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INFORMATIONAL MEMO REGARDING CHOICE OF BUSINESS ENTITY

Posted by attorney John Fernandes

This document outlines some of the considerations relevant to the decision about what type of entity to use. Although you will need to discuss these considerations in more detail before you select a form of entity, this Memo will introduce you to the issues as well as facilitate our discussions and proceed more efficiently.

1. Alternatives Available

There are a number of forms of business entity available, limited liability companies, S corporations and C corporations. Although there are businesses in existence that use all of these forms, almost all new small businesses today choose to be organized as, LLCs, or S corporations. These forms are the most popular because they have features that are advantageous to start-up businesses and lack features that can be disadvantageous to such businesses.

Limited Liability Company

Limited liability companies avoid both of the disadvantages of sole proprietorships. An LLC is an entity that is separate from its owners, so ownership of a business operated by an LLC can be divided between two or more owners, or an LLC can be owned by a one person. As a separate entity, the LLC, rather than its owners, is responsible for the debts and liabilities arising out of its business. If the business fails or if claims are made against the businesses that exceed its assets, the members may lose their investment in the LLC, but their personal assets are generally not at risk.

An LLC also provides the same favorable income tax treatment as a sole proprietorship. All income or loss of an LLC passes through the entity and is reported on the members’ individual income tax returns. If an LLC’s business incurs losses in its formative years, its members are in a position to offset these losses against other income.

Subchapter S Corporation

The advantages and disadvantages of an S corporation as compared to a sole proprietorship are similar to those of an LLC. Both S corporations and LLCs can have one or more owners, and both are treated as separate entities responsible for their own debts and liabilities, so owners enjoy limited liability. An S corporation is also more difficult and expensive to create and maintain than a sole proprietorship. But the process used to create and the processes necessary to maintain an S corporation are similar to those of an LLC. The costs of creation and maintenance are comparable for both types of entities.

2. Selecting a Form of Entity

You will need to decide between an LLC and an S corporation. Both forms of business entity share some common attributes, but there are important differences, and these differences may make one form of entity or the other a better choice for your business.

3. Advantages of LLCs

Although both LLCs and S corporations feature pass-through tax treatment, an LLC is more transparent for tax purposes than an S corporation. For example, property can generally be transferred tax-free by a member to an LLC, and property can generally be withdrawn from an LLC tax-free by a member. In the case of an S corporation, property can generally be transferred tax-free to the corporation at the time of its organization, but later transfers may result in the recognition of gain unless they are made by a shareholder who owns 80% or more of the stock of the S corporation.

Disproportionate Allocations and Distributions

Owners of a business sometimes have differing tax or cash needs, and an LLC provides more flexibility than an S corporation in addressing these needs. An LLC can, for example, attract investor owners by offering interests that have the attributes of preferred stock. Investors can be given a right to a minimum rate of return on their investment (as long as profits are adequate for its payment).

No Limits on Owners

Not only can an LLC facilitate the varying needs of its members, it can also have more owners and more diverse owners than an S corporation. An S corporation cannot have more than 100 shareholders, and all shareholders must be individuals who are citizens or residents of the United States, estates, or certain types of trusts. Corporations, partnerships and LLCs cannot own stock in an S corporation. These restrictions can limit the ability of an S corporation to bring in outside investors and can limit the ability of S corporation shareholders to transfer their stock to family members during life or upon death.

Flexible Management Structure

An LLC provides greater flexibility in management structure than an S corporation. An LLC can be organized as a member managed entity, in which case it is managed like a partnership, with each member having a vote on all management decisions and the ability to act for the LLC without the need for board of director approval. An LLC can also be organized as a manager managed entity, in which case one or more individuals have all the management powers, and other members have no right to participate in management.

Since an S corporation is like any other corporation for state law purposes, it must be managed like a corporation. This means that the shareholders must elect directors who are responsible for the management of the corporation, and the directors must appoint officers who execute their management directions. The corporate form of management is familiar to many people, but some find it rigid, particularly in the context of a small business with a limited number of shareholders who may prefer to operate the business more like a partnership. The corporate form may also be cumbersome in a situation where one or more of the owners of a business will be primarily responsible for its management and other owners will be mere investors.

4. Advantages of S Corporations

Employment Tax Treatment

S corporations are treated more favorably than LLCs for employment tax purposes. This is an important consideration that can be controlling in the decision of many businesses about whether to operate as an LLC or S corporation.

If all members of an LLC are individuals and participate in management of the LLC’s business, all of the LLC’s income is subject to self-employment tax. What’s more, the income is subject to self-employment tax in the year the LLC earns it even if the income is not distributed to members but is retained by the LLC to provide working capital or to acquire capital assets. Only certain limited types of LLC income, such as capital gains and rentals from real property, are exempt from self-employment tax. If an LLC is organized as a manger managed entity and has members who do not participate in management, income allocated to members who do not participate in management may also be exempt from self-employment tax.

In comparison, income of an S corporation is never subject to self-employment tax in the hands of its shareholders. Wages and salaries paid by S corporations to their shareholders are, however, subject to employment taxes in the same manner as compensation paid by to any other employee. The combined rate of employment taxes imposed on the employer and employee is the same as the rate of the self-employment tax, so the difference in tax systems does not create any savings. But what does create a savings is that employment taxes are only imposed on amounts paid out by an S corporation as compensation. Income of an S corporation that is retained by the business or is paid out as dividends is not subject to employment tax.

Self-employment tax is not a nickel and dime issue. The tax is imposed at a rate of 15.3% on self-employment income of up to $90,000 received by an individual in 2005, and is imposed at the rate of 2.9% on self-employment income in excess of that amount. Although one-half of an individual’s self-employment tax is deductible for income tax purposes, the imposition of self-employment tax as well as income tax on LLC income allocated to a member can significantly increase the rate of tax on the income.

Cash Basis Accounting

If a business has owners who do not participate in the operation and management of the business, it may be required to use accrual basis accounting if it is organized as an LLC, even if it does not have inventories or does not have a member that is a C corporation. This is the result of tax rules designed to prevent certain syndications from using cash accounting. These rules generally do not apply to S corporations.

Familiar Management Structure

Most states base their corporate laws on model legislation that has been widely adopted or base their corporate laws on long-standing concepts recognized in other states. As a result, there is a large body of law relating to the management and operations of S corporations, and this may reduce the number of potential areas for conflict between shareholders, directors and officers.

In contrast, the LLC laws of many states differ significantly from those of other states, and all LLC statutes are of relatively recent origin. Consequently, there may be more questions about the proper way to operate or manage an LLC.

5. Choosing Between an LLC and S Corporation

Neither an LLC nor an S corporation is the best choice for all businesses—both have advantages and disadvantages. The form of entity that is appropriate for your business will depend upon which of these advantages is most important to you. For example, if you plan to seek outside investors who may have differing tax and cash needs, or if your business will pay out most of its income currently to the owners, you may want to select an LLC. On the other hand, if you do not expect to bring in outside investors and have a business that will retain substantial income for working capital or other purposes, the employment tax advantages of an S corporation may make that form of entity the logical choice.

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