6. I understand that if I organize my business as an LLC, I will not be able to provide my employees with options or some other form of equity participation. Is that correct?

No. LLCs and partnerships can offer equity-based compensation plans. Indeed, the flexibility associated with LLCs and partnerships permits tailoring of compensation plans that can reduce or eliminate current income tax at the time of a grant.

7. If I am setting up an LLC, is there any reason to form it under the laws of one state rather than another?

In most instances there is no reason for a business to organize in another state rather than the one in which is operates.

8. Should you ever form a general partnership?

Not in today’s world, no.

The general rule is that all partners in a partnership are liable jointly and severally for all obligations of the partnership.  Limited liability partnerships are a type of general partnership that provides its general partners with limited liability for certain obligations of the partnership.  It has the benefits of a partnership and limitations on liabilities.  For example, partners in LLPs are not liable for the debts caused by the negligence of other partners.

9. I have heard about LLCs and LLPs, but what in the world is an LLLP?

Investment vehicles have traditionally been structured as limited partnerships. A limited partnership must have at least one general partner. Promoters have often minimized liability exposure by using an adequately (but not robustly) capitalized corporation as the general partner. Some states, such as Delaware, now expressly authorize limited partnerships to file a statement of qualification and become “limited liability limited partnerships,” or LLLPs. In these states, even the general partner is shielded from partnership liabilities.

10. If the Secretary of State allows me to reserve a name for a new entity, do I need to worry about any further name searches?

Maybe. Typically, Secretaries of State will reserve a name for anyone who wishes to form a new business entity. By reserving the name prior to organizing the entity, one can be assured that the Secretary of State’s office has checked its database and determined that the name is available for use.

The Secretary of State’s office, however, usually does not determine whether the chosen name may infringe upon federally registered or common law trademarks. If a new business anticipates building a broad identity around its entity name (think, for example, about Ben & Jerry’s Homemade, Inc., or Amazon.com, Inc.), then it should consider performing trademark searches before committing to a name. It may be cheaper to analyze the trademark issues now than to adopt a new corporate identity later.

Naturally, I have heard many more questions all over the map.  The ones we’ve just discussed are the ones I hear the most often.

1.  I understand the difference between an S and a regular C corporation, but what is a close corporation and how is it different?

There is a distinction between the classifying a business entity for state law purposes (which deals with issues like limited liability and requirements for running and maintaining the business) and the company’s federal tax classification.  Virtually all states permit the formation of “close corporations.” A close corporation has a limited number of shareholders typically no more than thirty-five, can operate without a board of directors, does not need to adopt bylaws, and generally operated with less formality than a “regular” corporation—without loosing any of the liability protection offered by “regular corporations.”  If you ran a entity without a board of directors, bylaws or failed to follow any of the required “corporate formalities,” you may be subject to personal liability.  By statue, statutory close corporations are exempted from taking such factors into account if the question of piercing the corporate veil ever arises.

For tax purposes, a close corporation’s status is an independent question.  A close corporation will be treated as a C corporation unless it qualifies for treatment as an S corporation and timely elects the “pass-through” treatment available under Subchapter S of the Internal Revenue Code (“IRC”).

2. With the drop in individual income tax rates does it make sense to organize my business as a regular C corporation?

When the top marginal rate for individuals was 39.6% and the top marginal rate for corporations was 35%, it was frequently advantageous to organize a business as a C corporation as long as the entity did not hold assets expected to appreciate in value and the business plan called for retaining earnings for capital investment. When the top tax bracket was reduced to 35% in 2006 many of the reasons were lost.  There are, however, still some attributes of a C corporation that are attractive, such as the availability of tax-advantaged fringe benefits for owners of the business and the potential 50% capital gains exclusion. The reduction in individual tax rates, however, makes entities that offer pass-through taxation more attractive than ever.

3. Why do the venture capital providers prefer funding C corporations?

I hear this one a lot.  For start-up businesses generating losses, a flow-through entity such as an LLC generally provides tax benefits that make it preferable to a C corporation.  A profitable C corporation may distribute after-tax earnings to shareholders in the form of dividends. In computing their tax liability, however, shareholders must generally include C corporation distributions in income, and cannot use C corporation losses as deductions.  Since LLCs can have multiple classes of equity interests and it is possible to fashion an LLC membership interest comparable to convertible preferred stock, one might think that the LLC form would be attractive to investors.

Nonetheless, venture capital providers generally make conversion to a C corporation a condition for providing funding. One reason is the non-recognition treatment available to C corporations for mergers and other kinds of reorganizations under IRC § 368.  This non-recognition treatment is not available to LLCs–or to corporations that have converted to C corporations in anticipation of a re-organization. Second, only C corporations can take advantage of the 50% capital gains exclusion under IRC § 1202. Venture capital providers seem willing to sacrifice short term tax benefits in hopes of maximizing the after-tax return to investors when a liquidity event occurs.

The preference for C corporations also appears to be driven by non-tax reasons. Investors, familiar with the structure of corporations, find it easier to get deals closed and manage their investments if all their portfolio companies are organized as corporations.

4. I sometimes get told that it is too expensive to form an LLC as a vehicle to operate hier sole proprietorship. Are they right?

No way! If an LLC is taxed as a partnership under the Internal Revenue Code, then the LLC does not pay any federal income taxes. The LLC, however, would generally be subject to a nominal fee to the state of filing.  If the LLC is a single member LLC, it is a disregarded entity for federal income tax purposes; it is not taxed as a partnership but as a sole proprietor is.

If an individual forms an LLC as a vehicle to operate what would otherwise be a sole proprietor-ship, the activities of the LLC are reported on Schedule C to the individual’s IRS Form 1040. There is no need to prepare and file a separate federal or state tax return for the LLC, or obtain a separate employer identification number.  The benefits of operating through a limited liability entity far outweigh the small formation costs.

5. What is the deal with self-employment tax and LLCs?

This one is murky. Once a determination has been made that a pass-through entity is an appropriate choice advisors have steered clients away from LLCs to S corporations in order to minimize federal payroll taxes.  A shareholder of an S corporation can be an employee of the S corporation, so the shareholder may report some of their share of business income as a shareholder distribution and some as compensation for services as an employee. Only that portion deemed to be compensation is subject to FICA (the contributions for old age, survivors and disability insurance, and hospitalization insurance) and unemployment taxes.

In an LLC taxed as a partnership, a member is considered self-employed rather than employed by the LLC. A member who performs services for the LLC is subject to SECA (the self-employment counterpart of FICA) on “net earnings from self-employment,” which includes (with certain exclusions) the member’s distributive shares of income or loss from any trade or business carried on by the LLC.  Thus, there is no question that a shareholder of an S corporation can shelter some income from employment taxes by taking some of the business income as a shareholder distribution rather than compensation for employment. In contrast, except as noted below, a member’s share of LLC profits will be subject to self employment taxes regardless of whether the member considers herself an “employee” of the LLC.

Subchapter S corporation was promulgated to enable small business to incorporate and avoid the double taxation normally imposed on corporate income as seen in a C corporation.  In many ways the Subchapter S Corporation is treated as an incorporated partnership for income tax purposes only.  This treatment allows profits and losses to “pass through” directly to shareholders.  At the same time, shareholders are shielded from individual liability.  While, there are no limits on the size of the corporation’s assets or income under Subchapter S, a business must comply with some detailed statutory and regulatory requirements.  The main advantages and disadvantages of Subchapter S status are summarized as follows:

ADVANTAGES:

1. Limitation on Shareholders’ liability of shareholders;

2. Avoidance of double taxation normally imposed on corporate income;

3. Easy transferability of shares;

4. Pass through of losses to shareholders;

5. Avoidance of taxes on unreasonable accumulations of income under per  I.R.C. §531.

6. Continuity; death of a shareholder does not require dissolution of the corporate organization.

DISADVANTAGES:

1. 25% limitation on “passive investment income” for three consecutive years;

2. Number of shareholders limited to 100;

3. Limitations on deductibility of losses to the sum of the shareholder’s basis in his stock and the indebtedness of the corporation to the shareholders;

4. Unintended termination of Subchapter S status for violation of Subchapter S eligibility requirements;

5. Technicality of tax treatment of Subchapter S corporations under the Internal Revenue Code.

6. Restricted transferability of shares to preclude sales to a non-qualifying shareholder.

7. State tax laws often do not provide for Subchapter S status.

Discussion

An “S” corporation is advantageous when a business organization desires to pass through losses and to retain sound limited liability for its shareholders.  It is often used in new businesses in which high net operating losses are initially expected.

A Subchapter S election allows shareholders to offset income on an individual level rather than at the corporate level.  A Subchapter S election may become disadvantageous when the organization begins to earn significant income or if the organization will earn a substantial portion of its income from what are known as “passive investments” typically rents, dividends, interest or sales or exchanges of stocks.  Where the corporation produces income, individual shareholders will be liable for their proportionate share of income taxes regardless of whether the income was actually distributed to the shareholders.

A Subchapter S corporation must make an election under I.R.C. § 1362 using form 2553.  Once an election is made, the business will not be liable for taxes at the corporate level, except for certain capital gains taxes (I.R.C. § 1374).  Again, income will be taxed to shareholders, with a few exceptions, even if it is not actually distributed.

Requirements

The major requirements of a Subchapter S corporation (I.R.C. § 1361-1379) are highlighted below.  An S corporation is a small business corporation for which a Subchapter S election is in effect for the taxable year.  An election under Subchapter S can be made only by an eligible “small business corporation.”

Small Business Corporation

The corporation must be limited as to the maximum number of shareholders permitted, the type of person who is eligible to hold shares in the corporation, and the classes of stock allowed in the corporation.  I.R.C. § 1361(b) (1).

Domestic Corporation

The corporation must be organized in the United States or under the laws of the United States or one of its territories.

Maximum of 100 Shareholders

The number of shareholders permitted is 100.  In determining who is a shareholder, the general rule is that the beneficial owner of the stock must be deemed to be the shareholder.  In general, each beneficial owner of jointly held property is considered a shareholder.  Thus, property held in joint tenancy or tenancy-in-common is deemed owned by each tenant for purposes of computing the maximum number of shareholders.  However, a husband and wife, and their estate, are treated as one shareholder.

Certain trusts are allowed to be shareholders of S corporations and the general rule is that the individual deemed to own the trust, the current income beneficiary, or the decedent’s estate are considered to be the shareholders.

Qualified Shareholders

Stock in a Subchapter S corporation must be held by qualified shareholders.  Under the IRC only the following may be shareholders in a Subchapter S corporation: An individual who is not a non-resident alien, the estate of an individual in bankruptcy, a decedent’s estate, and certain trusts.  Corporations and partnerships may not hold shares in an S corporation.

Eligible Corporations

Many types of businesses are explicitly excluded from the list of corporations eligible for S status.  An S corporation may not be a subsidiary of another corporation or a member of an affiliated group of corporations.  An S corporation also cannot be a bank, mutual savings and loan association or insurance company.

Very Important One Class of Stock

An S corporation may have only one class of stock outstanding.  However, the corporation may have differences in voting rights among the shares of common stock, without losing its S status.  However, all issued stock must be identical in terms of the shareholders’ interest in the profits and assets of the corporation.

Shareholder Loans

In certain cases, loans issued to shareholders may be considered a second class of stock which would disqualify the corporation from S corporation status.  However, there is a statutory safe harbor for loans having no “equity characteristics.”  This means that the debt must be a “straight debt,” or one which is an unconditional promise to pay on demand or on a specified date a certain sum of money.  The interest rate and interest payment date cannot be contingent on profits, the borrower’s discretion, or other uncertain factors.  Further, the loan cannot be convertible into stock and the creditor must be an individual, estate or a trust which would be eligible as a shareholder in an S corporation.  A debt that does not meet these safe harbor criteria would be considered a second class of stock which would disqualify the corporation from Subchapter S status.

Election, Termination or Revocation

Election

A Subchapter S election must be unanimously agreed to by the shareholders.  A Subchapter S election is made by filing the appropriate form with the Internal Revenue Service and attaching a signed statement indicating consent by each of the shareholders n form 2553.  As a general rule, beneficial owners should be treated as shareholders for consent purposes.  Where stock is co-owned by spouses or owned as joint tenants or tenants-in-common, both parties must separately consent to the election.

Generally, a Subchapter S election becomes effective on the first day of the taxable year if made on or before the fifteenth day of the third month of the corporation’s taxable year.  Thus, a Subchapter S election can be achieved retroactively if elected within 75 days of the first day of a taxable year.  In order to receive this retroactive treatment, a corporation must meet the following two requirements: (1) qualify as a small business corporation on each day through the election date and (2) have unanimous shareholder consent.  Otherwise, an election will not take effect until the first day of the following taxable year.  This prevents pre-election allocation of income or loss to shareholders who are either ineligible to be S corporation shareholders or shareholders who did not consent to the election.  Once a valid Subchapter S election is made, it remains in effect until revoked or terminated.

Revocation

Revocation will occur when the majority of the shareholders consent to a termination of the S corporation election.  Under the current rules, unanimous consent of all shareholders is not required.  Unless otherwise specified, the revocation is retroactively effective on the first day of the taxable year, if the revocation is made on or before the fifteenth day of the third month of the taxable year.  Otherwise, the revocation is effective on the first day of the following year.  The revocation may provide for a prospective effective date, which is not the first day of the taxable year, in which case there will be a “split year.”

A revocation statement should include the numbers of voting and non-voting stock issued and stock outstanding at the time the election is made and the date that the revocation becomes effective.  This must be accompanied by a consent statement which states the number of issued and outstanding, voting and non-voting stock, held by each shareholder who consents to the revocation.  Each consenting shareholder needs to sign this statement.

Termination

The following events can cause termination of Subchapter S status:

(1) Exceeding the maximum number of shareholders;

(2) Issuance of a second class of stock (including debt classified as a second class of stock);

(3) Transfer of stock to an ineligible shareholder (e.g. a corporation, partnership or non-eligible trust);

(4) Acquisition by the corporation of 80% or more of another corporation’s stock (I.R.C. § 1361(a)(2));

(5) Commencing business operations prohibited by I.R.C. § 1361(b)(2) (e.g. operation of a bank or insurance company);

(6) Passive investment income exceeding 25% and Subchapter C profits and earnings for three consecutive years.

A Subchapter S election termination is effective on the date the corporation ceases to be eligible for the Subchapter S election and once a termination is effected, a new Subchapter S election will not be permitted for five (5) years.

If the termination is “inadvertent,” the I.R.S. has discretion under I.R.C. § 1362(f) to set aside the termination.  This waiver will be granted if the corporation eliminates or corrects any causes for the termination, within “a reasonable period of time after discovery of the event resulting in such termination” and there is no tax avoidance from continued Subchapter S treatment.

Ask yourself if you really want to depend on the IRS’s good graces and discretion to reinstate your S-status.

The next form is a “limited liability company.  An LLC is an entity separate from its owners, so ownership can involve one, two or more owners. As a separate entity, the LLC (not its owners) is responsible for the liabilities of the business.  If the business fails you may lose your investment, but your assets are not at risk. Corporations are the oldest form of business entity and as a result, people are generally at ease with a corporation.

Corporations provide the strongest protection against personal liability but may or may not have the same tax advantages of an LLC.   An “S-Corp.” is made for small business and can’t have more than 100 shareholders; however, it does feature pass-through tax treatment like an LLC.   A “C” corporation has a big disadvantage for start-ups; that is, that the income or loss of a C corporation only taxable to the corporation and does not pass through to shareholders.  Shareholders cannot use start-up or other losses to against income received by sources other than the corporation.  Neither an LLC nor a corporation is the best choice for all businesses.

The form of entity that is appropriate for your business will depend upon your situation.   One would be well advised to seek counsel before starting up a company because the tax and legal ramifications of the choice are significant.