By Keith A. Wood*
May 2016
Image via Flickr | CC BY 2.0
I. Introduction
Whenever I am approached by a prospective entrepreneur, the first legal issue we address involves selecting the appropriate organizational form to use in operating the new business. Without a doubt, this is one of the most important decisions facing the new business owner. The choice will affect whether the entrepreneur will risk personal liability for the debts and obligations of the business enterprise and will have a profound effect on how business income will be taxed. For these same reasons, whenever I am approached by a new client, who has already been operating for some time, I always ask the same first question – “What type of business have you adopted, and why?”
A business venture will be classified, for business law and tax purposes, as a sole proprietorship, a partnership, a corporation or as a limited liability company (“LLC”). Since each of these organizational forms presents unique tax and non-tax issues, the business owner should take care in selecting (and maintaining) an organizational form that is most advantageous for both business law and tax purposes. In deciding whether to operate as a sole proprietorship, partnership, corporation or an LLC, the business owner should focus on three (3) primary considerations:
Limited Liability Concerns: How will the selection of an organizational form impact my personal liability for debts and obligations of my new business?
Organizational Complexity: How do the forms differ with respect to their relative organizational complexity and expense?
Tax Considerations: What tax advantages and disadvantages do these forms offer me?
This Article will review how these three (3) considerations apply differently to sole proprietorships, LLCs and corporations.
II. Limited Liability Concerns
Under North Carolina law, sole proprietors and partners of North Carolina general partnerships will have unlimited personal liability for all debts and obligations of the business entity. Examples of these types of business obligations might include personal injury claims or claims for breaches of various types of contracts, such as lease agreements, employment agreements and the like.
Owners of corporations and LLCs, on the other hand, normally do not have any personal liability for debts or liabilities of their business, except for liabilities that are personally guaranteed by the business owner or that are caused by the owner’s own acts or negligence. Therefore, because of the potential liabilities associated with business, most business ventures will be operated as corporations or LLCs.
III. Organizational Complexity
In order to secure the benefits of limited liability protection, LLCs and corporations must be operated as distinct legal entities, separate and apart from the personal affairs of the business owner. This means keeping separate books and accounts for personal and business activities and complying with various corporate law formalities (such as adopting bylaws, holding annual corporate meetings, and so forth). Indeed, legal and accounting compliance costs for corporations and LLCs can be significant.
Sole proprietorships and partnerships, on the other hand, are very simple and inexpensive to organize and structure. Therefore, many business owners are reluctant to operate their businesses as corporations or LLCs because of their organizational complexity and the added expenses of complying with certain corporate law formalities.
However, because corporations and LLCs also offer potential limited liability protection to their owners, the additional organizational complexity associated with corporations and LLCs can be relatively insignificant when compared to the unlimited personal liability exposure that sole proprietors and partners may face on a daily basis.
IV. Tax Considerations
As discussed above, because of limited liability concerns, most business owners will decide to operate as a corporation or as an LLC. Corporations and LLCs, however, offer dramatically different income tax and employment tax advantages and disadvantages. Therefore, in most cases, the final choice of an organizational form will depend upon tax considerations.
A. Corporations: S Corps and C Corps
For tax purposes, a corporation will be taxed as a “C” corporation or as an “S” corporation. “C” corporations and “S” corporations are named after their respective portions of the Internal Revenue Code, which applies two dramatically different systems of taxation for these two types of corporations. If the business owner decides to incorporate, rather than operate as an LLC, sole proprietorship or partnership, the IRS automatically treats the corporation as a C corporation, unless the business owner specifically makes an election to have the corporation taxed as an S corporation. An “S election” is made by filing IRS Form 2553 with the Internal Revenue Service, generally within 2 1/2 months after the incorporation date (or within 2 1/2 months of a new tax year for C corporations wishing to convert to S corporation status).
Under the tax laws, C corporations and their owners are treated as separate taxable entities, which means that C corporation income may be subject to two levels of income tax (the curse of the C corp. “double tax”). First, C corporation income will be subject to a corporate level tax as business income is earned. Then, as corporate profits are distributed to the owners, either as dividends or upon liquidation of the business if it is ever sold, a second level of income tax will be assessed at the individual shareholder level. Therefore, the income earned by a C corporation will be subject to income tax twice. This is called the C corp. “double tax.”
To avoid the C corporation “double tax”, many owners of C corporations will attempt to lower the C corporation taxable income through the payment of tax-deductible salary or bonus payments to owner-employees. The problem with this arrangement, however, is that these salary and bonus payments will be subject to employment taxes, which may reach as high as 15.3 percent.
In light of these tax disadvantages with C corporations, many owners elect to have their corporations taxed as S corporations. With S corporations, there is no corporate level income tax. Instead, all income earned by the S corporation will be taxed to the shareholders at their individual tax rates, regardless of whether the corporate income is actually distributed to them. But once they pay income tax on S corporation earnings, the owners usually can then withdraw the S corporation profits out of the company, free of additional income tax. Also, these shareholder distributions of profits usually won’t be subject to the 15.3 percent employment taxes, as long as the owners have paid themselves “reasonable compensation” for their services to the S corporation. And finally, if an S corporation recognizes a loss from its operations, these losses can in some cases be used by the owners to offset other taxable income for the year. Losses of C corporations, however, are not tax-deductible on the owners’ personal tax returns.
Notwithstanding some of the tax advantages of S corporation status, some entrepreneurs may be better off in the short run by operating as a C corporation. In some instances, personal income tax rates may exceed corporate income tax rates at certain levels of income. This means that, depending upon the level of business profits, it is possible that more income tax will be paid in the short run whenever S corporation status is selected. However, in the long run, C corporation status usually results in more income tax being paid, since C corporation income or gains will almost always be subject to a second level of income tax when profits are distributed as dividends or when the business is sold.
The bottom line here is that, because of the C corporation “double tax”, in most cases, business owners will be better off electing to treat their corporations as S corporations rather than as C corporations.
Not every business entity, however, may elect S corporation status. For example, under the tax law, only United States residents may be individual shareholders in an S corporation. Also, corporations and LLCs cannot own stock of an S corporation. Also, S corporations are prohibited from having more than one class of stock. Therefore, if the entrepreneur wants to offer preferred stock to inactive investors, the business will not qualify as an S corporation. Therefore, in many cases, S corporation status will not be available and the entrepreneur must decide between operating as a C corporation or as an LLC. But, because of the potential C corporation “double tax,” there has been a great deal of focus on the use of the LLCs instead of C or S corporations to operate an ongoing business that cannot qualify as an S corporation.
And finally, a tax problem with both S and C corporations is that any distributions of appreciated property to the shareholders will cause taxable gain recognition to the other S corporation shareholders or to the C corporation. This means that where appreciated property is distributed to one or more owners, all shareholders may be forced to recognize taxable income.
B. Limited Liability Companies
If properly structured, an LLC will be taxed as a partnership, which generally means that all profits and losses of the LLC will be “passed through” to the owners for tax purposes. In addition, as with corporations, LLCs offer potential limited liability protection to their owners. So, LLCs offer all of the tax advantages of S corporations, without all of the structural limitations imposed upon S corporations under the tax rules.
V. What is an LLC?
A. Organization and Operation of An LLC
An LLC is a type of business entity that is formed by filing Articles of Organization with the North Carolina Secretary of State. Once formed, the LLC is treated as a distinct legal entity, separate and apart from the personal affairs of their owners.
Owners of LLCs are called “members.” In this regard, members are much like shareholders of North Carolina corporations. The day-to-day affairs of the LLC are managed under the supervision of “managers” who act much like a corporate Board of Directors. In a “member managed” LLC, all members will also be managers. However, if the members choose, the LLC will be “manager managed” by a group of members or outsiders who will serve as managers.
B. How is an LLC taxed on its income?
LLCs have several income tax advantages over both S and C corporations. First, if properly structured, an LLC will not pay income tax on its income. Instead, the income from an LLC is “passed through” to the members and taxed at their individual tax rates. This means that LLC members usually will pay much less tax on LLC income than they would if the entity were a C corporation. In addition, LLCs are often better than S corporations since LLCs arc not prohibited from having foreign investors or from issuing ownership to other LLCs or even to S and C corporations.
Also, unlike S corporations, LLCs may have different classes of investors who may receive disproportionate allocations of LLC profits. And, with LLCs, appreciated property often can be distributed in-kind to the members without causing any members to recognize taxable gain.
Also, in deciding between S corporations and LLCs, employment taxes should be considered. In most cases, S corporation shareholders only pay employment taxes on salary they receive. Members of LLCs, however, usually are required to pay employment taxes on all income earned by the LLC.
On the other hand, there are some situations in which LLCs are clearly superior to S corporations.
Venture Capital Arrangements. In those cases where certain investors will require a preferred return on their investment, the S corporation arrangement will not be possible. In these cases, the business arrangement will necessitate the use of an LLC instead of the S corporation.
Appreciated Property Issues. As discussed above, a major disadvantage of S and C corporations results from the fact that distributions of appreciated property will cause taxable gain recognition to the corporation or its shareholders. Therefore, where the business plans to invest in real estate or patents or other types of assets that are likely to appreciate in the future, the LLC arrangement is almost always preferable.
VI. Conclusion
Because of the significant ramifications the choice of entity decision will have upon future success, profitability and viability of the business enterprise, the choice of entity question must be constantly re-evaluated and readdressed on an ongoing basis. And as the business continues to mature and evolve, or as tax laws or the specific activities of the business enterprise change, the business owner(s) must re-evaluate whether yesterday’s choice of entity decision is still appropriate for today and tomorrow.
*Keith A. Wood is both an attorney and CPA with a special background in taxes. His law practice is focused on business, tax and estates planning for a wide range of clients, including new startups, entrepreneurs and multigenerational family-owned businesses. Keith is a Director with the law firm Carruthers & Roth, P.A., located at 235 N. Edgeworth Street, Greensboro, NC 27402. He can be reached at (336) 478-1185 or by email at kaw@crlaw.com. For more information about Keith and his practice can be found at http://crlaw.com/people/keith-a-wood.