Choosing Your Business Entity: Solving the Conundrum

Are S and C corporations obsolete? With the proliferation of limited liability companies ("LLCs"), one might think so. And with the IRS launching a new study to assess the reporting compliance of S corporations, changes that will affect S corporations are likely to be on the way. This article seeks to clarify and contrast the considerations in selecting a form of entity.¹

Selecting an Entity

A primary consideration is whether to form the business as a "pass-through entity," which is a business that is taxed at the owner level. This choice affects the number and rate of taxes imposed, as well as the way the business is governed and operated. S corporations, general and limited partnerships, and limited liability companies, are normally taxed at the owner level, while C corporations are taxed at the entity level.

Another fundamental consideration is whether the form of entity is consistent with business expectations. For example, founders' perspectives may differ from those of initial investors, angel investors, venture capitalists, and key employees.

Knowledge of legal and regulatory risks is also important. There is quite a bit of uncertainty about the LLC form in Oregon, because Oregon has declined to adopt the National Conference of Commissioners on Uniform State Laws' Limited Liability Company Act, and there is limited Oregon case law. And while S corporations have grown increasingly popular over the years, they are about to get some extra attention from the Internal Revenue Service. An IRS study, completed last March, determined that unreported and unpaid taxes, known as the gross tax gap, exceeded $300 billion. As a result, the IRS will examine about 5,000 randomly selected S corporation returns from the 2003 and 2004 tax years. Corrective actions may affect S corporation formation and exemption requirements and tighten reporting requirements.

Additional factors to consider in forming an entity are control, personal liability, cash flow, and flexibility. In summary, the primary choices are as follows:

1. C Corporations. Owners are generally not liable for the organization's obligations. High-growth and emerging companies will usually select C corporations in order to coincide with financing and equity needs, and ownership expectations. Legal and regulatory risks are generally known.
2. S Corporations. S corporations are C corporations that have elected to be treated for tax purposes as pass-through entities. There are significant tax code restrictions for S corporations, such as the number of owners, types of owners, the use of multiple classes of stock, and ownership of operating affiliates. As with C corporations, owners are generally not liable for the organization's obligations. Institutional and venture capitalists are rarely interested in the advantages of an S election. As noted above, the IRS may take actions that will affect formation and exemption requirements and tighten reporting requirements.
3. LLCs. Like C and S corporations, owners are generally not liable for the obligations of the organization. Unlike S corporations, there are no limitations on ownership of an LLC, and there is great flexibility in structuring the relationships and participation of owners.
4. Partnerships and Limited Partnerships. While these are pass-through entities and allow flexibility in participation and tax planning, they do not provide personal liability protection for general partners. IRS tax classification and ruling guidelines are complex, and compliance is difficult. Failure to comply can result in losing the pass-through tax incidents and substantial tax liability. As compared to LLCs, these forms are also more limited in management participation, potential tax benefits, and simplicity. For these reasons, these entity forms are rarely used.

Playing the FICA Spread

If you desire a pass-through entity, and your income level is below the FICA wage base, which is $94,200 for 2006, in certain situations it may be possible to select an S corporation form and play the FICA spread. In simple terms, the income passed through an LLC is subject to self-employment taxes. S corporations, however, pay such taxes only on salary, not on dividends. Because the owner may receive dividends in lieu of salary, the savings for an owner who earns a salary of less than $100,000 per year can be significant, in the range of $5,000 per year.

Conversion

If you have chosen an entity that doesn't work for you, consider converting. It is not uncommon, or necessarily a reflection of poor planning, to begin as an LLC, convert to an S corporation, and then convert again to a C corporation. Choice of entity and timing of conversion often reflects the company's stage of growth, product development, wishes of founders or angel investors, and financing needs.

Conclusion

Every business is unique and requires careful consideration of many factors, and careful planning. There are pros and cons to each form. If you are considering forming a business, or if you are already in a business, you should carefully evaluate these issues with your advisers.

¹Sole proprietorships are not entities, and it is beyond the scope of this article to address charitable entities, business trusts, and statutory close corporations.

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