Editor: Rick Klahsen, CPA
When starting a new business one of the first questions an entrepreneur asks is, “What type of entity should I use?” This question is not one that should be taken lightly, nor is there a one-size-fits-all answer. There should be a great deal of discussion with the client and his or her attorney about the business operations, who the owners are today, who might participate in the ownership tomorrow, how the business will be financed, liabilities associated with the business, and what the eventual exit strategy might look like.
Most small businesses today are organized as S corporations for tax purposes because the S corporation avoids potential double taxation (unlike C corporations), allows working owners to be treated as employees, and limits employment taxes to reasonable salaries drawn by owners. The S corporation is not without its disadvantages, however. There are rigid rules about the number and type of shareholders and limitations on how income is allocated among shareholders. An S corporation may issue only one class of stock, although voting and nonvoting shares are permitted. Further, once property goes in, the owners generally cannot take it back out tax free, and when shares in an S corporation are sold, there are limited situations in which the basis of corporate assets may be adjusted.
The partnership tax structure, on the other hand, eliminates all those S corporation disadvantages in that:
- Anyone or any entity can be a partner;
- Profits and losses of the business may be allocated to owners in any reasonable manner that has substantial economic effect;
- Differing classes of ownership shares or units may be issued;
- In many cases property can be distributed out to a partner in a tax-deferred manner; and
- A purchase of partnership interests can often lead to an increase in the basis of partnership property.
The major disadvantages to a partnership are:
- All earnings allocated to a partner involved in the business are subject to self-employment taxes; and
- The flexible structure can make accounting for transactions and preparing tax returns more complex.
When taxpayers seek advice on entity choice, the analysis often focuses on two items: simplicity of operation and self-employment or payroll tax. When these are the only two items considered, it is no wonder the S corporation form is so popular. However, there are other important aspects that practitioners should consider when consulting on business structure.
Consider a situation in which an individual has been working on a business concept for a number of years but does not have the capital to get the business off the ground (the idea investor). Another entrepreneur has the capital but no ideas (the capital investor). These two entrepreneurs get together to implement the concept. If they formed this business as an S corporation, the idea investor would contribute his or her intellectual property and the capital investor would contribute cash. Considering a 50-50 relationship, both shareholders would share equally in the business’s profits and losses. This appears equitable from an economic standpoint. However, from a tax standpoint the capital investor has significant basis invested in the business but the idea investor does not.
If this same transaction were to occur in a partnership, the capital investor could be provided current amortization deductions for his or her investment through a Sec. 704(c) allocation. In order to make this situation work, the partnership would have to cure the Sec. 704(c) problem using a remedial allocation method to allocate additional deductions to the capital investor and additional ordinary income to the idea investor. At the end of the partnership’s life, both investors would have shared in the cash generated by the business in the same manner as in an S corporation; however, the taxation of this investment would be more equitably distributed according to the basis contributed to the partnership.
Additional Capital Needs
In today’s lending market it is often hard for a small business owner to borrow money when capital is needed to keep the business afloat. This can increase the need to find additional investors after the business is off the ground. In an S corporation environment, these additional investors would need to be individuals who would accept the same ownership status as the present owners with no greater liquidation priority. Unfortunately, these investors (who are often not individuals) are seeking a guaranteed return on their capital or a liquidation preference in the event the business does not survive or is sold (preferred interest). This leaves an S corporation with two options when looking for additional capital:
- Limit additional investors to only qualified S corporation shareholders who are not looking for a preferred interest; or
- Reorganize by contributing operating assets to an LLC, with the new investors becoming members in the LLC.
The latter option may be further complicated by disruption of customer/vendor contractual relationships and transfer or restatement of contracts in the new entity.
Note that there are two structuring solutions to the above problem that the investors could have implemented at the start of the business. They could have organized the business as a partnership or LLC in the first place, or they could have initially structured the operating business as a single-member LLC with 100% of its units owned by an S corporation holding company.
Consider the idea investor–capital investor concept mentioned above. Assume that several years later another idea investor comes along. The original investors decide that the business would like to admit the new idea investor as a one-third owner in exchange for his or her idea. To receive tax-free treatment on a contribution of capital to an S corporation, the contributors must own at least 80% of the company’s voting power and at least 80% of all nonvoting shares. If a new idea investor is admitted for a one-third ownership interest in the corporation, the 80% nonrecognition threshold will not be met. If investors had initially formed the business as a partnership or an LLC, the 80% threshold would not exist and there would be no gain on the contribution. This transaction could result in a reverse Sec. 704(c) allocation allowing the existing partners additional deductions.
Selling a Portion of the Business
Once again consider the idea investor–capital investor concept. Five years after they have generated a number of new ideas, they decide it is time to sell the original idea in order to focus on newer projects. If the investors had organized as an S corporation, all the gain on the sale of the idea would be allocated 50-50 to each investor. Assume that the other ideas fall flat after the sale and the business goes bankrupt. The capital investor included gain on the sale of the original idea on his income tax return, but when his stock in the company became worthless a few years later, he could have a capital loss for whatever basis remained in his stock. This capital loss would be subject to the normal allowance of $3,000 a year or to offset other capital gains, but depending upon the amount of the investment, he may never be able to recover the value. In a partnership environment, the rules of Sec. 704(c) would eliminate this disparity. While both partners in the partnership would get 50% of the cash from the sale, any gain that was originally inherent in the idea when contributed would be allocated to the contributing partner, and the remainder would be allocated 50-50. If the partnership were to fail after the sale of the idea, the capital investor should not have any basis remaining because he recovered his basis when the idea was sold.
What happens if after a number of years the capital investor has received his return and decides to sell his interest in the business? There could be many limitations on who could buy the interest, but consider the basis of assets owned by the organization. In an S corporation environment, the sale of stock in the corporation will not result in any increase in basis of the S corporation property unless the sale meets the qualifications for a Sec. 338(h)(10) election. Without this step-up in basis, the new investor will not be able to deduct what she pays for the interest until she sells her interest. If the business had been organized as a partnership with a Sec. 754 election in place, the new partner could deduct her investment in the partnership through increased depreciation deductions regardless of the amount of the partnership purchased. This possibility of increased depreciation deductions may lead to a higher valuation of the partnership interest and more cash for the capital investor.
In the choice-of-entity decision, there are many considerations that should play a role. The S corporation form may lead to decreased compliance costs in the short run, but the flexibility provided by the partnership rules may lead to increased value for the business and easier operations in the future.
Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or firstname.lastname@example.org.