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Specific needs determine best corporate structure

With the recent availability of limited-liability companies in New York State, choosing the form of the entity for a new business venture has become more complicated. For purposes of this column, I am assuming that you already have decided you need a “pass- through” entity with limited liability for income-tax purposes. That is, you want to ensure that: only one layer of tax is imposed on the profits of the business, at the owner level; and the owners will not be personally liable for the obligations of the business.
Both limited-liability companies and S corporations provide this desirable combination. How can you choose between them?
There are many reasons to choose the LLC over the S corporation, but there are also circumstances when the S corporation will be the best choice. The first and perhaps most common reason to choose an LLC is because an S corporation simply is not available.
S corporations are subject to many restrictions under the Internal Revenue Code. For example, they may have as shareholders only U.S.-resident individuals, estates and certain trusts. If a corporation, partnership or other entity is anticipated as a shareholder of the organization, an S election would not be available. Thus, the only choice would be an LLC.
Similarly, an S corporation can have only one class of stock, though differences in voting rights are permitted within the class. This means that each share in the corporation must have an equal interest in the profits and losses of the organization at all times.
Many business transactions require a more flexible division of economic interests. For example, assume that a new business venture involves two owners. Mr. Rich will be contributing $1 million in cash to fund the start-up costs and initial working capital of the organization. Mr. Brains will provide no cash, but will contribute his business concepts and full-time work efforts in order to make the business go. They have agreed on a 50/50 division of profits.
This might seem to be a readily workable scenario for an S corporation, since a 50/50 division of profits has been agreed upon. But what if there are losses?
Mr. Rich’s dollars are what will go down the drain if the venture loses money, and he really should be entitled to deduct the losses. If the S corporation’s ownership is 50/50, however, half of the losses will be allocated to Mr. Brains, who will be unable to use them.
An LLC can avoid this problem with special allocation provisions. Its operating agreement could provide that all losses are allocated to Mr. Rich (because he put the cash in) but that the profits are allocated 50/50. In this way, the flexibility of the LLC permits a division of profit and loss which accurately reflects the business risks taken by the parties.
This example also illustrates another tax distinction between S corporations and LLCs that makes the LLC form valuable. In the above example, Mr. Brains would receive his stock in the S corporation in large part in return for the services he performs. The fair market value of stock received in return for services is taxed under the Internal Revenue Code as ordinary compensation income to the shareholder-employee.
Thus, by working in return for stock, Mr. Brains may accrue a substantial tax bill. The exact amount to be taxed to Mr. Brains is unclear, but could be significant. If Mr. Rich was willing to pay $1 million for his one-half interest, Mr. Brains presumably has received stock with a value of $1 million.
The rule for LLCs is different. An owner in an LLC can receive a “profits” interest in return for services, with no current recognition of income. Thus, in a properly drafted LLC agreement, the tax risk to Mr. Brains in our example simply disappears.
There are a number of other technical tax differences between LLCs and S corporations that generally favor LLCs. For example, if the entity owns appreciated real estate, the technical rules make it easier for an LLC to borrow against the real estate and distribute the proceeds without tax impact.
All of these arguments in favor of an LLC do not mean that every new organization should adopt this format. There are times when an S corporation will be the preferred choice. For many entities, there are no issues regarding the type of ownership or the intricate division of profit and loss discussed above. Many businesses are happy with a “plain-vanilla” division in straight percentages, which is exactly what an S corporation accomplishes. So long as it is clear that all of the owners will be qualifying shareholders, then the S corporation works well.
There is even one circumstance in which Internal Revenue Service restrictions make an S corporation superior. The IRS has not yet ruled on the tax treatment of a one-owner LLC. But it has hinted strongly of unfavorable tax treatment being imposed on such an entity. While it is usually possible to avoid this issue by bringing in a spouse or other family member as a 1 or 2 percent owner of an LLC, an S corporation faces no such problems in the first place. A one-owner S corporation works just fine.
An S corporation also generally is cheaper to form than an LLC. This results in part from the fact that the organization features a structure that is more “plain vanilla” than that established by an LLC operating agreement. But another part of that expense is simply imposed by New York law. An LLC is required to publish notice of its formation in local newspapers. This can add several hundred dollars to the cost of formation.
Finally, where the owners of the entity also will be the key employees, an S corporation sometimes can provide employment-tax advantages. All of the income of either entity will be taxed to the owners for income-tax purposes, so the income-tax treatment is equal.
For an LLC, however, all of the income of active owners also will be subject to self-employment tax. In an S corporation, only that amount which is paid out as a reasonable salary to the owner- employee is subject to employment taxes; any amount distributed as corporate earnings is exempt.
This can provide a significant tax savings, particularly for very successful entities. The Medicare portion of the tax, which formerly was imposed only on the first $130,000 of earnings, now is imposed without a cap.
While this difference provides an advantage for S corporations, it should not be overstated. A one-person S corporation deriving all of its income from the efforts of that individual is hard-pressed to argue that its earnings are from “corporate” efforts as opposed to the efforts of the single shareholder-employee. Thus, the “reasonable compensation” payable to the employee likely would equal most, if not all, of the corporate earnings, subjecting them to employment taxes.
The Internal Revenue Service has successfully brought cases against individuals who have artificially lowered their salary income and raised their S-corporation operating income in an effort to avoid employment taxes. Thus, it is only where the corporation derives earnings from the efforts of other employees, including those who are not shareholders, that the differences in employment- tax treatment can be a significant motivation in favor of adopting an S corporation.
In short, the new LLC form provides a useful structure in many circumstances, and often will be the entity of choice. However, there is no one answer to the question of whether an LLC or an S corporation is preferable in all circumstances. In each case, an analysis of the business factors involved is required to lead one to the correct choice.
(Michael McEvoy is a partner in the law firm of Harter, Secrest & Emery, where he concentrates his practice on tax matters.)


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