation to an LLC
The last commonly contemplated conversion is a corporation to an LLC. This strategy creates an immediate taxable transaction at the entity level (for a C corporation) and the shareholder level (for both a C corporation and S corporation). Most often, this form of conversion is executed when a new purchaser of the business prefers to buy assets. Rarely will an existing owner of a business prefer to accelerate a taxable gain in order to gain the benefits of an LLC.
If you are interested in starting a new business or changing your current business entity, contact your Baker Tilly tax advisor to help you determine the ownership structure that is best for you.