Proper entity formation can have a significant impact on subsequent business issues such as tax rates, corporate governance, and business growth. Although choosing the proper entity structure may seem like a formality to starting and growing your business, it is imperative to the future success, ease, and efficiency of future growth to pick the right entity structure at the formation stage.
Tax Implications. When it comes to taxation, there are generally two categories of business entities – C corporations and pass through entities. A C corporation’s profits are taxed once at the company level and a second time when distributions are made to shareholders. While many companies choose to convert to C corporations as they experience significant growth, some investors in new businesses elect a pass through entity to avoid a C corporation’s double taxation. Pass through entities, however, such as limited liability companies or S corporations, allocate profits and losses to their owners who then report those profits and losses on their individual tax returns based on their percentage ownership. While both S corporations and limited liability companies afford owners with the benefit of single taxation, there are some significant differences in how these two entity forms are taxed that bear consideration.
First, members in a limited liability company who are active in the business must pay self-employment taxes, which include taxes for Medicare and social security, on all profits distributed to them and reported on their tax returns. Shareholders of S corporations, however, only pay self-employment taxes on salaries to employees, not on profits allocated to shareholders. Thus, depending on the business, a company can save significant tax dollars by paying “reasonable” salaries to its shareholders, and distributing profits free of self-employment taxes.
Second, an employee who is granted S corporation stock or who exercises an option to purchase S corporation stock recognizes taxable income if the fair market value of the stock exceeds the purchase price for the stock. However, a limited liability company can grant an interest that is limited to future profits in the limited liability company to an employee on a tax-free basis.
Lastly, while both S corporations and limited liability companies recognize basis in ownership interests equal to the amount of money or property contributed to the company, plus allocated profits, less distributions and losses, any debt incurred by a limited liability company increases its members’ basis in their membership interests. This debt can support tax-deferred distributions to its members.
As a third option, a business can also choose the limited liability company structure and elect to be taxed as an S corporation. This may be a hybrid option to afford businesses that prefer S corporation taxation with the management flexibility of a limited liability company.
Corporate Governance and Regulatory Requirements. When it comes to structure and flexibility of operations, limited liability companies can accommodate a variety of management structures and governance practices, while S corporations are subject to stricter management regulations. Investors tend to prefer the corporate structure over the limited liability company structure (oftentimes for more complicated tax reasons). However, if a business does not anticipate seeking a public offering, needing capital raises or a future sale of stock, the limited liability company structure may be more appropriate due to its simple and flexible management structure. Limited liability companies can choose to have members or elect managers to operate the business and also choose whether or not to have corporate officers. Corporations, however, are required to have a board of directors and corporate officers. Corporations also have to comply with regulations regarding the adoption of corporate bylaws, holding shareholder meetings, maintaining meeting minutes, and issuing stock.
S Corporations are bound to comply with greater regulatory requirements. While limited liability companies can have an unlimited number of members, S corporations are not permitted to have more than 100 shareholders. Additionally, another corporate entity cannot be a shareholder of an S corporation, and if the shareholder is an individual, he or she is required to be a US citizen or a permanent resident. S corporations can only have one class of stock and profits and losses must be distributed in proportion to a shareholder’s actual interest. Limited liability companies, on the other hand, can have more than one class of membership units and can have disproportionate distributions to its members. If an S corporation is not in compliance with all requirements, it risks losing its S corporation status and being treated as a C corporation subject to double taxation.
Entity Conversion. While it is possible to convert from one entity type to another, doing so can trigger tax liability. Accordingly, it is best to determine the most appropriate business structure when first establishing the business. Generally speaking, converting a limited liability company to an S corporation or a C corporation is tax free, but not the reverse. Additionally, it is generally easier to convert from an S corporation to a C corporation than it is to convert a limited liability company to a C corporation. As investors tend to prefer taking corporate stock over limited liability company membership interests, fast growing businesses should consider choosing the corporation structure at formation or converting from a limited liability company to a corporation structure sooner rather than later.