Key Factors Affecting Choice of Entity
The following summarizes many of the tax and nontax differences in the various business forms.
1. 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.
A general partnership usually has no formal registration requirements. It may be established 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 with articles of organization a state, and must comply with state requirements that are a condition of its limited liability status.
2. 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. However, the corporation 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.
3. Limited Liability of Owners
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.
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.
4. 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. This double taxation often can be minimized in the context of closely held corporations, however, if the entity pays out most or all of its earnings as deductible salary (the amount must be reasonable) or rent.
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.
5. Owner Compensation
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 usually the least preferred because they 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. 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.
6. Fringe Benefits
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. 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.