TO BE OR NOT TO BE:
CORPORATION, PARTNERSHIP, LLC?
After a delay of 38 years, I have decided to reduce to writing my perspective on these basic questions: “Should I incorporate? Should I do business as a partnership? An LLC? What should I consider in making these decisions”
This article will deal with some basics, but will not cover business continuation issues, or specific issues dealt with in a buy-sell situation, such as death, disability, disagreement, dissolution, or drugs:
Formalities of Existence
Of the major forms of business, C and S corporations have the most burdensome requirements regarding formalities of existence. These requirements reflect the fact that a corporation is a separate legal entity from its owners. A corporation must file articles of incorporation with the secretary of the state in the jurisdiction of organization. It must also adopt bylaws, elect a board of directors, hold organizational meetings, and keep minutes thereof. Although these are the general rules with regard to the formalities a corporation must observe, each state has its own incorporation requirements that must be examined and observed.
When a corporation is formed, it is, by default, taxed as a C corporation. In order to be taxed as an S corporation, an election must be timely made with the Internal Revenue Service (by filing a Form 2553). The tax consequences are discussed in a later section of this article. If an untimely election is not made, the corporation will be taxed as a C corporation.
A general partnership usually has no formal registration requirements. It may be formed informally without a written agreement. A limited partnership, as a creature of state statute, must observe certain formalities. In particular, a certificate of limited partnership must be filed with the secretary of the state of formation. In addition, the partnership must follow the organizational requirements imposed by that state. Similarly, a limited liability company must file articles of organization with the secretary of state, and must comply with state requirements that are a condition of its limited liability status.
Corporations: stockholders elect directors, directors elect officers (consisting of president, secretary, treasurer, and optional offices, such as vice presidents). The directors are the primary corporate authorities in determining the corporation’s mission; the officers carry out the day to day responsibilities. The stockholders do not have to be directors, and the directors do not have to be officers (although in a one-man corporation, the stockholder will be the director, and the director will be the officers). Duties and responsibilities of stockholders, directors and officers set forth in statutes, certificates of organization filed with the Secretary of State, and By-laws (which are adopted by the stockholders).
Partnerships: the partners can bind the partnership. Duties and responsibilities are set forth in statutes and partnership agreement.
Limited partnerships: the general partners have all authority in making decisions; the limited partners have little or no authority in the decision making process. Duties and responsibilities are set forth in articles of organization filed with Secretary of State, statutes, and limited partnership agreement (adopted by all partners).
LLCs: can be operated by the members, or by one or more managers. The managers have all authority in making decisions; the members have little or no authority in the decision making process. Duties and responsibilities are set forth in articles of organization filed with Secretary of State, statutes, and operating agreement (adopted by members and manager).
All ownership interests in all entities discussed are considered as personal property.
Corporations: owned by stockholders, who are issued stock certificates.
Partnerships, limited partnerships: owned by partners (whose interest is reflected in a capital account for each partner)
Tax Aspects of Formation
When a C or an S corporation is formed, the owners generally contribute property or services to the entity in exchange for stock. If property is contributed, the owners do not recognize gain on receipt of the stock provided they are in control of the company. That is, if they own 80% or more of the voting power or 80% or more of all other classes of stock. If, however, the contributors receive something other than stock (i.e., cash), they must recognize gain in the amount of the nonqualifying property received. This rule also applies if the individual contributes property subject to debt (i.e., the transferor is treated as having received cash equal to the amount of the debt). An individual who contributes services in exchange for stock must generally recognize gain, unless the stock has no value at the time of the exchange. If the corporate stock has value, it may be able to deduct the compensation to the extent it is not treated as a capital expenditure.
The tax consequences of forming a partnership or a limited liability company taxed as a partnership are similar to those governing corporate formation. A contribution to the entity in exchange for an ownership interest is generally not a taxable event. However, the partnership nonrecognition rules are more liberal than the corporate rules in that there is no requirement that the owners be in “control” of the partnership after the contribution. If, however, a partner contributes encumbered property to a partnership, the receipt of such property is treated as a transfer of cash to the contributing owner and is likely to be treated as a partnership distribution equal to the amount of the debt. Specifically, the other owners' share of the liability is deemed to be distributed to the contributing owner.
A partner (or LLC member) who contributes services in exchange for a partnership interest generally recognizes gain equal to the value of the interest received. However, if the partner receives only a right to future partnership profits as opposed to a capital interest, then no gain is recognized.
The Internal Revenue Service has permitted LLCs to be taxed as S corporations, by filing a Form 8832, which is an Entity Classification Election form, and a Form 2553. If the LLC is owned by one person, such an election might give some tax benefits which are not readily apparent. Let me illustrate this as follows: Suppose a one person LLC is formed. Normally, the income and expenses are reported on the owner’s Form 1040, on Schedule C. However, if the LLC elects to be taxed as an S Corporation, the LLC will file a corporate return (a Form 1120S), and income and expenses will be reported to the owner on a Form 1120S K-1. Presumably, part of the expenses will be reported as salary to the owner, but part of the earnings might be reported to the owner as dividends (which are not subject to the self-employment tax of 15.3%).
Let’s take this example a step further: suppose the LLC is owned by two or more persons. By default, the members of the LLC will receive a Form 1065 K-1 (since the LLC will be “taxed” as a partnership, when it files its Form 1065); the profits and losses will then be transferred to the respective Forms 1040 of the members involved. However, earnings from the LLC are subject to self-employment taxes, if the owners are actively involved in the management of the company. PLR 9432018 (8-8-94).
Should the LLC elect to be taxed as an S Corporation, part of the earnings might be distributed as “corporate” dividends, and such dividends are not subject to the 15.3% self employment taxes.
There are restrictions on the type of stockholders who qualify as S Corporation stockholders: for example, the stockholders must be U.S. Citizens. In addition, there can be no more than 75 stockholders, and there can only be one class of stock.
Limited Liability of Owners
(piercing the corporate veil)
In general, the owners of a C or an S corporation are not personally liable for the entity's obligations. However, an owner who guarantees a debt or commits a tort while acting on behalf of the entity may lose this protection. This protection may also be lost if the corporate veil is “pierced.” This can occur if the entity either is poorly capitalized or fails to maintain a separate identity from its owners.
A limited liability company also provides its owners with limited liability, subject to the following qualification: if the LLC is owned by one person, then the limited liability rules do not apply. The reasoning for this result was stated in Re: Ashley Albright, USBC, D Colo., Case 01-11367 (Bankr. LEXIS 291, 2003): “Because there are no other members in the LLC, the entire membership interest passed to the bankruptcy estate, and the Trustee (in Bankruptcy) has become a “substituted member”. The . . . Limited Liability Company Act requires the unanimous consent of “other members” in order to allow a transferee to participate in the management of the LLC. Because there are no other members in the LLC, no written unanimous approval of the transfer was necessary.”
In other words, a creditor (such as a Trustee in Bankruptcy) can seize an ownership interest in the LLC, since the owner’s interest is not subject to restrictions on transfer (if there were more than one owner, there would be restrictions on transferring an owner’s interest, such as, a judgment creditor attempting to seize and transfer the interest to himself or herself.
Unlike a corporation or limited liability company, a general partnership does not afford its owners limited personal liability. The owners are personally liable for partnership debts and for the acts of fellow owners performed in furtherance of partnership business. General partners in a limited partnership have the same type of personal liability as do their counterparts in a general partnership. However, the liability of limited partners who do not manage the business is limited to the extent of their respective investment in the enterprise.
Taxation as Separate Entity versus Pass-Through Entity
One of the biggest factors affecting the choice of entity decision is whether the entity should be taxed as a separate entity or whether its items of income, credit, loss, and deduction should pass through and be reported by the owners on their personal tax returns. C corporations are taxed as separate entities. One disadvantage to a C corporation is that its earnings can be taxed twice –once when earned at the corporate level and again when distributed to shareholders. If the entity pays out most or all of its earnings as deductible salary (the amount must be reasonable) or rent, this double taxation often can be minimized in the context of closely held corporations, however,
S corporations, partnerships, and limited liability companies taxed as partnerships provide pass-through treatment. In general, there is no entity-level tax so the earnings are only taxed once – at the owners' marginal rates. Unlike S corporations, partnerships permit special allocations of tax attributes provided such allocations have substantial economic effect. Such allocations can often help a business raise equity capital from outside investors while enabling the general partners to maintain control of the business. Pass-through entities are often good choices for businesses that are expected to generate losses in the early years because the active owners ordinarily can apply those losses against income from other sources.
An owner of a C corporation can be compensated through salary, fringe benefits, pension and profit sharing plans, and dividends. Of these types of compensation, dividends are subject to tax at both the entity and shareholder levels. Nonliquidating distributions to shareholders are dividends to the extent of corporate earnings and profits. The excess is treated as a return of capital. Salaries, to the extent they are reasonable in amount, are effectively taxed only once (as income to the owner) because they are deductible by the entity. Most types of fringe benefits and pension and profit sharing plans receive tax-favored treatment in that they can be funded with pre-tax dollars and often do not generate current income to the recipient.
Because S corporations, partnerships, and limited liability companies taxed as partnerships are pass-through entities, each owner is allocated a share of the entity's income and other tax attributes based on the owner's ownership interest. These items are then reported on the owner's individual return (and in many instances, the stockholder will be taxed on “undistributed net income”, which means, the stockholder is taxed on income that he or she never received). When an S corporation distributes property, the owner-recipient generally recognizes gain only to the extent the value of the property exceeds the owner's stock basis. An S corporation may also compensate its owners through salary. Salary is includible in the owner's income and is deductible by the corporation.
A partner (or LLC member) generally recognizes no gain or loss on a current distribution of property by the partnership. There is an exception with regard to the receipt of certain ordinary income assets often referred to as “hot assets.” Also, a partner receiving a cash distribution must recognize gain to the extent that the amount received exceeds his basis in his partnership interest.
A C corporation has the greatest ability to provide fringe benefits on a tax-favored basis. Such benefits can include life insurance (with limits), health insurance, certain death benefits, and meals and lodging in limited circumstances (keep in mind, however, that life insurance premiums are not deductible by the corporation, for income tax purposes). In addition, contributions by the corporation to a qualified pension plan may also be deductible when made but not currently taxable. The corporation can also set up a cafeteria plan to let employees pick and choose fringe benefits. This flexibility is much greater than that afforded partnerships and S corporations.
In general, a partnership or a limited liability company may deduct the cost of providing the benefit, but the owners must include the value of such benefit in income. Thus, there is no real tax benefit to either the entity or the owners. This same rule applies to any shareholder in an S corporation who owns at least 2% of the corporation's stock.
Conclusion: This article is analogous to a bottomless pit, because much more could be written than has been. However, giving some information is better, I suppose, than giving none at all. Good luck as you consider the many variables.