A venture can be operated through a variety of legal forms. In the United States, these include entities such as sole proprietorships, partnerships, limited liability companies, and corporations. Does entity choice make any difference on the tax aspects? Much of the impetus for the growth in LLCs versus corporations is the tax advantage of these flow-through entities. However, in strategic tax management, minimizing tax is, but one objective in the firm’s strategic plan. Even if a firm is not an entrepreneur, an understanding of the tax treatments of noncorporate entities is critical. Many corporate restructurings and international ventures use noncorporate entities. Thus, a basic understanding of flow-through tax treatments is necessary, as it is discussed in this post.
Limited Liability Companies [LLC] Become the Most Popular
The widespread adoption of limited liability company (LLC) statutes in the United States has been a much-heralded development. As of 1999, all states passed such statutes. Because the LLC provides investors with limited liability, pass-through taxation, and far more organizational flexibility than a limited partnership or an S corporation, the LLC is destined to become the business organizational form of the future. In 1988, the IRS finally determined that LLC income would be classified as a partnership rather than a corporation, and subject to one level of income tax. According to one estimate, since 1988 the number of LLCs has grown dramatically to approximately 50,000.
Another sign of the popularity of LLCs was confirmed by Dun & Bradstreet, which conducted a study of 4 million businesses formed between 1990 and 1996. The number of corporate-type entities (including LLCs) grew, while the number of partnerships and proprietorships went down. The number of corporations grew by 5.3% over the period, while the other two formations declined by more than 2.5% each among businesses with 50 or fewer employees.
One other important background concept should also be mentioned: the U.S. check-the-box regulations. Under these rules, management can simply check a box on a noncorporate entity’s tax return to pick whether it is to be treated as a tax-free flow-through entity or as a taxable corporation. Whether the entrepreneur—or manager of a newly formed subsidiary business—should choose flow-through or corporate treatment is the subject of much of this post.
The entity choice for tax purposes should be based on a strategic planning process that considers a host of nontax strategic goals as well (as discussed in. For tax purposes, the basic entity choices are double-taxed entities (C corporations) and flowthrough entities (partnerships, S corporations, and limited liability corporations [LLCs]). Each of these has unique tax attributes, and one cannot unequivocally say that any entity is better than the other.
Depending on the entrepreneur’s strategic plan, nontax attributes that differ across entities are:
- Risk management
- Managerial control
- Raising capital
- Pre-tax return
When an enterprise is formed, the general U.S. rule is that this event is tax deferred. That is, the exchange of ownership interests for property does not trigger recognition of gain (or loss) by either the enterprise or the owners. Instead, the owner’s basis in the property is carried over to the enterprise, and also is used as the owner’s initial basis in the ownership interest received.
When forming a corporation, part of the transactions costs are directly related to capital structure. When first formed, the owners receive corporate shares in exchange for assets. (If shares are exchanged for service, the transaction is taxable. It basically is treated as though the services are paid for in cash, and then shares are purchased with the cash.) Under IRC Section 351, any gain or loss on the contributed assets may be tax deferred. To the extent the owners also receive boot—for example debt (such as a corporate bond) or cash—in the exchange, any built-in gain on property contributed is immediately taxed to the extent of this boot received. Gain also can be triggered if an owner transfers debts to the corporation, but generally only to the extent the debt relieved exceeds the owner’s basis in the assets contributed.
The tax problem arises if non-cash property is put into the corporation, and only if that property’s fair market value is higher than its adjusted tax basis. The latter occurs if the property has gone up in value, or if rapid tax depreciation has driven down the tax adjusted basis.
To be eligible for Section 351 tax deferral, these criteria must be met:
- The owner transfers property (tangible or intangible) to the corporation.
- In return, the owner receives shares in the corporation.
- Immediately after the transfer, the shareholder who transferred the property owns at least 80% of the value and voting power of the corporation’s shares.
Note: A group of taxpayers can qualify for deferral, as long as they meet the 80% test as a group in addition to each meeting the other two tests. If a shareholder receives something other than shares (such as a bond), it is called boot. The gain taxed to the shareholder is the lesser of:
- Boot received
- Realized (total) gain on assets transferred to the corporation
The realized gain of a corporation is $100 – 50 = $50, for instance. However, because the requirements of Section 351 have been met, the realized gain is eligible for deferral. Since no boot is received, the gain is not taxed. Instead, under the rules of IRC Section 358, machineries have a lower basis to a corporation, so if a corporation eventually sells it for $100, the $50 gain is taxed then. Thus, Section 351 is a time value/timing tax-management technique. Possible questions arise:
- What if the shareholder instead received bonds? Then the entire $50 is currently taxed to the owner. However, machineries’s tax basis is stepped up to $100, so there will be no built-in gain when it is sold.
- What if $100 of cash, instead of a machine, is transferred? Then there is no gain (and thus no tax) even if the shareholder receives bonds.
The results are similar if a flow-through entity (any type of partnership, an S corporation, or an LLC), is involved. That is, if assets are contributed in exchange for an ownership interest, the transaction generally is not taxable either to the entity or the owners. Gain inherent in the property transferred is deferred. This is accomplished by reducing the owner’s adjusted basis in the investment in the flowthrough entity. The exceptions just noted apply. In addition, taxation can be triggered if the transaction is a disguised sale of properties.
Tax Consequences of C Corporation–Shareholder [Manager] Transactions
Type of payment from corporation to shareholder:
Manager Shareholder (manager) C Corporation
Dividend Taxable Not deductible
Salary Taxable Deductible
Perquisites Depending on type, Deductible
medical not taxable
or pension plan)
Other Entity Choices
In addition to the entity choices shown previously, other entity types may be selected. Here is a brief overview:
- Limited liability partnership (LLP) – Now recognized by over half of the states in the United States, an LLP is essentially a general partnership with one important exception. In the case of legal actions, only the partner(s) performing the service can be sued for their personal (nonpartnership) assets. The other partners are thus protected. Many CPA firms (notably Arthur Andersen) have chosen this form of entity, since most states do not allow licensed professionals to practice as LLCs or as limited partnerships. The tax treatment is the same as a partnership.
- Personal (Service) Corporations or Professional Corporations (PCs) – Many service professionals practice in this form. While not affording the liability protection (of personal assets) that a regular corporation does, the PC offers more protection (depending on the state) than does a sole proprietorship or general partnership. PCs can elect either C or S corporate status for U.S. tax purposes.
- State and Other Country Tax Treatments of Various Entities. These vary by state and by country, but for the most part are similar to that of the United States.
Specialized Venture Legal Forms
Although the vast bulk of business transactions in the United States are conducted in the legal form of a corporation, the other forms discussed throughout this post—such as partnerships and limited liability companies—are not uncommon. Nor is the technique of using multiple entities, such as a parent corporation with many subsidiaries, or combinations of entities, such as a partnership of corporations.
There are specialized legal forms, however, which are not used regularly or are used in certain industries. A good example is the Real Estate Investment Trust, which is explained below.
Special Entity: Real Estate Investment Trusts [REITs]
A special, nontaxed, flow-through entity, the real estate investment trust (REIT) has become increasingly popular in the United States. Its use is restricted to investments in real estate. A REIT essentially is a corporation that, if it meets certain requirements, is tax free. The requirements include: (1) it has less than 100 shareholders, (2) 95% or more of its income comes from real estate, and (3) it distributes at least 95% of its income each year. For the income test, its income must not be from the sale of real estate (e.g., a real estate developer or construction company).
A number of holding companies are REITs, using the REIT to hold investments in office buildings, shopping malls, and apartment buildings, from which the REIT collects rental income. A number of hotel chains have also used this entity.
Recently a number of large corporations have begun using REITs to shelter their income from real estate. In response, the IRS is has attempted to place some restrictions on this entity. In particular, the IRS issued a ruling on what is known as step-down preferred stock. This also is called “conduit entities issuing fast-pay preferred stock.” These securities (sold in the private market for institutions under the SEC’s relaxed Rule 144a) pay a lofty interest rate of 13% to 14% in the first 10 years, and then drop to 1%. Bear Stearns was thought to be among the most aggressive marketer of these securities, which included investors, such as Union Carbide and Disney.
Under the practice, preferred stock issues were sold to tax-exempt investors, such as pension plans. In the transactions, the buyer and the seller would jointly create a real estate investment trust, each contributing $100 million. Through the REIT, the buyer would get inflated dividends, which, because of the buyer’s tax status, would be tax free. After paying the oversized dividends for 10 years, the seller would buy out the buyer’s share of the investment for a nominal amount, liquidate the REIT, and distribute the remaining $200 million in assets to the seller.
Under U.S. tax law, such a liquidation is generally thought to be tax free. But what was really happening? The IRS declared, was that the seller was selling preferred stock and not paying taxes on $100 million of income.
As noted in the paraprace, explanations that delve into more esoteric tax issues have been isolated into the “Limitations On Entity Tax Planning [A Case Example]” on the next section of this post, so that they can be scanned quickly and found later if the issues arise. is a prime example, highlighting, as it does, some of the densest areas of taxation that deal with highly sophisticated and perfectly legal tax-management techniques.
Limitations On Entity Tax Planning [A Case Example]
For partnerships and LLCs, each owner’s deductions in any one year are limited to the owner’s net investment (or capital account in the entity) plus the owner’s share of the entity’s debt. In other words, loss is limited to the owner’s tax basis.
Plant & Equipment: 200
Liabilities & Equity
If A is a 60% owner, then her basis is her capital account of $75, plus her share of the debt (calculated as 60% of $175 = $105), or a total basis of $180. If the partnership (or LLC) has a tax loss of $400, A’s share is 60% ($400) = $240. However, she can deduct only $180 (her basis) in the current year. The remaining $60 carried over to future years until A has sufficient basis to cover the loss.
For an S corporation, the rules are slightly different. Substitute “stock equity” for “capital accounts”. A could only deduct $75 of loss, and the remaining $165 would carry over to future years. Unlike partnerships and LLCs, for an S corporation the liability of $175 can be included only in A’s basis if it is owed to A (i.e., she loaned the S corporation the money).
Thus, choice of entity relates to anticipation (timing and time-value issues), with partnerships and LLCs having an advantage over S and C corporations.
Passive Activity Loss Limitations
Unless the entity owner is actively involved in management of the enterprise, a loss from a flow-through enterprise is limited to passive activity income (or income from other flow-through entity investments) for the year. Using the previous example, if partner A is actively involved in management, then her loss is only subject to the basis limitation of $180. If, however, she is simply a passive investor, and she has no other positive income from any other flow-through entities, she cannot deduct any of the loss:
The entire $240 carries forward to subsequent years when the flow-through generates positive taxable income. Any unused losses under the passive activity rules can be utilized to offset gain when the owner liquidates her interest, or liquidates the entity, in a taxable transaction.
There are a number of definitions for active involvement in management. The simplest, and easiest to document, is if the owner puts in at least 500 hours per year of time directly related to the entity.
An advantage of partnerships and LLCs over S corporations is the possible use of special allocations. Referring back to the A-B partnership example, suppose partner A is in the 35% tax bracket, and partner B is in the 15% bracket. Because a tax loss is worth more to partner A, it might be best for the partnership (or LLC) to specially allocate 100% of the loss to her. To accomplish this, the allocation must have “substantial economic effect”.
This test has two requirements:
- The loss reduces the partner’s (here partner A) capital account.
- Any liquidation proceeds must be based on relative capital accounts (i.e., if partner A’s capital account is negative, she must pay the balance back to partner B).
These two requirements force partner A to accept lower cash flow in a later year for any extra tax benefits in prior years. To see how this works, suppose in the previous example that the partnership is liquidated at the beginning of the next year, with net (after liability payoff) liquidation proceeds of $75. Because A has a post–special allocation capital account of $(325), the first $25 of proceeds go to B. Then the remaining $50 also go to B, in proportion to his capital account. The net result of this is that A has lost $45 in liquidation cash proceeds (60% of $75) in order to get an extra $56 (40% × 35% × $400) in tax savings.
In general, if substantial economic effect can be delayed until liquidation, the higher the net present value of the special allocation. In this case, for example, if partner A’s discount rate is 10% and the liquidation occurs 10 years after the allocation, the present value of the lost cash flow is only $45 × 0.3855 = $17.34.
In addition to the anticipation (timing and time-value) attributes of special allocations, they have a unique negotiation possibility: Partners (and LLC owners) in different tax brackets can negotiate the tax benefits between the owners.
Accumulated Earnings Tax and Personal Holding Company Tax
There are penalty taxes, added onto a C corporation’s regular tax bill in the United States, if a corporation is audited and found not to have paid enough dividends. In effect, these special taxes force certain closely held corporations to pay dividends. (Although the accumulated earning tax technically applies to all corporations, it is extremely rare for the IRS to attempt to impose it on publicly traded corporations.) Because dividends are not deductible by corporations, but are taxed as ordinary income to the shareholders, the result is usually a significant increase in overall taxes.
The accumulated earnings tax is triggered when corporations have retained earnings of more than $250,000 [$150,000 if a personal service corporation], unless the accumulations can be justified by reasonable business needs. Among the accepted needs are working capital and certain reserves for business contingencies, such as expansion, self-insurance, and redemptions of stock to pay death taxes. The personal holding company tax applies even to reasonable accumulations if the corporation has too much passive income. This tax can be imposed only on closely held corporations, but not if they are financial institutions. Closely held means that at any time during the last half year, more than 50% of the value of its outstanding shares are owned, directly or indirectly, by no more than five individuals. Passive income is from interest, dividends, some rents, and most royalties; too much means that such personal holding company amounts to no less than 60% of the corporation’s adjusted ordinary gross income. The tax typically applies where an individual incorporates herself or the assets of an active business are sold but the corporation is not liquidated. Using flow-through entities like limited liability companies avoids this tax.
Applying Strategy, Anticipation, Value-adding, Negotiating and Transforming to Entity Choice
Suppose you and an associate start a business that produces business software. Under your guidance, programmers have developed the prototypes, which you have beta-tested in small businesses. You have each invested $10,000, which has been used primarily to pay the programmers. You have no formal legal agreements between you and your friend. You have a $150,000-per-year job in another company and about $500,000 of net worth. Your friend is a graduate student earning $10,000 per year and has $5,000 in savings. You eventually will require about $200,000 to rewrite the software so that it can be used by larger businesses. You are considering doing business through a separate entity, with the stipulation that you and your friend will remain equal owners.
Use the strategic tax planning framework to suggest an entity choice:
Strategy – Capital raising, management, and control: You and your friend would like to retain control, so a goal could be to have any new investors brought in to be treated as lenders or passive capital investors. Lenders can be in any entity type, although if venture capitalists provide an unsecured loan, they probably would want some potential control. Banks probably would require a loan secured by your personal assets. The tax advantage of debt is deductibility of interest payments. The sum of $200,000 is not large enough to require a public offering, so use of a C corporation is not mandated. Instead, private placements could work, through sale of S corporation stock, LLC certificates, or limited partnership interests. A limited partnership is a bad idea from a liability perspective, because both you and your friend would most likely be the managing general partners. This would subject your personal assets to creditor’s risk. Thus, either an S corporation or an LLC is indicated.
Anticipation – As noted previously, no major changes are expected in any entity type. However, with LLCs becoming more prevalent, the legal costs of forming them could become cheaper. Timing issues are also at play. For example, the typical expectation that there will be NOLs early on favors the use of flow-throughs entities, such as LLCs. When the firm becomes profitable later on, the owners can convert it to a C corporation to take advantage of possibly lower corporate tax rates. This might not be favorable in all circumstances. For example, the penalty taxes discussed in the previous case example.
Value-Adding – The double tax on C corporations, at first blush, makes them seem less attractive than flow-through entities. More taxes paid at the entity level mean less to be reinvested in the business. Although some of the double tax can be mitigated through salary payments, the flowthrough entities dominate as the best choice under these conditions. Adjusting Value-Adding for Risk As noted, risk management points to either an LLC or an S corporation. The entity would not have to pay a risk premium to investors, either, because only their initial investment would be subject to risk. An attorney would be needed, whose fees for drafting and filing would be about: corporation: $1,000, S corporation or Limited Partnership [LP]: $2,000, and LLC: $3,000. If any new equity owners are admitted, about $250 per new person would likely be charged.
Negotiating – Because of the nature of the business, you anticipate tax NOLs for the first few years. By forming an LLC, you have the flexibility of allocating these losses among owners through special allocations, an option unavailable to S corporations.
Transforming – All entities can be liquidated at capital gain rates. In case the business fails, an S corporation is favored because of the possible use of Section 1244 stock. After weighing all the factors, you decide to form the business as an LLC.