Choosing the Proper Form of
Organization for a New Business Venture

By Charles A. Wry, Jr.

Updated April 2011

Founders of a new business generally realize early on that they need to conduct the business through some kind of legal entity to limit their personal liabilities for the debts and obligations the business generates. Often, the three entity types from which the founders must choose are the “C” corporation, the “S” corporation and the limited liability company (or “LLC”). While all three entity types insulate the founders from personal liability, the differences among the three types for tax purposes are substantial. A C corporation, on the one hand, reports and pays tax on its income separately from its owners. The income or loss of an S corporation or LLC, on the other hand, generally is reported by the owners on their personal returns. The choice, therefore, is often tax-driven and requires an analysis of how the founders expect to profit from the business.

The C Corporation

Some Basics. A C corporation reports and pays taxes on its income. Because any income (including gain from an asset sale) that a C corporation distributes to its shareholders is taxable again in the hands of the shareholders, distributed income of a C corporation can be subject to tax at higher effective rates than those applicable to the distributed income of an S corporation or LLC.1 The losses of a C corporation are also reported by the corporation rather than by its shareholders. With limited exceptions, owners report any losses of their investments as capital losses only when they dispose of their shares. Individuals may use capital losses to offset only capital gains and small amounts of ordinary income (and may carry unused capital losses forward but not back).

Factors Favoring the C Corporation. While the potential for double taxation is a serious concern, a number of factors may favor the C corporation. Those factors include the following:

• Venture capital funds often prefer to invest in C corporations. The funds may not make equity investments in S corporations because the funds are partnerships.2 Equity investments in LLCs can cause tax problems for the funds’ tax-exempt and foreign partners.
• Equity based compensation arrangements are simplest with C corporations. C corporations (and S corporations, but not LLCs) may grant tax favored “incentive stock options” (or “ISOs”).3
• Only shares of stock in C corporations may be “qualified small business stock.” If certain requirements are satisfied, and subject to certain limitations, an individual may (i) exclude a portion of his or her gain on the sale of qualified small business stock held for more than five years or (ii) roll his or her gain on a sale of qualified small business stock held for more than six months into another qualified small business.4 Special look-through rules apply to stock held by partnerships. Stock issued while a corporation is an S corporation generally may not be qualified small business stock even if the corporation becomes a C corporation.
• The shareholders of a C corporation (or an S corporation, but not an LLC) may exchange their stock for stock of a corporate acquiror without tax (other than on any cash or other non-stock property they receive) if the exchange is part of a transaction that qualifies as a “reorganization” for tax purposes. Instead, the shareholders defer the reporting of their gains until they dispose of their stock in the acquiror.
• At any time that C corporate tax rates are lower than individual rates, reinvested income of a C corporation may be taxed at a lower effective rate than reinvested income of an S corporation or LLC.
• The use of a C corporation prevents the owners from having to file tax returns in all the states and other jurisdictions in which the business has a tax presence.

When a C Corporation Makes Sense. Founders should consider the C corporation if they intend to grow their business for a public offering or sale by (i) obtaining venture capital financing and (ii) motivating employees and consultants with equity. The primary risk to forming the business as a C corporation is the potential for double taxation if the business becomes a “cash cow” or if an acquiror wants to buy the assets of the business in a taxable transaction. Sometimes, founders of a business with this type of plan want to take a “wait and see” approach to preserve their ability (i) to sell assets without double tax and at individual capital gain rates and (ii) to report early stage losses (subject to applicable “passive activity loss,” “at risk” and other limitations) on their personal returns. The “wait and see” approach may be better served by using an LLC as the interim entity because, among other things, stock received by the founders when they convert their LLC to a C corporation can be qualified small business stock.

The S Corporation

Some Basics. The income and, subject to certain limitations, losses of an S corporation are reported by the corporation’s shareholders in proportion to their shareholdings. Thus, the use of an S corporation usually avoids the double taxation of distributed earnings characteristic of the C corporation.5 Distributions of “tax-paid” S corporation income are not subject to further taxation in the hands of the shareholders. Unfortunately, due to qualification requirements, the S corporation is not always available as an option. Among the more onerous qualification requirements are that the corporation (i) have only a single class of stock (differences solely in voting rights are permissible) and (ii) have 100 or fewer shareholders (all of whom must be U.S. resident individuals, estates or certain types of trusts, qualified retirement plan trusts or charitable organizations).6

Factors Favoring the S Corporation. Often, founders must first decide between a C corporation, on the one hand, and an S corporation or an LLC, on the other (that is, between a taxable entity and a non-taxable, or “pass-through,” entity). Then, once the founders have ruled out the C corporation (usually because they suspect that their returns may take the form of periodic distributions of operating income or a distribution of the proceeds of a sale of the assets of the business), they must decide between the S corporation and the LLC. Among the factors that may favor the S corporation over the LLC are the following:

• S corporations may be more versatile than LLCs in terms of exit strategy. Like shareholders of a C corporation (but not the owners of an LLC), shareholders of an S corporation may exchange their stock for stock of a corporate acquiror without tax (other than on any cash or other non-stock property they receive) if the exchange is part of a transaction that qualifies as a “reorganization” for tax purposes. In addition, it may be easier for the owners of an S corporation than for the owners of an LLC to report their exit gains as capital gains rather than ordinary income by structuring their exit as a stock (as opposed to asset) sale.
• Although equity incentive arrangements are more complicated with S corporations than with C corporations, they are simpler with S corporations than with LLCs. Like C corporations, S corporations may grant ISOs.
• If a participating owner of an S corporation receives reasonable wage payments from the S corporation as well as S corporation distributions, only the wage payments are subject to employment tax. A participating owner of an LLC, on the other hand, may be subject to self-employment tax on his or her entire share of the LLC’s business income.7
• S corporations may be eligible for local property tax exemptions that are not available to LLCs. These exemptions can be particularly important if the business will have significant amounts of inventory, machinery or other personal property.

When an S Corporation Makes Sense. Founders should consider the S corporation if they want a simple arrangement that will avoid double taxation while (i) preserving their ability to sell the business for stock of an acquiror on a non-taxable basis, (ii) maintaining their ability to motivate employees and consultants by granting ISOs and (iii) minimizing employment taxes.

The LLC

Some Basics. Unless an LLC elects to be treated as a C corporation, it is treated as a partnership (or, if it has only a single owner, as a sole proprietorship) for tax purposes. Because the income and, subject to certain limitations, losses of an LLC are reported by the LLC’s owners (referred to as “members”) in accordance with their agreement, the LLC also avoids the double taxation issues presented by a C corporation. While an LLC is far more flexible than an S corporation in many respects, the added flexibility often comes at the price of added complexity.8

Factors Favoring the LLC. Among the factors that may favor the LLC over the S corporation are the following:

• An LLC is not subject to the S corporation qualification requirements. In particular, an LLC may have multiple classes of owners (with different economic rights and preferences) and may include entities and foreigners among its owners.
• With certain exceptions, an LLC may distribute appreciated assets without triggering gain. Assets may therefore pass in and out of an LLC more freely than with an S corporation. For this reason, the LLC is the type of entity that is most easily converted to another type if circumstances change. The conversion of a C corporation or S corporation to an LLC generally triggers tax on any appreciation in the value of the corporation’s assets.
• To avoid tax on a contribution of appreciated property to an S corporation (or C corporation) for stock, the person making the contribution must, among other things, own (either individually or together with other persons making contemporaneous contributions of cash or property) at least 80% of the outstanding stock of the corporation as of the time immediately after the contribution is made. No such “control” requirement applies to contributions of appreciated property to LLCs. As a result, adding new owners for property contributions can be simpler for LLCs than for S corporations.
• If the owners of an LLC exchange their LLC interests for shares of stock in a conversion of the LLC to a C corporation, the shares of stock issued to the owners are not precluded from being qualified small business stock by reason of the prior existence of the LLC. If all the other requirements for qualified small business stock treatment are satisfied, the owners have merely postponed the beginning of their holding periods until they receive their shares of stock.
• The owners of an LLC may include their shares of the LLC’s borrowings in their tax bases in their interests in the LLC, even if they are not personally liable for the borrowings. The inclusion of borrowings in basis enables the owners to withdraw borrowing proceeds from the LLC on a tax-free basis and (subject to applicable “passive activity loss,” “at risk” and other limitations) report greater amounts of loss.
• If an LLC makes a special tax election, a person who acquires an interest in the LLC by purchase or inheritance may “write up” his or her share of the LLC’s basis in its assets to his or her initial basis in his or her interest in the LLC (thereby enabling him or her to report less income or greater deductions with respect to the assets). The same election permits the LLC to “write up” its tax basis in its assets when an owner’s interest is redeemed by the LLC at a gain.9

When an LLC Makes Sense. Founders should consider the LLC if they want to avoid the double taxation of distributed corporate earnings (or any taxation on in-kind distributions) while preserving their ability to issue interests of multiple classes (providing holders with different economic rights and preferences) or to owners who could not qualify as S corporation shareholders. The LLC is also the best choice when the founders want to use a pass-through entity on an interim basis without precluding the ultimate treatment of their interests in the business as qualified small business stock. The LLC may also be better suited than the C corporation or the S corporation to activities involving investments in assets such as real estate or securities.

Conclusion

In conclusion, a C corporation may be the best choice if the founders intend to reap their profits by selling their shares after growing the business using venture capital financing and equity incentives to personnel. If the founders anticipate reaping their profits in the form of distributions of income from the business (including gain from an exit structured as an asset sale), however, they should consider using an S corporation or an LLC.

If you would like to discuss choice of entity issues, please feel free to contact Chip Wry.

---

Footnotes.

1. Currently, a C corporation (that is not a “qualified personal service corporation”) is taxed federally at a rate of 34% on its taxable income greater than $75,000 (35% on its taxable income greater than $10,000,000). At least through 2012, a U.S. individual is subject to a maximum federal tax rate of (i) 35% on his or her ordinary income, (ii) with certain exceptions, 15% on his or her long-term capital gains, and (iii) 15% on his or her dividends from domestic C corporations. Thus, $100 of income earned by a C corporation leaves only $56.10 for the shareholders if the corporation pays $34 of tax on the income and the shareholders pay $9.90 of tax on the $66 remaining for distribution to them after the corporation has paid its tax (a 43.9% effective federal rate on the $100 of corporate earnings). After 2012, dividends are scheduled to be taxable at ordinary rates again, and the 15% individual long-term capital gain rate is scheduled to be increased to 20%. The absence of any preferential federal rates applicable to long-term capital gains of C corporations can exacerbate the double taxation of distributed long-term capital gains of C corporations. Income that is paid out to the owners in a way that is deductible for the corporation (e.g., as reasonable compensation) is not subject to double taxation but is taxable to the recipient at ordinary compensation rates (and, in addition, is subject to employment or self-employment tax).

2. In addition, the funds usually want to purchase preferred stock, which an S corporation may not offer. See the discussion of S corporation qualification requirements below.

3. In practice, it can be difficult to provide corporate equity incentives that permit the participants to both avoid tax (or an obligation to pay the then fair market value of their stock) upon receiving their stock and report the benefits of their arrangements at long-term capital gain rates when they dispose of their stock. Although equity compensation arrangements with LLCs can be complicated, an LLC’s ability to issue “profits interests” based on liquidation value presents the possibility of minimizing up-front tax costs of awards while preserving the timing and character advantages generally associated with restricted stock awards.

4. Historically (at least from 2001 to February of 2009), the maximum excludible portion was 50%, and the non-excluded portion was generally taxed at a 28% rate. In addition, a portion of any excluded gain has historically been a preference item under the alternative minimum tax. Given the rate at which the unexcluded portion was taxed, the qualified small business stock provision lost much of its luster in 2003 when the maximum rate generally applicable to long-term capital gains from stock sales was reduced to to 15%. The benefits of the provision have been enhanced, at least on a temporary basis, by recent legislation. The American Recovery and Reinvestment Tax Act of 2009 breathed some new life into the provision by increasing the maximum excludible portion to 75% for qualified small business stock acquired after February 17, 2009 (and, as enacted, before January 1, 2011). For qualified small business stock purchased after September 27, 2010 and before January 1, 2012, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 increased the maximum excludible portion to 100% and exempted excluded gain from the alternative minimum tax.

5. Special rules apply to an S corporation that has assets acquired, or earnings and profits accumulated, while it or any corporation it acquired in a tax-free exchange was a C corporation. Since the focus of this memorandum is on structuring a new business venture, those special rules are not discussed. It should also be noted that S corporations may be subject to state income tax. For example, Massachusetts taxes S corporations with annual gross receipts exceeding a certain threshold amount.

6. For purposes of the 100 shareholder limitation, spouses are, and members of a family may be, treated as one shareholder.

7. While the amount of income subject to the social security component of the employment or self-employment tax is subject to a cap, the cap does not apply to a 2.9% Medicare component. The employment tax advantages of the S corporation may be the subject of future legislation.

8. There may, though, be situations where the LLC is simpler than the S corporation. For example, an LLC with a single owner generally need not even file separate tax returns.

9. Under certain circumstances, redemption payments by service LLCs can even be deductible.

---

Article tools

Contact author | Download PDF | Print | Bookmark | Send to friend

---

 

Return to top of page

Return to Business Resources index