Nine Questions Regarding Choice of Business Entity

In recent years, North Carolina has revamped its corporations, partnerships and limited partnerships statutes and added a statute permitting formation of limited liability companies (or "LLCs"). The main objectives of a prospective business owner are to choose an entity that will “shield” the owner from personal exposure to the business liabilities and obtain favorable tax treatment. With several available choices, what is the best entity to use? There are significant tax and non-tax distinctions among the available entity choices. Your selection should be made in light of your company's circumstances (one size/entity does not fit all!).

The following are “frequently asked questions” regarding choice of business entities:

1. What is the difference between an S and a C corporation?

A corporation will be treated as a C corp unless it qualifies for and makes a timely election as an S corp in order to achieve "pass-through" tax treatment. Thus, owners of an S corp will be taxed only once – at the personal income tax level – while owners of a C corp face dual level taxation – once when the corporation pays tax on its income, and again when income is distributed to the owner, where the owner’s income is taxed. The protective shield against business liabilities is the same for both kinds of corporations.

2. With the drop in individual income tax rates does it make sense to organize my business as a C corp?

Prior to 2001, the top marginal rate for individuals was 39.6% and the top marginal rate for C corps was 35%, so it was frequently advantageous to organize a business as a C corp (other factors excluded from this consideration). As a result of the 2001 tax act, the 39.6% bracket is gradually reduced so that it will be 35% by 2006. There are still some attributes of a C corporation that are attractive, such as the availability of tax-advantaged fringe benefits for owners of the business and the 50% capital gains exclusion potentially available under IRC §1202. The reduction in individual tax rates, however, makes entities that offer pass-through taxation more attractive than ever.

3. Why do the venture capital providers prefer funding C corps?

For start-up businesses generating losses, a flow-through entity such as an LLC or an S corp, generally provides tax benefits that make it preferable to a C corp. A profitable C corp may distribute after-tax earnings to shareholders as dividends. In computing their tax liability, however, shareholders must generally include C corp distributions in income, and cannot use C corp losses as deductions. Since LLCs can have multiple classes of equity interests and it is possible to fashion an LLC membership interest comparable to convertible preferred stock, one might think that the LLC form would be attractive to investors. Nonetheless, venture capital providers generally make conversion to a C corp a condition for providing funding. One reason is the nonrecognition treatment available to C corps for mergers and other kinds of reorganizations under IRC§ 368. This nonrecognition treatment is not available to LLCs or S corps -- or to corps that have converted to C corps in anticipation of a reorganization. A second reason is the 50% capital gains exclusion under IRC §1202 that is available only to C corps. The venture capital providers seem willing to sacrifice short term tax benefits in hopes of maximizing the after-tax return to investors when a liquidity event occurs. The preference for C corps also appears to be driven by non-tax reasons. Investors are familiar with the structure of corps, and they find it easier to get deals closed and manage their investments if all their portfolio companies are organized as corps.

4. The client says it's too expensive to form an LLC as a vehicle to operate her sole proprietorship. Is she right?

No. If an LLC is taxed as a partnership under the Internal Revenue Code, then the LLC does not pay any federal income taxes. The LLC would, however, generally be subject to an annual $200 state tax. If the LLC is a single member LLC, it is a disregarded entity for income tax purposes; it is not taxed as a partnership and therefore is not subject to the $250 minimum tax. If an individual forms an LLC as a vehicle to operate what would otherwise be a sole proprietorship, the activities of the LLC are reported on Schedule C to the individual's IRS Form 1040. There is no need to prepare and file a separate federal or state tax return for the LLC, or obtain a separate employer identification number. An LLC also has a significant advantage of operating through a limited liability entity.

5. What's the deal with self-employment tax and LLCs?

This one is murky. Once a determination has been made that a pass-through entity is an appropriate choice for a client, advisors in some circumstances have steered clients away from LLCs and toward S corporations in order to minimize federal payroll taxes. A shareholder of an S corporation can be an employee of the S corporation, so the shareholder may report some of her share of business income as a shareholder distribution and some as compensation for services as an employee. Only that portion deemed to be compensation is subject to FICA (the contributions for old age, survivors and disability insurance and hospitalization insurance) and unemployment taxes. In an LLC taxed as a partnership, a member is considered self-employed rather than employed by the LLC. A member who performs services for the LLC is subject to SECA (the self-employment counterpart of FICA) on "net earnings from self-employment," which includes (with certain exclusions) the member's distributive shares of income or loss from any trade or business carried on by the LLC. IRC § 1402. Thus, there is no question that a shareholder of an S corporation can shelter some income from employment taxes by taking some of the business income as a shareholder distribution rather than compensation for employment. In contrast, except as noted below, a member's share of LLC profits will be subject to self-employment taxes regardless of whether the member considers herself an "employee" of the LLC . If an LLC is formed to hold assets such as real estate or intellectual property, its owners can probably take the position that their distributive shares are not subject to SECA because their income is derived from capital rather than services. Under regulations proposed by the IRS in 1997, non-service LLCs would be permitted to bifurcate members' interests so that a member's distributive share is not subject to self-employment tax but payments for services are. Prop. Reg. 1.1402(a)-2. Since LLCs, unlike S corporations, may issue multiple classes of equity interests, it may be possible for owners to draw relatively more income as investor income and relatively less as service income. The Treasury, however, has not issued the proposed regulations in temporary or final form. Congress has not spoken. While there may be a substantial tax planning opportunity in structuring LLC operating agreements to reduce payroll tax liability, considerable uncertainty exists.

6. I understand that if I organize my business as an LLC, I will not be able to provide my employees with options. Is that correct?

No. LLCs and partnerships can offer equity-based compensation plans. Indeed, the flexibility associated with LLCs and partnerships permits tailoring of compensation plans that can reduce or eliminate current income tax at the time of a grant. There are two significant differences, however, between option plans to purchase corporate stock versus options to purchase an interest in an LLC or a partnership. First, options to purchase an LLC interest cannot be structured as qualified "incentive stock options" under Section 422 of the Internal Revenue Code. Thus, if an employee purchases an LLC interest by exercising an option, the employee will have income subject to income and employment taxes if the fair market value of the LLC interest is greater than the amount, if any, the employee pays for the interest. Second, unlike the purchase of stock in a corporation under an option plan (incentive or otherwise), the purchase of an LLC interest for less than fair market value can result in taxable income to the pre-existing partners, unless the new member is entitled to only a share of future profits of the LLC. In addition, the employee who becomes a partner/member through exercise of an option will generally be subject to self-employment tax and cannot participate in employee benefits programs that are unavailable to partners under the Internal Revenue Code.

7. If I'm setting up an LLC, is there any reason to form it under the laws of another state?

The North Carolina's LLC statute is based upon the Uniform Limited Liability Company Act. It is a flexible, modern statute. It permits formation of one-member LLCs. Therefore, in most instances there is no reason for a business operating in Vermont to organize in another state. There is one circumstance, however, in which the Vermont statute may not be the best choice. In the estate planning context, interests in an LLC may be eligible for a number of discounts in determining the transfer tax value of the interest. Courts have allowed discounts both for lack of marketability of an interest and for lack of control over distribution of economic benefits, including the ability to cause the entity's liquidation. However, under IRC § 2704, restrictions that would effectively limit the ability of an entity to liquidate will be disregarded in valuing the interest transferred. There are exceptions to the foregoing rule, one of which is any restriction "imposed, or required to be imposed, by a Federal or State law." Under the Vermont statute, if a member dissociates from the company, the company is dissolved unless a majority in interest of the remaining members agree to continue the business or the company's operating agreement provides that the business of the company continues. 11 V.S.A. § 3101. Therefore, while the members of an LLC could agree by operative document that the disassociation of a member from the company does not result in the company's dissolution, that is a consensual agreement rather than a restriction imposed by Vermont law, and for valuation purposes under section 2704 would be disregarded. By contrast, under the laws of some other states, including Delaware, unless the members of an LLC agree to the contrary, dissociation does not cause dissolution of the company. This is a restriction that is considered to be imposed by "State law," and therefore is a restriction that can be taken into account in valuing an interest in the LLC. Consequently, some advisors take the position that the valuation discounts for lack of marketability and control can be higher if an LLC is formed in a state where the default provision in the statute is that a member cannot force dissolution by dissociating from the company.

8. I've heard about LLCs and LLPs, but what in the world is an LLLP?

Investment vehicles have traditionally been structured as limited partnerships. A limited partnership must have at least one general partner. Promoters have often minimized liability exposure by using an adequately (but not robustly) capitalized corporation as the general partner. Some states, such as Delaware, now expressly authorize limited partnerships to file a statement of qualification and become limited liability limited partnerships, or LLLPs. In these states, even the general partner is shielded from partnership liabilities. Vermont law does not expressly sanction LLLPs. Section 3291 of Title 11 does say that "any lawful partnership" may qualify as a limited liability partnership, but this provision is in the general partnership statute and the limited partnership statute does not mention the subject. Therefore, if a Vermont limited partnership files a statement of qualification, it is not entirely clear whether the general partner would be liable for the obligations of the partnership.

9. If the Secretary of State allows me to reserve a name for a new entity, do I need to worry about any further name searches?

Maybe. The Vermont Secretary of State will reserve a name for anyone who wishes to form a new business entity. By reserving the name prior to organizing the entity, one can be assured that the Secretary of State's office has checked its database and determined that the name is available for use. The Secretary of State's office, however, does not determine whether the chosen name may infringe upon federally registered or common law trademarks. If a new business anticipates building a broad identity around its entity name (think, for example, about Ben & Jerry's Homemade, Inc. or Amazon.com, Inc.), then it should consider performing trademark searches before committing to a name. It may be cheaper to analyze the trademark issues now than to adopt a new corporate identity later.