Choice of Entity: Which is best for my company?
I was recently asked by a client to provide advice on entity selection. Given how common this question will prove to be in my practice, I wanted to share my answer so clients are better prepared when they come in to my office for their free consultation.
First of all, let me commend you on taking to the time to approach your business in the correct manner. I can’t tell you how many times business owners try to shortcut the process by not involving an attorney and CPA from the start, resulting in entities having to be closed down and properly restarted. The desire to “save money” up front can cause entities to be faced with high penalties, additional fees to professionals, legal vulnerabilities, and issues with regulatory agencies such as the IRS, as well as state and local governments. In addition, major tax breaks can be lost if the entity is not structured properly upon formation.
Please excuse the length of the e-mail, but this is not a simple question and I want to give you adequate explanations. I will provide you with a generalized answer to your question, but I strongly recommend you contact my office and make an appointment to discuss your specific business details since I do offer a free 30 min consultation. Due to tax complexities, one detail can often change the advice I give to clients; therefore, I want to make sure all the pertinent facts are considered up front, and that you are made aware of all the additional steps you need to take to be in compliance with all tax & licensing regulatory bodies.
First, I'll discuss C corporations: This entity form is quite rare for small businesses; it is almost exclusively used by public companies and corporations with 101 shareholders or more. The most important advantage of a C corporation is that it offers greater ease in obtaining financing since venture capitalists require the company to be a C-corp when seeking funds. However, this advantage comes at very high costs: C corporations are subject to double taxation, meaning the income is taxed twice, both at the corporate level, and again at the personal level when income is received as dividends. In addition, corporate losses are not passed to the owners, but remain with the corporation to offset future income. This last point is of great consideration to a company that is expected to have losses in the first few years due to start-up/expansion expenses.
The only times I would recommend a C corp as the entity of choice from the start are as follows: 1) The company will go public in the next 2 years and is not expecting losses in these beginning years, or
2) a) The company is not expected to have losses, b) the income will remain minimal and constant over the years, and 3) the shareholders will incur high fringe costs such as health, life & disability insurance, as well as company car expenses.
The reason for the latter scenario is because C corporation allow for fringe benefits to be deducted by the corporation, but not taxed to the shareholders. This is an advantage unique to the C corporation. However, the disadvantages outweigh the advantages if the corporation is expected to have losses in the first years, followed by great growth in later years. Therefore, I do not recommend a C-corporation at this time. However, a conversion to a C corporation will become advisable when the company is expected to become public. The C corporation can allow the company to accumulate earnings for future expansion at a lower cost, and would become more able to attract venture capitalists for funding. We would keep track of the expectancy to go public each year, and reconsider the entity form when it becomes advantageous to do so. In looking towards the future, both LLC and S-corporations can convert to a C-corporation at a later time, but as you will see in the discussion below, it will be much easier for the conversion to happen if the entity is initially set up as an S-corp. Please do keep in mind that if you are an S-corp converting to a C-corp, five years must pass before the entity could convert back to an S-corp should the company change their mind. Therefore, a conversion must be carefully considered since it has significant consequences. As a C-corp, the income will be taxed twice at the federal level, and the rate for California would jump from 1.5% for an S-corp to 8.84% for a C-corp.
Given the information in your email, I would recommend an LLC or S-corp at the present time, and later converting to a C-corp 2 years or so before the company is expected to go public.
Both LLC’s and S-corp provide the following advantages:
1) Liability protection is provided by both forms of doing business, however the differences between the two in terms of liability is better discussed with Jennifer.
2) Unlike a C-corp, losses are passed to the owners.
3) Unlike a C-corp, income is only taxed once, at the owner level for federal taxation (California taxes C corps, S corps, and LLC’s, although at different rates).
Since we have eliminated the C corp at this time, which is better, an LLC or an S-corp? The answer to the question depends on a lot of different factors, information which isn’t contained in your email. Therefore, I will give you general information:
LLC’s advantages when compared to S-corps:
1) LLC’s don’t require formal meetings, and generally have less paperwork.
2) LLC’s that are treated as partnerships can provide more flexibility in allocating income and losses between the owners.
3) LLC’s with multiple members have more flexibility in the management of operations.
4) LLC’s are better suited in holding appreciating property such as real estate.
LLC’s disadvantage when compared to S-corps:
1) Both LLC’s and S-corps are pass-through entities and generally do not pay taxes at the federal level, but the entity does have a tax liability with California. LLC’s are taxed on gross receipts, while S-corps are taxed on net income. To illustrate, let’s say your company has gross receipts (sales) of $550,000, with $575,000 expenses (due to start-up/expansion) resulting in a $25,000 loss. Both types of entities are subject to the $800 minimum tax each year even if there’s no income earned that year. In addition to this tax, if your entity is an LLC, a fee is imposed based on the gross receipts in the amount of $2,500. If your entity is an S-corp the additional tax is 1.5% of the net income, which in this case is a loss, therefore no additional tax is assessed. In this scenario, being an LLC vs. an S-corp costs the entity an additional $2,500 in tax that year, and similarly in the future.
2) An LLC’s advantage can also be a disadvantage in the fact that all decisions and terms are governed by the operating agreement. If an operating agreement does not cover a specific situation, state law takes effect, often to the detriment of the members. However, this risk can be mitigated by using an attorney such as Jennifer instead of a company like LegalZoom which creates boilerplate documents.
3) LLC’s were started in 1980’s and are relatively a newer form of entity; therefore laws and regulations are more developed for corporations.
4) California statutes prohibit an LLC from engaging in any business that require a state license, certification, or registration under the California Business and Professions Code. Therefore, businesses providing services in construction, pest control, law, architecture, accounting, landscaping, real estate, and painting are prohibited from doing business as an LLC.
S-corp advantages when compared to LLC’s:
1) S-corporations allow for a reduction of social security tax, thus providing tax savings.
2) S-corporations usually result in tax savings for California taxes for most companies (except those holding real estate).
3) S-corporations allow for easier conversion to a C corp later on. All that will be necessary at that time is for the CPA to file a statement with the IRS voluntarily revoking the S election, and the election must be signed by the owners. Due to more recent change in legislation, California has made it easier and less costly for a company to convert from an LLC to a corporation by allowing a statutory conversion. However, the requirements are still more extensive than compared to changing from an S-corp to a C-corp. Specifically, in converting from an LLC to an S-corp the entity would be required to:
a) Adopt a plan of conversion
b) File Articles of Incorporation containing a statement of conversion with the Secretary of State
c) Pay a filing fee
d) Draft corporate bylaws
e) Hold an initial board meeting
f) Issue stock certificates
4) S-corporations have been around since 1958. Therefore, CPA’s know how the courts have ruled in tax areas and regulations have been written for many scenarios. In addition, attorneys know how courts have ruled in liability suits involving S-corporations. This makes corporations more predictable, and rules are more clear-cut. Without clear-cut answers, when faced with a gray tax area a company is left with requesting an opinion from the IRS which can cost $40,000, or potentially rolling the dice that the IRS may find against the client’s position during an audit and assess penalties.
S-corp disadvantages when compared to LLC’s:
1) The IRS requires that S-corporations have adequate compensation paid to a shareholder who manages the day-day business. This means the CPA must determine the amount that constitutes adequate compensation for each of the shareholders. Failure to do so can result in the IRS assessing penalties, and has been the subject of many recent IRS audits of S-corporations. Adequate compensation means that payroll must be calculated, taxes withheld, and payroll returns filed. Failure to do so can result in high penalties. Therefore, it is important to involve a CPA from the start of the S-corporation.
2) S-corporations have no flexibility in allocation of income. Rules governing S-corps require that only one class of stock can exist, and all profits and losses are allocated based on ownership.
3) S-corporations have strict rules. If the following rules are broken, the IRS can revoke the S election and treat the entity as a C corporation, subject to double taxation and increased California taxes. S-corporations must:
b) Have only allowable shareholders
II. May not include partnerships, corporations or non-resident alien shareholders (no foreign persons allowed)
d) Have only one class of stock
e) Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations)
4) Like C-corporations, S-corporations have more administrative requirements in order to remain compliant, such as recording corporate actions in minutes. Jennifer can expand on what these requirements may be.
5) If sweat equity is involved, S-Corp formation can result in high taxable income to the owners if one or more of the shareholders are contributing services instead of cash. A knowledgeable CPA must be involved under this scenario to avoid disastrous outcomes.
As you can see, there are many factors involved in choosing an entity. I would like to schedule a time for you to come to my office so we can go through the facts and make the best decision possible. In addition, we can discuss business license requirements, annual information reports, and tax considerations based on which entity you decide to create.
Regardless of the entity you choose, please consider a couple of things. One of the biggest advantages of creating an entity is for the liability protection. However, a company must be careful to be in legal compliance, or risk the court piercing the corporate veil and holding the owners personally liable. From a legal standpoint your attorney can help you meet the yearly compliance requirements. In addition, the accounting must be handled properly, meaning a separate bank account must be kept, and any actions between the company and its shareholders must be treated as though conducted with a third party. I can help you with what that will entail. Also, it is my opinion that once an entity is established, the tax return can no longer be done by a non-CPA. Individuals with W-2’s and no rental properties or businesses can do their own taxes adequately. Although not recommended, sole proprietors may also be able to do their own tax return depending on their business/accounting skills. However, entities have such tax complexities that they require a CPA’s knowledge and experience. The final thing to consider is, depending on which entity is chosen, the company will also be required to file an annual or biennial Statement of Information with the Secretary of State. Both the attorney and the CPA can file this, so I can coordinate with him or her to determine who should be responsible for this. To ensure all tax and legal matters are completed, it is always best to have the CPA and attorney work together since the issues overlap.
Meanwhile, please feel free to take advantage of the free resources I have on my website for businesses:
You may also find interest in my firm’s start-up services as they relate to non-legal matters:
Persida Matei, CPA, MST
Persida Matei | 09/16/2014
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