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Entity Selection and Business Formation

C-Corporation

Advantages

  • Limited liability of shareholders. The C corporation is a separate legal entity, and if it is adequately capitalized and proper corporate formalities are followed, the shareholders should generally have liability protection from the debts and obligations of the entity.
  • Easier to raise capital through public offering of stock.
  • Shareholders of publicly traded corporations can come and go with ease.
  • No shareholder-level tax on undistributed income.
  • Given the duration that the C corporation entity form has been in existence, a well-established body of law is available with respect to both the tax and non-tax legal treatment of C corporations.
  • No ownership restrictions apply (in contrast with the ones to which the S corporation is subject).
  • Multiple classes of stock permitted (unlike for S corporation).
  • Code Sec. 1202 reduced rate of capital gains taxation on the sale of qualified small business stock.
  • Code Sec. 1244 ordinary loss deduction for a failed small business corporation.
  • The ability to file consolidated returns with controlled subsidiaries.

Disadvantages

  • Double taxation. Income is taxed twice, first at the corporate level and second when earnings are distributed to shareholders in the form of dividends.
  • No capital gains rate differential; all income is taxed on the same rate schedule.
  • Distributions of appreciated property usually triggers gain at the corporate level.
  • Formalities and regulations must be followed very closely in conjunction with the laws regarding incorporating in a specific state; failure to do so can create a situation where shareholders may be held liable.
  • Costlier to start than other business entities.
  • More time and effort to maintain.
  • Potential tax traps, such as the accumulated earnings tax (Code Sec. 531) and personal holding company tax (Code Sec. 541).
  • Shareholders do not benefit from corporate losses.
  • C corporations generally are required to use the accrual method of accounting, which can result in owing taxes on income that has not yet been received.


S-Corporation

Advantages

  • Shareholder limited liability. The S corporation is a separate legal entity, and if it is adequately capitalized and proper corporate formalities are followed, the shareholders should generally have liability protection from the debts and obligations of the entity.
  • An S corporation can easily convert to a C corporation if a public stock offering becomes desirable.
  • Corporate losses flow through, which shareholders may be able to use to offset other income.
  • An S corporation usually has the option of using the cash or accrual method of accounting.
  • S corporation earnings are not subject to self-employment taxes; however, IRS established precedence with Revenue Ruling 74-44 that requires S corporations to pay reasonable salaries to shareholder-employees, or risk having the distribution to a shareholder be reclassified as taxable salaries.

Disadvantages

  • Cannot have more than 100 shareholders.
  • Cannot have as a shareholder a person who is not an individual other than an estate, trust, or certain tax-exempt organizations.
  • Cannot have a nonresident alien as a shareholder.
  • Cannot have more than one class of stock.
  • Code Sec. 1374 built-in-gains tax on sale of assets within ten years after conversion from C-Corporation to S-Corporation.


Multi-Member LLC, taxed as a Partnership

Advantages

  • Provides limited liability for its members.
  • No limitations on the number of members, as is the case for the S corporation.
  • Allows for varying classes of membership.
  • An LLC is permitted to specially allocate income and losses among its members.
  • Losses of an LLC flow through to the members; however, the members can use the losses only to the extent of their tax basis in the LLC.
  • Members, subject to certain exceptions, are allowed tax basis for the LLC's debt, which enhances the ability to use losses that flow through.
  • Tax-free distributions of appreciated property to the extent of basis.
  • Ability to elect step up members' interests in the LLC.

Disadvantages

  • Given the relatively young age of the LLC as an entity form, the body of law is less established, and therefore, less certain. ¬†Although, the State of Delaware has well established case law regarding LLCs.
  • Losses on Small Business Stock. {Code Sec. 1244} ¬†does not apply to LLCs.
  • Limitations imposed on contributions and distributions pursuant to Code Sec. 704(c).
  • Transfer of 50% or more of the membership interests terminates the LLC.
  • Disposition of an LLC interest can result in taxation at ordinary income rates under certain circumstances.