Generally, the first consideration in setting up a business is the choice of entity in which to conduct the business. To that end, there are tax and nontax considerations. This item presents an overview of some of the tax points that should be kept in mind when choosing an entity. It focuses primarily on the taxation of the partnership and corporate forms of doing business, the pros and cons of each, as well as the distinctions between C corporations and S corporations.
To set the stage, the item sets forth some nontax considerations for partnerships, corporations, and limited liability companies (LLCs). For tax purposes, an LLC may afford more flexibility because, through a simple election, it can be taxed either as a partnership, a C corporation, or an S corporation. Next, this item focuses on tax considerations, contrasting the income taxation of partnerships, C corporations, and S corporations, and exploring issues such as compensatory options and attracting investors. Finally, this item examines a few critical post-formation considerations, focusing on the implications of foreign operations and certain issues related to separating business lines.
A business must take many factors into account when deciding which form of entity is appropriate. The ease and cost of entity formation may cause some business structures to stand out to entrepreneurs, particularly when they are starting out with very little capital. However, the flexibility of the structure is of significant importance, as startups are dynamic and have different needs at different stages of growth. Accounting for these needs from the start may reduce the likelihood of incurring avoidable costs in changing the type of business entity. The following business entities are the structures that entrepreneurs most commonly consider.
Partnership: A partnership is a legal entity for a business entered into by two or more persons. There are two types of partnerships: general or limited. In a general partnership, all the partners are personally liable for partnership debts. In a limited partnership, however, at least one partner must be designated as the general partner, and that general partner has unlimited personal liability for partnership debts. The limited partners, on the other hand, are liable only to the extent of their investment in the company. However, a limited partner might lose his or her "limited" status and thus be personally liable for partnership debts if he or she is viewed as playing a role in management, i.e., acting as something other than a purely passive investor.
Corporation: Corporations are legal entities independent from their owners and provide some protection from personal liability. Thus, a shareholder's risk of loss is limited to his or her direct investment in the corporation. However, to sustain that liability shield, certain legal formalities must be observed, e.g., a corporate charter, bylaws, and a board of directors, as well as compliance with regulatory reporting requirements. Compliance with these formalities often comes with significant legal costs, which may be daunting for a startup company.
Additionally, shareholder and stock restrictions under Sec. 1361 come into play when comparing an S corporation to a C corporation. C corporations allow for an unlimited number of shareholders, with no restrictions on the type of ownership, whereas S corporations have a limit of 100 shareholders, all of which must be either U.S. citizens or permanent residents, certain trusts, bankruptcy estates, other estates, and certain tax-exempt organizations, not corporations (including LLCs) or partnerships. Although a C corporation does not restrict stock issuance, an S corporation can have only one class of stock.
LLC: LLCs have become increasingly common, particularly in the startup realm. In general, it is far easier and less expensive to set up an LLC than it is to set up a corporation. An LLC only requires an operating agreement outlining the expected duties of managers and the general governance of the company, thereby avoiding some of the costlier corporate formalities mentioned above.
In addition, an LLC offers the same liability protection as that afforded by corporations (and better than that of partnerships). The liability shield for LLCs would appear no more vulnerable to piercing than the one for corporations. As a practical matter, the protection for LLCs might be stronger than that for corporations. While courts purport to apply the same corporate veil standards to both corporations and LLCs, the grounds are often relaxed for LLCs, both for inadequate capitalization and for failure to observe corporate formalities (see Ribstein and Keatinge, 2 Ribstein and Keatinge on Limited Liability Companies §12:3 (Clark Boardman Callaghan 2014); Rugani, "Twenty-First Century Equity: Tailoring the Corporate Veil Piercing Doctrine to Limited Liability Companies in North Carolina," 47 Wake Forest L. Rev . 899, 903–904 (2012); and Westmeyer v. Flynn , 382 Ill. App. 3d 952, 957–958 (2008) (stating that under Delaware law, an LLC is treated for liability purposes as a corporation)). In fact, several states have decreed by statute that the failure of an LLC to observe corporate formalities may not serve as the sole ground for imposing personal liability on any LLC member (see, e.g., Colo. Rev. Stat. § 7-80-107 (2014); Ga. Code § 14-11-314 (2014); 805 Ill. Comp. Stat. 180/10-10 (2014); Mont. Code § 35-8-304; and Utah Code § 48-2c-605).
Importantly, an LLC offers more flexibility than either a partnership or a corporation on the tax front. Specifically, by way of a simple election, an LLC can be treated for tax purposes as a partnership, a C corporation, or an S corporation. An LLC with more than one owner is treated by default classification as a partnership for tax purposes. However, at any time, the LLC can file a Form 8832, Entity Classification Election , with the IRS and elect to be treated as a corporation. If the LLC prefers to be treated as an S corporation (and it otherwise qualifies as an S corporation, e.g., in number and type of shareholders and having only one class of stock), it can file a Form 2553, Election by a Small Business Corporation . From a tax perspective, this flexibility may be attractive for a startup business.
Tax Elections in General
Corporations and LLCs can both be attractive entity options, but the ease and flexibility of LLCs often makes them a better choice. As described above, an LLC can also make an election to be taxed as a partnership, an S corporation, or a C corporation, without actually converting to one of these entities. Determinations of which type of tax treatment the LLC wishes to receive and whether, or at which time, the LLC will convert are two of the most important choices an entrepreneur must make. These characteristics make LLCs a good option for startups, offering nearly all of the advantages inherent in the corporate or partnership structure, with few drawbacks.
Taxation as a partnership: For LLCs treated as partnerships for tax purposes, earnings and losses pass through the LLC to its owners, and each owner's respective share (generally determined by the LLC's operating agreement) is included on the owner's return. Thus, it is a single tax regime, as there is no taxation at the entity level. Taxation as a partnership can be a particularly good option if the business will be holding property expected to increase in value, as gain will be taxed at only one level. However, taxation as a partnership can come with a few downsides. If significant services the members provide to the LLC give rise to the majority of the LLC's income, the members typically must pay self-employment tax (consisting of Medicare and Social Security taxes) on their share (see Sec. 1402(a)(13); Renkemeyer , Campbell and Weaver, LLP , 136 T.C. 137 (2011); and Chief Counsel Advice 201436049). Another downside is that having a large number of investors in the LLC can make compliance time-consuming and costly, as Forms K-1 allocating profit and loss must be issued to each member.
Taxation as a C corporation: The C corporation rules envision a double-tax regime—earnings are taxed at the corporate level and then again at the shareholder level upon the distribution of a dividend. Though avoiding the double-tax structure of a C corporation is usually desirable, the members of an LLC may find it beneficial to be taxed at these two levels. Taxation as a C corporation allows for the splitting of money between the members of the LLC and the LLC itself, which may result in overall tax savings, depending on the rate of taxation on retained earnings for the business, and on income of the individual.
Although this C corporation treatment can be advantageous, it is often not immediately helpful for startups; it takes time for a business to reach profitability (and consequently, build up retained earnings). Rather, it is something an entrepreneur may want to keep in mind for the future. In the case where an LLC initially classified as a partnership elects to be treated as a corporation, it is treated as contributing its assets to the corporation in exchange for stock and subsequently liquidating by distributing the stock to its members (Regs. Sec. 301.7701-3(g)(1)(i . Such a transaction may be structured to be tax-free under Sec. 351, provided that the transaction was undertaken as part of a plan to transfer partnership operations to a corporation, was organized for a valid business purpose, and was not a device to avoid recognition of gain (see Sec. 351; Rev. Rul. 84-111; and Rev. Rul. 70-239).
Taxation as an S corporation: S corporations are more common than C corporations, and while they are also corporations, they maintain a special tax status. S corporations are passthrough entities, meaning the profits and losses are not taxed at the corporate level, but are instead divided pro rata among the owners and included on the owners' personal tax returns. The self-employment tax in an S corporation setting is limited to the compensation received for services, rather than applied to all income received from the business, as long as shareholder-employees pay themselves reasonable compensation.
Depending on the terms of the existing operating agreement, a business owner may need to modify this agreement before electing S corporation status, so as not to violate the single-class-of-stock requirement. If the LLC does not meet the requirements to be an S corporation, filing a Form 2553 will simply cause the LLC to revert to taxation as a partnership, while filing both a Form 8832 and a Form 2553 will cause the LLC to be subject to the two-level taxation of a C corporation. Thus, ensuring that all the requirements are met is critical before making an S corporation election.
Some startups may wish to issue stock options as compensation as an incentive for retaining key employees. Stock option plans issuing incentive stock options (ISOs) receive favorable tax treatment and are an attractive feature for employees. Employee stock ownership plans (ESOPs) also provide certain tax benefits. A startup wishing to issue these types of instruments might be better advised to avoid the LLC form in favor of the corporate form because LLCs cannot issue stock. An LLC can offer a somewhat comparable incentive through membership interests or debt instruments, but this might not be viable from a tax perspective, as it may not be as attractive to employees (see Steingold, Legal Guide for Starting & Running a Small Business 23 (Nolo 2013)).
An LLC's ability to easily convert to another entity may work well for a startup with plans of someday undertaking an initial public offering. However, encouraging investment with an LLC as the chosen entity may be a problem for startups requiring additional funding. Tax-exempt organizations, such as qualified pension plans and individual retirement accounts, provide a significant capital pool for private-equity funds and venture capitalists, which in turn operate as a major source of funding for startups seeking capital. Private-equity funds consisting of these organizations, which are generally exempt from income tax on passive investment, are subject under Sec. 511 to tax on unrelated business taxable income (UBTI) when investing in an LLC.
Despite the tax ramifications, certain tax-exempt investors do not appear to be entirely deterred from investing in LLCs; rather, they have used convertible debt and options to prevent immediate realization of UBTI, as well as blocker corporations (see Hugg, "How Tax-Exempt Investors Can Avoid UBTI: Structuring Private Equity Investments in LLCs" (2004). However, an increasing number of private-equity funds have simply decided to accept some UBTI, though typically these funds have restrictions on the percentage of capital that may be dedicated to UBTI-generating investments (see Morgan, Lewis & Bockius LLP, "Accommodating Tax-Exempt Investors: Understanding UBTI" (2012).
While UBTI may be a deterrent for a venture capital fund, rather than a deal breaker, the inability to obtain preferred stock from an LLC has historically functioned as the latter. LLCs are not subject to the one-class-of-stock restriction of S corporations, but LLCs sell membership interests in the business, rather than shares, and typically anyone purchasing a stake has as much decision-making power as the other members of the LLC (see Sweeney, "LLC or Corporation? How to Pick the Right Business Structure for Your Startup," Huffington Post (Sept. 13, 2013)). Traditionally, venture capitalists and angels desired preferred stock and thus only invested in C corporations (id.). However, it appears that the preferred stock obstacle is no longer seen as insurmountable, and many venture capitalists are warming up to the idea of investing in LLCs.
The terms of an LLC interest are governed by its operating agreement, and an amendment can be made to this agreement to give certain preferential rights to a venture capital group. While a C corporation may still have an advantage in terms of attracting significant investment from these large players, LLCs have gained viability due to their flexibility and easy conversion into C corporations, whereby membership rights are exchanged for corporate shares through agreement (provided that the operating agreement and state statute provide for transferability) (Steingold, Legal Guide for Starting & Running a Small Business 23 (Nolo 2013)). S corporations, however, continue to remain unattractive to venture capitalists, as the restrictions on the types of shareholders that are permitted excludes the majority of these firms, which tend to be organized as partnerships or LLCs (Blair and Marcum, "Entrepreneurial Decisions and Legal Issues in Early Venture Stages: Advice That Shouldn't Be Ignored," 54 Business Horizons 143, 146 (2011)).
Whichever type of entity is chosen, entrepreneurs should keep a few critical considerations in mind after forming the business. Keeping accurate and detailed records is a crucial aspect of operating a business, particularly for a startup looking to eventually sell or go public. Foreign activities and spinoffs are two operational aspects an entrepreneur should keep in mind after getting a business off the ground. Foreign activities may implicate a host of tax-related issues, including foreign tax credits and intangible property transfers. In the event an entrepreneur wishes to separate a business line and sell it, the spinoff rules must be taken into account. Both foreign activities and spinoffs are explored in greater detail below.
Foreign activities: Any operation by a U.S. entity in a foreign country involves additional, and significant, considerations. As in the United States, the first step in operating in a foreign country is choice of entity, such as incorporating a branch overseas—which might allow for an election to be treated as a disregarded entity. (Certain "foreign eligible entities," such as LLCs, may be treated as disregarded, while others are per se corporations under the Code for which an election cannot be made (Regs. Sec. 301.7701).) The interaction of foreign rules on entity classification and taxes with U.S. international tax rules raises many additional issues, including foreign taxes and the transfer of intellectual property. These rules and their interaction are beyond the scope of this item, but they cannot be ignored if the startup will be operating internationally.
Spinoffs: A few years after forming a startup, an entrepreneur may begin to notice differences in profitability between business lines or differences in business operations that cause conflict among talent and resource allocation, management, and company direction. In this situation, the entrepreneur may want to consider spinning off one of the business lines, which is permissible subject to the reorganization rules of Secs. 368(a)(1)(D) and 355. Both C corporations and S corporations may undertake this type of tax-free reorganization, where an existing company (distributing) transfers the unwanted business line to a newly formed corporation (controlled) in exchange for stock of that corporation, and the stock is then distributed to the shareholders of the existing company, with the result being the separation of the business lines that is tax-free for the corporation and the shareholders (Sec. 368(a)(1)(D)).
For this type of transaction to be nontaxable, certain control, distribution, and active trade or business requirements must be met, which include the significant requirements that there must be a business purpose for the transaction and the transaction cannot serve as a "device" for distributing disguised dividends (Sec . 355). (Note that Secs. 355(d) and (e), in certain cases, will impose a corporate-level tax on a Sec. 355 spinoff. Also note that, in certain circumstances, a partnership might lend itself well to a tax-free division of businesses, subject, among other things, to the "anti-mixing bowl" considerations of Sec. 737.)
As evidenced by the many topics above, numerous tax-related issues are implicated in the undertaking of a business, and an entrepreneur faces many challenges and decisions at every life stage of the startup venture. Choosing the initial business structure for the entity is the first step, but determining when, and if, to convert to another form involves an assessment of the company's specific needs, circumstances, and plans. LLCs are advantageous in this regard, as they allow for increased flexibility for both the initial tax regime and later conversions to other tax regimes.
Of course, choosing a business structure is highly
dependent on the unique circumstances and needs of a
startup. These circumstances are also determinative of
the decision to separate business lines. Regardless of
form, proper recordkeeping is a necessity for any
business, and complying with regulations on foreign
activities and spinoff procedures is critical for
ventures undertaking those transactions (or just
thinking about doing so). The topics covered in this
item represent broad considerations for entrepreneurs,
as no startup is able to adopt a one-size-fits-all
solution. Any and all company decisions must be made
with the particular circumstances and objectives of
the business in mind.
This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. Deloitte, its affiliates and related entities, shall not be responsible for any loss sustained by any person who relies on this publication.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington.
For additional information about these items, contact Mr. Almeras at 202-758-1437 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.