Choosing which type of entity to use is among the most important decisions a business can make. Most clients wish to avoid personal liability for the obligations of the business (an attribute of corporations) and may also wish to personally deduct the losses of the business and avoid double taxation of the income of and distributions from the business (attributes of partnerships). For businesses with these objectives, the limited liability company may offer the best of both worlds. An LLC is generally treated as a partnership for tax purposes. At the same time, the LLC’s members, like corporate shareholders, are not personally liable for the debts of the business.
However, LLCs are not always the best form of entity, even for a closely held business. There may be circumstances in which a corporation or limited partnership is a more appropriate form.
Sole Proprietorship. A sole proprietorship is nothing more than a business in which an individual engages in business personally rather than by means of a separate entity such as a corporation. The sole proprietorship avoids many of the formalities and reporting requirements associated with other forms of business organization. However, the proprietor is personally liable for the obligations of the business, thus making a limited liability entity such as a corporation or LLC an attractive alternative.
Corporation (Including S Corporation). A corporation is a limited liability entity, in that none of the owners (shareholders) are liable for the obligations of the corporation. Corporations formed under California law are governed by California’s General Corporation Law (Corp C §§100-2319).
The income of a corporation (other than an S corporation) is taxable, both by the federal government and California, at the corporate tax rate. Thus, a corporation and its shareholders are subject to “double taxation,” because the corporation pays tax on its income and the shareholders pay tax on dividends received from the corporation, and the corporation is not allowed to deduct dividends as an expense.
Double taxation may be minimized in certain cases by the payment of salaries to shareholders and by the use of shareholder loans. In addition, a corporation that retains most of its income may find the corporate tax structure beneficial because the marginal rates applicable to corporations are often lower than the marginal rates applicable to individuals.
Qualifying corporations can ameliorate the effect of double taxation by making an S corporation election. If a corporation makes a valid S corporation election, then, for federal tax purposes, the corporation’s net profits, losses, and tax credits are passed through (and taxed) to the corporation’s shareholders, without being taxed to the corporation. Thus, S corporations are treated similarly, but not identically, to partnerships. There are important restrictions on the ability to qualify as an S corporation.
General Partnership. A general partnership is an association of two or more persons to carry on as co-owners of a business for profit that is not a limited partnership. Corp C §16101(7).
A general partnership has the following characteristics:
(1) Each partner is an agent of the partnership and can bind the partnership in its ordinary course of business (Corp C §16301(1)); and
(2) Each partner is personally liable for the obligations of the partnership (Corp C §16306).
A joint venture is an entity formed for a limited or temporary business purpose. Joint ventures have generally been treated as general partnerships under California law. However, LLCs may become the entity of choice for many limited purpose business ventures.
A general partnership is generally not subject to federal or California income or franchise tax. For federal tax purposes, a partnership is any joint enterprise other than a trust or estate that carries on a business and is not organized as a corporation under state law. IRC §§761(a), 7701(a)(2); Reg §301.7701-2.
Limited Partnership. A limited partnership is a partnership with one or more “limited partners” (partners who do not participate in the control of the business and who are not personally liable for the obligations of the partnership), and one or more “general partners” (partners who actively engage in the management and control of the business and who have unlimited personal liability for the obligations of the partnership). Corp C §15611(r).
Limited partnerships formed in California on and after July 1, 1984, are governed by the California Revised Limited Partnership Act (Corp C §§15611-15723). Limited partnerships formed in California before July 1, 1984, that have not elected to be governed by the new act are governed by the California Uniform Limited Partnership Act (Corp C §§15501-15533). See Corp C §§15710-15714.
A limited partnership, like a general partnership, is generally not subject to federal or California income tax. Unlike a general partnership, a limited partnership is subject to an annual franchise tax of $ 800.00. Rev & T C §§17935, 23153.
Limited Liability Partnership. Many states have statutes authorizing the formation of limited liability partnerships (LLPs). An LLP is a form of general partnership in which the liability of each partner may be limited. Under most LLP statutes, a partner is relieved of liability for the negligence, wrongful acts, and misconduct of another partner and of employees and agents of the LLP. However, partners are not relieved of liability for their own negligent or wrongful acts or misconduct, or for the negligent or wrongful acts or misconduct of any person acting under their direct supervision and control. In most states, partners of an LLP remain liable for the contractual obligations of the partnership.
Limited Liability Company. A limited liability company (LLC) is an unincorporated business organization whose members do not have personal liability for the debts of the LLC. LLCs formed in California are governed by the Beverly-Killea Limited Liability Company Act (the Act) (Corp C §§17000-17655). A domestic LLC with one member is automatically disregarded for federal and California tax purposes unless the LLC files an election to be taxed as a corporation. Reg §301.7701-3. A domestic LLC with two or more members is automatically classified as a partnership for federal tax purposes unless the LLC files an election to be taxed as a corporation. Reg §301.7701-2.
An LLC doing business in California must pay an annual franchise tax plus a statutory fee for any year in which the LLC’s total income is $ 250,000.00 or more. Rev & T C §17942(a)-(b).
Advantageous Uses of LLC’s. The favored tax treatment of the LLC, its limited liability features, and its flexibility for structuring financial and managerial operations make the LLC a form of business organization to be considered for a new business. An LLC can be particularly advantageous in the following situations:
Start-up businesses. Every start-up business should consider the LLC form of organization, whether it is a corner grocery store, real estate venture, or corporate high-tech joint venture.
Existing unincorporated businesses. Any existing business that is a partnership and any sole proprietor bringing in a partner should consider converting to LLC form. Generally, the conversion can be done without triggering income tax.
Venture capital investors. Because of the organizational and structural flexibility of LLCs, the ability to engage in management without fear of liability, and the ability to make special allocations and deduct losses, an LLC may be attractive to venture capital investors. An LLC may not be able to attract venture capital, however, if it restricts the right of investors to sell their ownership interests or if the venture capital investor is a partnership that has tax-exempt or foreign partners.
Real estate investments. LLCs should be particularly attractive for real estate investments because LLCs combine limited liability and flexible management with the ability to pass through losses and deductions, make special allocations, and avoid double taxation on the sale of appreciated assets.
Joint ventures. An LLC can be an attractive alternative to a general partnership or corporation as a means of organizing a joint venture or “strategic alliance.” LLCs are preferable to general partnerships because of the limited liability they provide to members (thus eliminating the need for a venturer to form a special-purpose corporation) and are preferable to corporations because of pass-through tax treatment and the avoidance of double taxation.
Estate planning. The LLC, by virtue of its partnership tax treatment, limited liability, and flexibility of management and financial structures, may prove to be a valuable estate-planning tool for transferring ownership interests in businesses and real estate.
Problem Areas for an LLC. Although the LLC form of organization has many desirable features, it is not suitable for every business. An LLC may not be appropriate in the following situations:
Existing incorporated businesses. Converting a corporation into an LLC will generally result in a taxable liquidation of the corporation, even if the corporation has elected to be an S corporation. A statutory merger or conversion of a corporation into an LLC, for example, will ordinarily be treated as a liquidation of the corporation and a contribution of the distributed assets by the shareholders to the LLC. The tax cost of liquidating the corporation should be calculated and considered before deciding to convert the form of business organization from a corporation to an LLC.
Businesses planning to go public. With some exceptions, a partnership whose ownership interests are publicly traded is taxed as a corporation. An LLC that becomes publicly traded would therefore lose one of the primary benefits of being an LLC, i.e., partnership tax treatment, and, compounding that loss, the capital markets might discount the value of an ownership interest because of unfamiliarity with LLC interests as compared to stock. An LLC could incorporate before going public and avoid this result, and for certain businesses, an initial period of operation as an LLC may be suitable. Until it incorporates, however, an LLC could not offer tax-favored incentive stock options and employee stock purchase plans, which are common ways of compensating and motivating employees working for a business intending to go public, and, as mentioned above, an LLC might not attract certain investors.
Professional practices. A California LLC is not authorized to practice a profession that, if practiced in corporate form, would have to be organized as a professional corporation.
Certain regulated businesses. An LLC may not be suitable for a business that requires a license, certification, or registration under California’s Business and Professions Code. The limitation on practicing a profession, as specified in the preceding paragraph (Corp C §17375), may apply more broadly to any business that requires such licensure, certification, or registration; most practitioners are being cautious and advising clients they cannot use the LLC form of organization for any business that requires a license, certification, or registration under the Business and Professions Code. In addition, businesses in certain regulated industries may need to be in corporate form to comply with regulatory requirements.
Ease or Difficulty of Formation; Transaction Costs. In general, the ease or complexity of forming a business enterprise (and the associated costs) depend more on the scope and complexity of the specific business venture than on the form of entity chosen. A general partnership formed to engage in a complex transaction, with detailed allocations of profits and losses and sophisticated management controls, may be much more complicated, and costly, to form than will a one-shareholder corporation engaging in a simple business.
Corporation. Although corporations are perhaps subject to the most formalities, corporations may in many cases be the simplest and least expensive entity to form, primarily because the parties need not negotiate a detailed agreement governing the structure and operation of the corporation, but can instead rely on the provisions of the General Corporation Law (Corp C §§100-2319). However, if the parties want to restrict the transferability or voting rights of corporate stock, or provide for different classes of stock, a detailed agreement or specially drafted articles of incorporation may be required.
A corporation is formed by filing articles of incorporation with the California Secretary of State and paying the appropriate filing fee. Corp C §200; Govt C §12186. The articles must be signed and filed by the incorporator, who need not be a shareholder. Corp C §200(b).
An amount of at least $ 800.00 in estimated tax generally must be paid by the 15th day of the fourth month of a corporation’s taxable year. Rev & T C §§23151, 19025. However, a corporation is not subject to the minimum tax for its first taxable year. Rev & T C §§23153, 23221. Thus, there is no prepayment of minimum franchise tax and a new corporation will pay only an estimated tax based on earnings in its first taxable year.
After formation, directors must be elected by the shareholders or appointed by the initial incorporator (Corp C §§164, 300-317), officers must be appointed by the directors (Corp C §312), bylaws should be prepared and adopted (Corp C §§211-212), and shares of stock issued to the shareholders (Corp C §§400-423). The election of directors and officers, the adoption of bylaws, the initial issuance of corporate shares, and other organizational matters should be reflected in organizational minutes.
Within 90 days after filing the articles of incorporation, the corporation must file with the Secretary of State a Statement by Domestic Stock Corporation, providing the name and address of the corporation’s directors and executive officers, the general nature of the corporation’s principal business activity, and the address of the corporation’s principal business office. Corp C §1502.
Limited Liability Company. An LLC is formed by filing articles of organization with the Secretary of State on the prescribed form (Secretary of State Form LLC-1) and the payment of a nominal statutory fee. Corp C §17050(a); Govt C §12190. The articles must be signed and filed by the organizer of the LLC, who need not be a member or manager of the LLC. Corp C §17050(a).
Either before or after filing the articles of organization, all the members must enter into an operating agreement. Corp C §17050(a). The operating agreement may be oral. Corp C §17001(ab). However, it is advisable that the agreement be in writing, and it is essential that it address all material issues among the members. The cost and complexity of the agreement will depend on the nature of the LLC and its business. As with partnership agreements, completing the LLC operating agreement may involve extensive negotiating and drafting.
Within 90 days after filing the articles of organization, the LLC must file with the Secretary of State a Statement of Information (LLC-12), providing the name and address of the LLC’s managers (if it is a manager-managed LLC) or its members (if it is a member-managed LLC), the general nature of the LLC’s principal business activity, the name and address of the LLC’s agent for service of process, and the address of the LLC’s principal business office. Corp C §17060.
An LLC doing business in California is required to pay an annual franchise tax of $800.00 for the privilege. Rev & T C §§17941(a), 23153(d)(1); §§5.4-5.5. Like limited partnerships, LLCs are not required to pay the tax when filing the articles of organization, but to pay it on or before the 15th day of the fourth month of the LLC’s taxable year. Rev & T C §17941(c).
Classification of Entities for Tax Purposes. The fundamental distinction between a corporation and a general partnership, limited partnership, limited liability partnership, or LLC is that a corporation (other than an S corporation) is subject to entity level tax while partnerships and LLCs classified as partnerships are as “pass-through” entities, in which items of income, loss, deduction, gain, and credit are not taxed at the entity level but are passed through to the partners or members.
Entities other than corporations and business trusts may elect to be classified as partnerships or corporations under the IRS check-the-box regulations. LLCs are generally classified as partnerships unless they elect to be taxed as corporations.
Tax Consequences of Formation. Neither a corporation, a partnership, nor an LLC is ordinarily taxed on the receipt of capital contributions (whether of cash, property, or services) by shareholders, partners, or members (as applicable). IRC §§721 (partnership and LLC), 1032 (corporation). However, a shareholder, partner, or LLC member may be taxed on the contribution, depending on the nature of the contribution.
Contributions of Cash. A contribution of cash in exchange for shares of corporate stock, a partnership interest, or a membership interest in an LLC will not result in a taxable event for the contributing party.
Contributions of Property. The contribution of property in exchange for shares of corporate stock (including shares in an S corporation) is a taxable event for the contributing party unless the transaction constitutes a tax-free exchange under IRC §351 (transfers to a controlled corporation). If a contribution of property to a corporation is taxable, it will be treated as a sale of the property in exchange for the shares of corporate stock and the shareholder will usually be taxed on the difference, if any, between the shareholder’s basis in the property and the property’s fair market value. IRC §1001.
The contribution of property in exchange for an interest in either a partnership or an LLC (assuming the LLC is treated as a partnership or disregarded for tax purposes) is generally not a taxable event, and will not subject the contributing partner or member to tax liability. IRC §721(a). However, if the contributed property is subject to a liability, the contributing partner or member may recognize gain to the extent that the liability exceeds the sum of (1) the partner’s or member’s basis in the contributed property plus (2) the partner’s or member’s basis in the partnership or LLC before the contribution. Furthermore, a contribution of property to a partnership (and, presumably, an LLC) may be recharacterized as a sale of the property by the partner to the partnership, under the “disguised sale” rules of IRC §707(a)(2)(B). See §§4.20, 5.64.
Contributions of Services. Contributions of services to a corporation (including an S corporation) in return for unrestricted shares of stock will generally be taxed to the contributing party as ordinary income to the extent of the fair market value of the stock received, although subjecting the stock to restrictions may enable the shareholder to defer taxable income. IRC §§61, 83.
If a partner of a partnership or a member of an LLC taxed as a partnership contributes services to the partnership or LLC, as applicable, and receives in return an interest in the profits of the entity, but no interest in the underlying capital, in most situations the IRS will not take the position that the profits interest is taxable on receipt. Rev Proc 93-27, 1993-2 Cum Bull 343. If the partner or member receives a capital interest in the entity in exchange for services, however, the partner or member has taxable income. Reg §1.721-1(b)(1).
Entity Level Tax; Double Taxation. The net income of a “C corporation” (i.e., a corporation that has not made an election to be an S corporation) is subject to taxation at the corporate level. IRC §11(a). Dividends distributed to shareholders are taxed to the shareholders at a rate of 15 percent (IRC §§1(h), 301), with no corresponding deduction to the corporation, resulting in the double taxation of corporate income distributed to shareholders. California does not have a preferential tax rate for dividends. Furthermore, if assets are distributed to shareholders, any gain inherent in the assets is recognized by the corporation on the distribution (IRC §311(b)), while losses inherent in distributed assets can be recognized only in a liquidating distribution, and then limitations apply (IRC §336(d)).
Double taxation often can be avoided by distributing income to shareholder/ employees as salaries or by using corporate earnings to pay interest on debt owed to shareholders or rents or royalties on property leased or licensed from shareholders. In each instance, while the shareholders have income, the corporation receives a corresponding tax deduction. These types of transactions are closely scrutinized by the IRS, so care should be exercised to ensure that the amounts paid are reasonable. In considering the reasonableness of compensation “from the perspective of a hypothetical investor,” courts in the Ninth Circuit apply a five-factor test, that takes into account: (1) the employee’s role in the company; (2) compensation paid to similarly situated employees in similar companies; (3) the character and condition of the company; (4) whether a conflict of interest exists that might permit the company to disguise dividend payments as deductible compensation; and (5) whether the compensation was paid under a structured, formal, and consistently applied program. Elliotts, Inc. v Commissioner (9th Cir 1983) 716 F2d 1241, 1245. In O.S.C. & Assocs. v Commissioner (9th Cir 1999) 187 F3d 1116, the court held that a closely held corporation could not deduct compensation payments made to two employees who were also its shareholders because, even if reasonable, they were payments of dividends in disguise. In Label/Graphics, Inc. v Commissioner (9th Cir 2000) 221 F3d 1091, the court held that a corporation could deduct less than half of compensation paid to the corporation’s president, key employee, and sole shareholder. In E.J. Harrison & Sons, Inc., TC Memo 2003-239, the Tax Court applying the Elliotts test disallowed deductions for approximately $ 1.8 million of $ 2.1 million in compensation paid over a three-year period to one of four officer-shareholders of a family business engaged in waste pickup and disposal services.
Double taxation cannot be avoided by transferring appreciated property to an LLC or limited partnership and then distributing membership or limited partnership interests to the shareholders. In Pope & Talbot, Inc. v Commissioner (9th Cir 1999) 162 F3d 1236, the court held that the gain on a corporation’s transfer of appreciated property to a limited partnership was determined by the hypothetical fair market value of the property as if the corporation had sold it, not by the aggregate value of the interests received by the shareholders.
Businesses that reinvest most of their income, rather than distribute it, may find the corporate tax structure more beneficial, because income left in the corporation for reinvestment (e.g., income less than $ 75,000.00 per year) in the business may be taxed at a lower rate than it would be in the hands of an individual shareholder. However, it may be dangerous to accumulate too much income inside a corporation. See IRC §§531-537 (accumulated earnings tax), and IRC §§541-547 (personal holding company tax).
Gain realized on a shareholder’s disposition of corporate stock is generally taxed at a 15-percent rate. IRC §1(h). There is a 50-percent exclusion from gross income for gain on disposition of qualified small business stock as defined in IRC §1202. Significantly, the 50-percent exclusion also applies for California income tax purposes. However, an amount of gain equal to the gain excluded is taxed at a 28-percent rate rather than a 15-percent rate. IRC §1(h)(4), (7). Alternatively, gain realized on the sale of qualified small business stock may be rolled over to other qualified small business stock within 60 days. IRC §1045.
Inability to Utilize Losses. Corporate losses stay in the corporation, and cannot be deducted by the shareholders, as they can be deducted by partners, shareholders, and members in the case of partnerships, S corporations, and LLCs. Deductions must be postponed until the corporation has income, and may be permanently lost. Generally, for California tax purposes, only a portion of a net operating loss (NOL) incurred in any income year is eligible for carryover by an individual or corporate taxpayer, unless the taxpayer operates a new business or an eligible small business. Rev & T C §§17276, 24416. The portion eligible for carryover is 65 percent for taxable years beginning on or after January 1, 2004. For partnerships and LLCs, however, the NOL is not deductible at the entity level but may be deducted against other income by the individual partners or members, subject to a basis limitation. For S corporations, the NOL may be deducted by the shareholders, subject to a basis limitation.
Passive Loss Rules; At-Risk Rules. The at-risk rules of IRC §465 and the passive loss rules of IRC §469 will apply to a corporation if five or fewer shareholders own over half of the stock of the corporation. IRC §§465(a)(1)(B), 469(a)(2)(B), (j)(1), 542(a)(2). In the case of the passive loss rules, the only limitation is that passive losses cannot be deducted from portfolio income (e.g., interest and dividends); corporate passive losses are fully deductible from the corporation’s “net active income.” IRC §469(e)(2).
S Corporation. To become an S corporation, an “S election” is filed with the IRS under IRC §1362. The election has the effect of making the corporation a pass-through entity for federal tax purposes, but does not change the nature of the entity as a corporation for state law purposes.
State law determines whether a taxpayer is a beneficial shareholder of an S corporation for federal income tax liability purposes. In Pahl v Commissioner (9th Cir 1998) 150 F3d 1124, the taxpayer entered into an agreement to purchase shares of stock to become a 25-percent shareholder of a law firm organized as an S corporation. The taxpayer never paid for any shares and failed to report his share of profits and losses. The court found the taxpayer to be a shareholder of the S corporation under California law and upheld the tax liabilities and penalties imposed by the IRS.
Pass-Through Entity. The income and losses of an S corporation generally flow through to, and are taxed to or deducted by, the shareholders, retaining the character they had to the S corporation. Nonresidents are subject to California income tax on the amount of California source income they receive from S corporations doing business in California. Valentino v Franchise Tax Bd. (2001) 87 CA4th 1284, 105 CR2d 304. The basis in the shareholder’s stock is increased by the shareholder’s share of income and decreased by the shareholder’s share of losses. IRC §1367. The shareholder’s loss deduction is limited to the basis in the shareholder’s stock and the basis of any debt owed by the corporation to the shareholder. IRC §1366. See, e.g., Diane S. Blodgett, TC Memo 2003-212. However, pass-through items from an S corporation are not included in net earnings from self-employment. Therefore, taxpayers may not deduct pass-through losses from an S corporation in determining their self-employment taxes under IRC §1401. Ding v Commissioner (9th Cir 1999) 200 F3d 587. Likewise, shareholders may not deduct pass-through income from an S corporation contributed to the shareholder’s Keogh account for income tax purposes. Durando v U.S. (9th Cir 1995) 70 F3d 548.
Requirements to Qualify as an S Corporation. To qualify as an S corporation, a corporation cannot (IRC §1361):
- have more than 75 shareholders;
- have anyone other than an individual, an estate, or certain trusts and certain tax-exempt organizations, as shareholders (corporate and partnership shareholders are not permitted);
- have a nonresident alien as a shareholder;
- have more than one class of stock, except that differences in voting rights are permitted;
- be an insurance company;
- be a foreign corporation;
- be a domestic international sales corporation; or
- have an IRC §936 election in effect (involving Puerto Rico and possession tax credit).
An S corporation may own 100 percent of another S corporation or 80 percent or more of the stock of a C corporation, but an S corporation cannot elect to file a consolidated return with its affiliated C corporation under IRC §1504. Once an S election is made, failure to meet the requirements will terminate the S election, i.e., S corporation status can be inadvertently terminated. IRC §1362(d)(2). Once terminated, the election cannot normally be made again for five years. IRC §1362(g). However, inadvertent terminations may be waived under IRC §1362(f). Note that a qualified federal S corporation is treated as an S corporation for California tax purposes.
Distributions to Shareholders. A shareholder is taxed on his or her share of S corporation income, regardless of whether the shareholder receives that income. Distributions are not taxable to a shareholder except to the extent the money and fair market value of property distributed exceeds the shareholder’s basis in his or her stock and the basis of debt owed by the corporation to the shareholder. IRC §1368. However, the S corporation will recognize any gain on the distribution of property under IRC §311(b), but, except in liquidation, no loss. Normally, as with other S corporation income, the gain will flow through and be taxed to the shareholders. The amount of money and the fair market value of property distributed to a shareholder reduce the basis of his stock. IRC §1367. The shareholder takes a fair market value basis in distributed property under IRC §301(d).
Tamara L. Harper is here to help you negotiate the maze of corporate regulations, giving you peace of mind and limiting your liability exposure. Ms. Harper shows business entrepreneurs how to protect their assets and preserve their wealth by limiting their liability exposure, registering their intellectual property, and holding property in trust.