FORM OF BUSINESS

C Corporation? S Corporation? LLC? What's best for the small closely-held business?

By Alan R. SumutkaWith thousands of employees being "downsized," small business ownership appears to be flourishing. Although some entrepreneurs harbor visions of an empire, few are likely to raise large amounts of capital except from other partners, or through expanded operations. Most hope merely to earn a living. They desire to 1) control and manage their business with minimum interference from outsiders, 2) insulate themselves from liability, 3) obtain tax free, company-paid fringe benefits, 4) minimize professional fees, and 5) minimize their tax liability.

Recently touted as a virtual panacea in business entity planning and selection, the case for the limited liability company (LLC) appears to be oversimplified and overpromoted. In fact, a C or S corporation is probably the optimum entity for many small businesses.

Although numerous issues are evaluated to determine the appropriate form of organization, the overall objectives of the businessowner and certain fundamental threshold issues usually drive the selection process. The purpose of this article is to identify, analyze, and illustrate the threshold issues in the context of the sole proprietorship, partnership, LLC, and C and S corporation entity selection process. Because active owner involvement is assumed, little discussion of a limited partnership is included. The threshold issues and the extent they apply to the various forms of entity are shown in the accompanying exhibit.

Ownership and Management
Control

Ownership Restrictions. Federal and state laws limit or restrict ownership for certain types of entities. This serves to eliminate some options immediately.

A one-person owner can operate a sole proprietorship or an S or C corporation, although some states require two owners for a C corporation. A one-person owner is precluded from organizing a general partnership, which requires at least two owners. Although many states require LLCs to have at least two owners, a growing number of states permit single owner LLCs. Also, the IRS recently removed the main impediment to the single member LLC with its finalization of the "check-the-box" regulations.

Businesses with two or more owners can operate in all forms, except a sole proprietorship. Generally, no limits are placed on the number of owners, except that an S corporation is limited to 75 shareholders, an increase from the previous limit of 35 brought about by the recent enactment of the Small Business Job Protection Act of 1996 (SBJPA).

Restrictions are placed on the type of owners, but few are insurmountable. Owners of a sole proprietorship can be individuals only. State law may restrict the type of owner in a C corporation or an LLC to prohibit professionals from "hiding behind the corporate veil" of limited liability. C corporation owners in a personal service corporation (PSC) may lose tax benefits. As detailed in IRC section 448(d)(2), a PSC is a corporation whose principal activity is the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, the performing arts, or consulting, and substantially all of whose stock is owned by employees, retired employees, or their estates.

S corporation ownership is limited to individuals who are U.S. citizens and resident aliens, estates, certain exempt organizations (now under section 1316 of SBJPA), and certain trusts (i.e., grantor trusts, IRC section 678 trusts, qualified Subchapter S trusts, certain testamentary trusts, voting trusts, and new "electing small business trusts" under Sec. 1302 of SBJPA). Therefore, those not permitted to own S corporations include nonresident aliens, C corporations, certain trusts, and partnerships.

Few Limitations Apply to
Partnerships.

Management Control. Owners seeking to manage their operations, will find that any of the traditional forms will do. Unless an LLC operating agreement confines management to a group of managers, LLC members manage the operations. In a limited partnership, only a general partner(s) exercises management authority. Limited partners cannot participate in the business, although some states provide some latitude.

In some instances (e.g., family businesses), an owner may desire to bring others (e.g., children) into a business, but with no management authority. Most entities are accommodating. For example, LLC members can stipulate management by a group of managers. A family member can own a capital interest in a limited partnership, obtain a share of partnership income, yet lack management authority. A C corporation owner can issue nonvoting stock to family members. Because an S corporation can issue only one class of stock, but with different voting rights, the same results can be attained.

Risk Management

Limited Liability. Personal liability for business debts is a serious risk most owners seek to limit. The appropriate entity can minimize losses to the investment in the business.

Sole proprietorships do not enjoy limited liability; proprietors are personally liable for business debts. Under the Uniform Partnership Act, general partners are personally liable for all debts and obligations of the general partnership--including any wrongful act or omission of any partner acting in the ordinary course of the business of the partnership

Traditionally, a C or S corporation provides limited liability for all owners. Corporate shareholders are liable for business debts to the extent of their business investments, personally guaranteed business debts, and personally committed fraud or torts.

"Partnership hybrids" provide some form of liability protection to owners. Under the Uniform Limited Partnership Act, a limited partnership is formed with one or more general partners and one or more limited partners. A limited partner is not bound by the obligations of the partnership unless, in addition to the exercise of rights and powers as a limited partner, a limited partner participates in management. Otherwise, the liability of a limited partner generally extends only to his or her capital contribution. Since a general partner enjoys no limited liability, a C corporation often acts as a general partner. Of course, this tactic increases formation and compliance costs.

An LLC provides the same limited liability to all members as corporations provide shareholders. With taxation similar to a partnership and with no personal liability for members, an LLC is often viewed as a limited partnership with no general partners.

Recently many states enacted legislation that permits the formation of limited liability partnerships (LLPs). Although state laws vary, most LLPs are general partnerships that offer some limited liability to partners (but often less than that available under an LLC). Like a general partnership, a partner in an LLP is jointly and severally liable for all commercial debt of the partnership and is personally liable for his or her own negligence, malpractice, wrongful acts, or misconduct and that of any person under his or her direct supervision or control. The major advantage of an LLP is that a partner is not personally liable for such acts committed by other partners.

Reliability of Business Form. Traditional organizational forms operate under well-developed tax and commercial law. By complying with objective standards promulgated in a myriad of statutes, interpretations, and court decisions, a C or S corporation, general partnership, limited partnership, or sole proprietorship diminish uncertainty and offer comfort about issues concerning each entity.

New entities lack a legal history and fail to provide a comfort level. For example, the legal rights of minority shareholders are relatively well defined in case law. Rights of minority LLC members do not enjoy the same degree of clarity.

As previously noted, most states require LLCs to have at least two members. Consideration should be given to the impact of the potential loss of one member on LLC status in states not providing for this contingency.

LLPs are in an infant stage, but offer fewer challenges. Typically sanctioned by amending a state general partnership statute, an LLP is less subjective and complicated to form than an LLC.

Reliability of Business Form in Interstate Commerce. Uncertainty as to the reliability of business form is compounded by interstate trade where businesses face state statutes that vary dramatically or lack a legislative history. For example, New Jersey only permitted LLCs in 1994 and LLPs in 1995.

States may not recognize a form of entity. For example, until 1993 S corporations operating in New Jersey were taxed as C corporations because New Jersey did not recognize their existence. Other states may recognize one form of entity but tax it as another. For example, although Florida and Texas recognize LLCs, they are taxed as corporations.

Company-Paid Fringe Benefits

If nondiscrimination rules are satisfied, C corporation owner/employees obtain excludable company-paid fringe benefits. More than two percent owners of S corporations deduct most fringe benefit costs through the corporation but include the cost in individual income. Similarly, partnership payments for some benefits to partners (including LLC members) are treated as deductible guaranteed payments by the partnership and included as partner income. Fringe benefits paid for the benefit of a sole proprietor are not deductible.

Although numerous fringe benefits can be offered to employees (from educational assistance plans to stock option plans), the benefit and/or compliance costs are often too expensive for small businessowners. Others, such as no-additional-cost services, discounts, meals, and lodging, are unrealistic. However, certain benefits generate significant cash savings that alone can justify C corporation status. For example, most C corporation owner/employees rejoice at the deduction for the cost of family medical insurance plans, some that can cost $12,000 annually.

Sole Owner/Employee. When the owner of the entity is the sole worker, benefits are available to the owner/
employee only, without violating nondiscrimination rules. Typical company-paid benefits sought by most small C corporation owner/employees include family accident/health insurance and retirement plan contributions. In some cases, a medical expense reimbursement plan is established to provide reimbursement for uncovered medical expenses or a dental plan is offered. Payment for disability insurance premiums may be requested, but disability benefits would be taxable. A provision in the recently enacted Health Insurance Portability and Accountability Act of 1996 (HIPAA) may be enticing. Under section 321 of the act, premiums for a qualified long-term care insurance contract issued after 1996 are treated as accident and health insurance premiums. The benefits from an indemnity type contract for actual long-term care expenses are tax-free to the recipient. Contracts that pay a set daily dollar benefit are excludable up to $175 per day. The total tax savings from these benefits provide a compelling reason for C corporation status.

In no other entity are the above benefits deductible by the entity and excludable by the individual. However, generally a self-employed individual can deduct 30% of health insurance premiums as a deduction for adjusted gross income and the remainder can be taken as an itemized deduction in 1996. Pursuant to HIPAA (section 311), the deduction (including payments for long-term care insurance) increases as follows: 1997­40%, 1998 though 2002­45%, 2003­50%, 2004­60%, 2005­70%, 2006 and thereafter-80%.

Other Employees. Under nondiscrimination laws, a C corporation owner must provide similar benefits to all employees to obtain favorable tax treatment. Therefore, an owner/employee whose objective is to achieve sizable tax-free benefits but who will be employing more than a small work force may find the C corporation a costly approach.

Nonetheless, if other employees exist, a C corporation owner/employee may be able to obtain excludable, company-paid accident and health insurance (including long-term care coverage) for himself or herself only. Under Reg. Sec. 1.105-5, "a plan may cover one or more employees, and there may be different plans for different employees or classes of employees." As clarified in the Wigutow case (TC Memo, 1983-620), "the plan must be 'for employees' rather than for some other class of persons such as shareholders and their relatives." Also, "stockholder employees may well [constitute] a natural category of employees sufficient to indicate that the genesis of the plan was as the employee rather than the stockholder relationship. ...Recently we sustained a plan that covered only the sole shareholder noting that his duties clearly distinguished him as a key employee." Finally, "neither the statute nor the regulation requires that all employees be covered under some sort of plan before a different plan for the benefit of an employee-shareholder will be recognized under section 105." In summary, if an owner/employee has duties that clearly distinguish himself or herself from others as a "key employee," a plan covering all "key employees" appears to satisfy the requirements of IRC section 105 and permits the owner/employee to be the only covered employee.

Simplicity and Costs

Formation. Because many new entrepreneurs are strapped for cash, formation costs are a dominant issue. Expensive optimum alternatives may be shed in favor of a less expensive, acceptable form.

Of course, the easiest and least expensive option is a sole proprietorship. With no formal requirements to begin, no legal fees are incurred. Although savvy partners prepare a partnership agreement to document operating details, many small (often family-run), equally-owned and managed general partnerships forgo this document to minimize legal fees.

To be formed pursuant to state laws, C corporations usually require legal assistance. A valid certificate of incorporation with appropriate resolutions, minutes, and corporate seal are the threshold for protection from lawsuits that seek to "pierce the corporate veil" by challenging the corporation's substance and existence. Typical incorporation costs vary from $300 to $500; but many small businessowners find incorporation relatively easy to the point they incorporate without legal help. S corporations, formed in the same manner as C corporations, incur comparable legal fees, but require Federal and state S election filings also.

Because legal advice is required to deal with the uncertainties caused by a dearth of legal history, LLC formation is complicated and expensive. Legal fees often range from $1,000 to $5,000, a
reason some owners consider other options, regardless of LLC benefits.

Availability of Fiscal Year-End. Owners usually try to end a tax year at the conclusion of a natural business year. Tax results mirror operating results (which promotes management control and efficiency) and the risk of ending a year at a peak in operations is diminished. Only a C corporation provides an unencumbered opportunity to have any year-end. A proprietorship must have the same tax year as the owner, usually a calendar year-end. A partnership or LLC year-end must coincide with that of the majority owner, typically a calendar year-end, unless the business complies with the burdensome IRC Sec. 444 provisions to pay tax on deferred income. Generally, an S corporation must have a
year-end unless the IRS approves a
different year, usually a natural
business year. These qualifying requirements add complications and increase compliance costs.

Availability of Cash Method of Accounting. Many small businessowners prefer simple recordkeeping and find the cash method of accounting appealing. Generally, it is available to all organizational forms that do not have inventory except for C corporations that have average gross receipts over the three preceding years exceeding $5 million, S corporations that qualify as tax shelters, and partnership/LLCs that have a C corporation as a partner or qualify as a tax shelter. Although some confusion exists regarding use of the cash method for "limited partners" or "limited entrepreneurs," IRS letter ruling 9321047 (2/25/93) appears to approve the method for LLCs.

Taxation of Profits and Losses

An owner's tax liability depends on whether profits are paid to an owner or retained in a business. However, because projecting future profits and compensation is difficult, this tax issue is rarely the primary basis for entity selection.

Double Taxation Upon Sale/Liquidation of Business. A significant uncertainty at business formation is the likely future value of the business when sale or liquidation might be contemplated. If the perceived sales/liquidation value is greater than the likely book value, the owner may incur a double tax on sale or liquidation. If formed as a C corporation, the corporation incurs a corporate level tax on the gain on sale or liquidation and the owner incurs an individual tax on the liquidating dividend. Generally, no other entity subjects the owner to this form of double taxation

Profits Paid to Owners as Compensation. For a typical small businessowner, business profits are the source of livelihood and are extracted in total from the business as salary, guaranteed payments, or withdrawals. As illustrated in Example 1, the tax consequences are similar whether an owner/employee of a C or S corporation extracts all profits by salary payments or whether a partner, member, or proprietor extract all profits by withdrawal (or guaranteed payment). However, as illustrated in Example 2, if no or some profits are extracted, tax savings are available only to an S corporation.

In Examples 1 and 2, it is assumed a single individual earns either $50,000 or $125,000 in a business in 1996. Consideration is given to Federal income taxes, self-employment taxes, and Social Security taxes (OASDI and MHI). Although state income and payroll taxes and Federal unemployment tax should be considered, they are ignored because their rates vary by jurisdiction.

In Example 1, C or S corporation profits are "zeroed out" for the corporation earning $50,000 by a $46,447 salary payment to the owner/employee, which generates employer Social Security taxes of $3,553. The total tax paid by the owner/employee amounts to $15,158 ($3,553 in Social Security taxes paid by the business and $11,605 in income and Social Security tax paid by the individual). For the partnership, LLC, or proprietorship, the owner extracts the $50,000 in profit as a withdrawal and incurs a similar $15,122 in total taxes ($8,057 in income taxes and $7,065 in self-employment tax). Even if the partner took $50,000 in guaranteed payments, the result would be the same. (Although the $50,000 in guaranteed payments reduce business earnings to zero, the $50,000 is taxed at individual income tax rates and is subject to self-employment tax.) Also as illustrated in Example 1, if earnings were $125,000, the C or S corporation incurs $41,350 in total taxes and either noncorporate entity incurs $41,254 in total taxes.

As Example 1 illustrates, when profits are "zeroed out" in a C or S corporation or withdrawn totally in a noncorporate entity, the tax difference is usually inconsequential because similar incomes are taxed at the same individual income tax rates, and employer/employee Social Security taxes closely approximate self-employment taxes. However, if profits are extremely large in a C corporation, the owner/employee may be unable to extract all earnings due to unreasonable compensation issues. At that point the risk of double taxation of dividends bodes poorly for a C corporation.

In some instances, an S corporation incurs significantly less total taxes than all other entities because S corporation earnings are not subject to self-employment taxes. As illustrated in Example 2, if an S corporation earned $50,000 in profit, paid none of it as salary to the owner/employee, and the owner/employee withdrew all of it tax-free from the accumulated adjustment account, the total taxes paid amount to $9,046. This is in comparison to $15,158 in total taxes if the business paid the owner/employee $46,667 and incurred $3,553 in Social Security taxes. At $125,000 in profits, the savings are more pronounced. The tax on the distributive share amounts to $31,855 compared to a total tax of $41,350 if salary was paid, a savings of $9,495.

While Example 2 illustrates the potential payroll tax savings associated with an S corporation, when an S corporation officer/shareholder performs substantial services, the individual is considered an employee. If reasonable compensation for services is not paid (other than as dividends), often the IRS litigates to recharacterize the distributions as salary to obtain the lost payroll taxes (Dunn & Clark, P.A., 853 F Supp 365, DC Idaho 1994). Some state officials opine that the distributive share of S corporation earnings represents compensation and is used as the wage base for determining certain state payroll tax liabilities.

Despite these challenges, if a reasonable salary is paid to an S corporation owner/employee, the S corporation is superior to all other entities from a tax savings perspective. As detailed in Example 2, if business profits before salary amount to $50,000, a reasonable $30,000 in salary is paid to an owner/employee, and the remainder is withdrawn tax-free from the accumulated adjustments account, the total taxes paid are $12,994 (vs. $15,158 when all earnings were "zeroed out"). Similarly, if profits before salary are $125,000 and a reasonable $60,000 in salary is paid, the total taxes paid are $39,613 (vs. $41,350 when all profits are "zeroed out"). Tax savings are magnified if a lower salary is deemed
reasonable.

Profits Retained in the Business. If an owner retains all profits in the business to foster growth, generalizations about the appropriate form of entity can be dangerous. As illustrated in Example 3, at certain profit levels a C or S corporation is more tax efficient than a noncorporate entity because it is not burdened with self-employment taxes. However, at other income levels, differing graduated tax rates of a C corporation generate varying results when compared to an S corporation, which is taxed at individual rates and subject to differing tax brackets for differing filing statuses.

As can be seen in Example 3, a single individual who expects to retain $50,000 in 1996 profit in the business will pay $7,500 in total taxes as a C corporation, $9,046 as an S corporation, and $15,122 as a partnership, LLC, or proprietorship. However, it is not wise to conclude a C corporation is always the optimum entity. Also as illustrated in Example 3, if expected profit is $125,000, total taxes are $32,000 for a C corporation, $31,855 for an S corporation, and $41,254 for either noncorporate entity, suggesting a slight S corporation priority. However, although the calculations are not illustrated in Example 3, assuming the owner was married, filing a joint return, the $125,000 profit would generate the following total taxes: C corporation, still $32,000; S corporation, only $26,972; and noncorporate entities, $36,371.

Generalizing about the optimum entity based on the prospect of total profit retention is unrealistic. Each situation must be evaluated based on its own facts and assumptions, some of which are questionable. For example, can all profits be retained in a business? Is it possible for an owner to earn a livelihood without some form of compensation/ cash from the business? If so, for how long? If a business is a C corporation, at what point does an accumulated earnings tax issue surface? Also, there is the matter of taxation on future distributions on a sale or liquidation.

Profits Paid to Owners as Ordinary Dividends. C corporation owners can receive ordinary dividend distributions. However, due to double taxation, such distributions are rare. Usually profits are paid to a C corporation owner as salary and fringe benefits. Where appropriate, owners lend funds or lease property to a C corporation and extract cash as principal, interest, or lease payments, none of which are subject to payroll taxes. In summary, for most small businessowners, double taxation of dividends is more a theoretical issue than a practical problem.

Net Operating Losses. If net operating losses are likely, theoretically an S corporation, partnership, LLC, or proprietorship offer a significant advantage over a C corporation. The losses offset personal income in the loss year and provide an immediate tax benefit. Ordinarily C corporation losses provide no immediate tax benefit since their losses offset C corporation profits only by carrying losses back three years and/or forward 15 years.

Although the potential advantage of immediate net operating loss deduction appears significant, it is best determined on a case-by-case basis. Few entrepreneurs expect to begin operations and lose money. For those who accept the possibility of start-up losses, the potential one-time advantage of the deduction must be weighed against the possible long-term disadvantages of operating as a pass-through entity, especially since a start-up C corporation loss can offset future C corporation profits. Also, to gain a tax benefit, an owner needs sufficient personal income, which may not exist, to be offset by a loss. If profitable years are followed by loss years, the carry back provisions of C corporation losses minimize the advantages of other entities. *

Alan R. Sumutka, MBA, CPA, is an associate professor of accounting at Rider University.

Ownership and Management Participation

1. Ownership restrictions:

* One owner acceptable

* Two or more owners acceptable

2. Participation in management

Risk Management

1. Limited liability

2. Reliability of business form

3. Reliability of business form in interstate commerce

Excludable, Company-Paid Fringe Benefits

1. To sole owner/employee

2. Limited benefits to sole owner/employee if other full-time employees

Simplicity and Costs

1. Formation

2. Unrestricted availability of fiscal year-end

3. Availability of cash method of accounting

Taxation of Profits and Losses

1. Avoidance of double taxation upon sale or liquidation of business

2. Generalizable tax advantage available if all profits­

* extracted via total salary, guaranteed pay, or withdrawal

* extracted via "reasonable salary," guaranteed pay, or withdrawal

* retained in business

* paid as ordinary dividend

3. Tax advantage of net operating loss

The Choices Are Many

In starting a business, there are a number of threshold issues for the small business owner to consider in selecting a form of business. These include ownership and management control, risk management, company-paid fringe benefits, simplicity and cost, and taxation.

All traditional forms of business ownership provide owners with the means to manage their business. However, depending on the number and type of owners, certain ownership options may not be used.

If nondiscrimination rules are satisfied, C corporation owner/employees obtain excludable company-paid fringe benefits. No other entity allows a deduction for such benefits and an exclusion by the individual.

IN BRIEF

LLC/Ps are the most expensive entities to form. C corporations offer the best opportunity to select any fiscal year-end. The cash method of accounting is available to all types of entities with certain restrictions.

Factors to be considered under taxation include possible taxation on the sale or liquidation of the business, profits paid to owners as compensation, profit retained in the business or paid as ordinary dividends, and net operating losses.