By Peter Watts
Choosing the structure of your business is challenging. Even more challenging is changing that structure later. Sometimes as businesses develop, the initial structure can begin to impede growth. It may be a time to change form. Changing the corporate form after a business is in operation can be problematic.
This article previews the basic characteristics, advantages, and disadvantages of the most common organizational forms: the C-Corporation, the S-Corporation, and the LLC. It then discusses the challenges of changing the form of business.
A "C" Corporation takes its name from Chapter C of the Internal Revenue Code. In general, a C-Corporation pays income taxes at the corporate level. When income is passed to the shareholders, they report the income on their own individual tax returns. The two layers of taxation are often referred to as "double taxation." The C-Corporation is the preferred form for a company that anticipates a public offering.
An "S" Corporation takes its name from Chapter S of the Internal Revenue Code. In general, an S Corporation does not pay any income tax. Instead, the corporation's income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns. There are eligibility limitations for shareholders of S-Corporations, and there are ongoing compliance issues. If a public offering is in the corporation's future, it may be advisable to elect C-Corporation status.
An LLC, or limited liability company, is an unincorporated organization. If formed correctly, it offers its unit holders the limited liability that is available to corporate shareholders. The LLC may elect to be taxed as a corporation or as a partnership. If the LLC elects to be taxed as a partnership, then the LLC does not pay any taxes. Instead, the LLC's income or losses are divided among and passed through to its unit holders.
The logical time to choose an organizational form is at the inception of the business. But some businesses may find it advantageous to convert to a different structure at subsequent stages of development. Conversion to a different structure can have significant consequences on taxation of any distributions, consequences that should be carefully considered.
A C-Corporation can elect to convert to S-Corporation status, which will move the assets into a single tax regime. Dispositions of assets carried into the S-Corporation regime will probably be subject to taxes on any built-in gains on the preconversion appreciation. Postconversion earnings and appreciation will be subject to taxation only at the shareholder level. This conversion may be attractive if the owner's goal is to prevent ongoing double taxation. But built-in gains may result in significant taxes being levied during the conversion year.
An S-Corporation may "check the box" in order to convert to a C-Corporation. The entity will begin to be taxed on the effective date of the conversion. Shareholders will begin to pay taxes on the distributions they receive from the corporation.
It is possible to convert an LLC to an S-Corporation, but there are tax reasons why the LLC to S-Corporation conversion is not favored. In an LLC, the general rule is that distributions of appreciated property will be treated as tax-free. The members will have a carryover basis in the distributed assets. But this is not the case with an S-Corporation. Distributed appreciated assets will cause shareholders in an S-Corporation to have taxable income. After they have been taxed, the shareholders will have a basis of current fair market value in the assets. This result limits the feasibility and attractiveness of the conversion.
An S-Corporation may generally be converted to an LLC without present taxable income.
Choosing a business structure involves knowing your current needs as well as your future goals. It is important to consult legal and tax advisers who can help you understand the consequences of each organizational form on your business and its shareholders.