THE ADVANTAGES AND DISADVANTAGES
VARIOUS LEGAL ENTITIES
Two Basic Categories
Limited Liability Companies ("LLC")
Subchapter S Corporations
Regular or C Corporation
Whether to be a C corporation, an S corporation, a limited liability company ("LLC"), a partnership, or a sole proprietorship is the key question. The answer to it varies depending upon the tax and non-tax characteristics that differentiate these various forms of doing business.
Two Basic Categories
For income tax purposes, entities fall into one of two categories. One is entities that are not taxable. They include sole proprietorships, partnerships, limited liability companies (unless an LLC elects to be treated as a C corporation), and S corporations. The other is an entity that is taxed. It is called a regular or C corporation.
Businesses organized as partnerships, limited liability companies, and S corporations are not subject to federal income taxation at the entity level. Thus, they are called passthrough entities. With passthrough entities, the income passes through the entity to be reported by and taxed directly to the owner or owners of the business.
A sole proprietorship is the simplest form of business organization; it is an unincorporated business activity owned by one person.
To pay federal income taxes, you fill out Form 1040 and Schedule C. There is no double taxation.
If you have no employees, you pay no federal or state unemployment taxes, and you need no employer identification number. If you have employees, you must get an employer identification number and comply with the state and federal employment tax requirements.
Because many businesses begin by having a period of time where they operate in the negative and have losses, the sole proprietorship is advantageous because these losses can be used to offset any form of income, including wages, interest, dividends, pensions, and rents, that you or you and your spouse, if filing jointly, may have. If the loss exceeds your income, you can carry back all business losses two years or carry forward business losses twenty years to offset any future income.
Sole proprietorships allow some fringe benefits such as 60% deduction for medical insurance in 2002 that the owner pays for. This deduction will eventually climb to 100%.
There are several disadvantages with sole proprietorships. Probably the major disadvantage is personal liability. Sole proprietors have unlimited liability in their business. Although much of the liability can be mitigated with insurance, nonetheless potential liability remains. You have substantial potential liability if you have any employees. For as an employer, you are liable for your employees’ acts within the scope of their employment and in certain cases for their acts even though outside the scope of employment.
Additionally, a sole proprietor must pay a self-employment tax on their business income. That self-employment tax equals the combined employer and employee payroll tax rate. However, the sole proprietor can claim one-half of the self-employment tax as an income tax deduction.
Persons who combine their resources and become co-owners of a business can organize that business as a partnership. A partnership is an unincorporated entity created by agreement among two or more persons. Partnerships are required to file a partnership tax return, Form 1065. Moreover, since most partnerships pay salaries to either the partners or staff, they need a federal employer identification number and are subject to federal and state employment tax on salaries.
Partnerships, however, are passthrough entities; there is no separate tax at the partnership level. All income and losses pass through to the partners as if they earned them individually. Losses occur when the partnership’s deductions exceed the partnership’s gross income.
Unlike sole proprietors, however, losses are limited to the basis in the partnership. Basis initially consists of what cash or property you contributed and all loans that you guaranteed or made to the partnership. For example, suppose that an equal partnership of Tom and Sue has $40,000.00 in gross income and $100,000.00 in deductions. Partner Tom’s basis for his interest in the partnership is $80,000.00 while partner Sue’s basis is only $10,000.00. Although each partner shares the loss of $60,000.00 equally ($30,000.00 each), only Tom can potentially deduct the full $30,000.00 since his basis exceeds that amount. Sue, however, can only potentially deduct $10,000.00 (the amount of her basis); the other $20,000.00 becomes a carryover until future years when her outside basis increases. That basis can increase if she contributes another $20.000.00 to the partnership or if the partnership borrows $40,000.00, or if her share of partnership income in some later year is $20,000.00.
Partnerships, like LLC, are favorable entities in which to own real estate. (See discussion below in LLC.)
The big disadvantage of partnerships is that you are unlimitedly liable for partnership’s debts and obligations and for the acts of your fellow partners.
Limited Liability Companies ("LLC")
A limited liability company is an unincorporated legal entity owned by one or more members. Unlike a partnership, every member of an LLC has limited liability for the LLC’s debts and the acts of other members or employees. Members can include individuals, partnerships, other LLCs, and corporations.
Generally when talking about owning real estate, a partnership or LLC are the best vehicle to own it. By taking a 754 election upon the death of a shareholder, the partnership or LLC gets a step up in basis.
For example, let’s assume a father own a 50% interest in a corporation and the corporation owns a 1 million dollar parcel of real estate with a $100,000 basis; if the father dies and leave his 50% interest to his son, the son receives a step up in basis in the corporation, but the corporation receives no adjustment to the basis of the real estate in the corporation. So when the corporation sells the real estate, it recognizes a $900,000 gain ($1 million - $100,000), and indirectly because the son owns a 50% basis in the corporation, the son is paying a tax on it. Let us assume instead that the father owned a 50% interest in an LLC and the LLC owns the real estate; if the father dies and leaves the 50% interest in the LLC to his son, and the LLC makes a 754 election, the son because he inherited it his pro rata share of the LLC assets have received a step up in basis to $500,000.00 since he owns one-half of it. If the LLC sells the real estate, the son has to recognize no gain since his basis was stepped up to $500,000. If the LLC does not sell the asset, the son has basis inside the LLC which he can depreciate; thus he gets a depreciation deduction. This also works if a partner purchases an interest in an LLC for $500.000, the purchaser would receive a basis of their pro rata share of the assets for their purchase price.
Because an LLC is a fairly recent innovation, many questions – both tax and legal -concerning their operation have yet to be fully resolved. For example, while all states recognize LLCs, not all states recognize single member LLCs. Thus, there is a certain element of uncertainty. Other questions include what formalities must be followed to ensure that the LLC form is not pierced by a consensual creditor of the LLC or by a victim of the LLC’s or its agent’s negligence?
If there is only one owner of an LLC, you would file and be taxed as a sole proprietorship. If there are two or more owners, you are taxed as a partnership. You can even elect to be treated as a corporation.
Subchapter S Corporations
A subchapter S corporation is a corporation organized under state law which becomes a subchapter S by the unanimous election of its shareholders. To document consent to the election, all the shareholders must sign and file a Form 2553 with the IRS. (IRC §1362(a).) With a subchapter S corporation, all income and losses flow through to the owners.
To elect to be a subchapter S corporation, you must meet certain eligibility requirements. They are: (1) that only citizens or permanent residents, estates, and certain trusts may be shareholders, (2) the number of shareholders is limited to 75 (however, a married couple is considered a single shareholder), and (3) the corporation can have only a single class of outstanding stock (although these shares can have different voting rights).
Generally speaking, if you observe appropriate corporate formalities, properly fund the corporation (do not grossly undercapitalize it), do not siphon off funds, do not shuffle assets without regard to stated ownership, and keep appropriate corporate records, you will limit your personal exposure to the assets of the corporation unless you personally cause the injury or guarantee its debt.
Another advantage is that the stockholders are taxed on the earnings based on their ownership. Thus, if you have minor children and make them shareholders, they are taxed on their share of the dividends. However, if the income generated is primarily attributable to the work performed by certain of the owners, rather than to property owned by the S corporation, then income assigned to nonworking owners is likely unjustified.
You may also be able to eliminate a portion of the social security taxes. For example, as a sole proprietor you net earnings are $50,000.00. Not only do you income pay on the $50,000, but also you pay 15.3% social security on the $50,000, amounting to $7650.00. But if you form an S corporation and pay yourself a salary of $35,000, and it is considered to be a reasonable salary, then you can pay yourself the rest in a form of a dividend. You would pay social security tax only on the salary, assuming it is a reasonable salary, and not on the dividend.
The disadvantages of an S corporation include that there can be no more than 75 stockholders who must be of a certain type and that it can’t have several classes of stock, thus limiting estate planning and reducing the chances of raising capital. An S corporation must follow the same formalities as a regular corporations. Certain fringe benefits are not available to it, such as this year you can only deduct 60% of health insurance with an S corporation. Regular corporations can deduct 100% of the premium. Regular corporations can deduct all of their disability insurance premiums; S corporations cannot.
Another item to note is that with both S corporations and partnerships, you can deduct any losses up to your basis in the stock or partnership. However, with partnerships, any debt that you guarantee is added to your basis. This is not true with S corporations. You must contribute property, money or loan the money to the corporation, not guarantee a debt.
Finally, generally neither S corporations nor C corporations should be used to hold real estate. Only a partnership or an LLC can make the 754 election and obtain a step up in basis upon the death of an owner. See the example discussed in the LLC section, above.
Regular or C Corporation
Corporations are separate legal entities formed under state law that must pay income taxes. Shares of a corporation are evidenced by its stock. Generally, shareholders in a corporation risk only their investment unless they guarantee the corporation’s indebtedness. Federal income taxes are computed by corporations using Form 1120. Generally speaking, corporations are taxed on all monies that are not paid out in expenses or bonuses or salaries. If monies are paid out as dividends to shareholders, you probably will have double taxation.
Corporations are required to observe certain formalities, keep certain records, segregate their funds, and be appropriately capitalized. You must have certain corporate records, have separate bank accounts, and must get an employer identification number from the IRS. Corporations can if appropriate planning is not followed bye subject to an accumulated earnings tax.
Corporations, however, have some advantages. The key advantage is limited liability. Generally speaking, if you observe appropriate corporate formalities, properly fund the corporation (do not grossly undercapitalize it), do not siphon off funds, do not shuffle assets without regard to stated ownership, and keep appropriate corporate records, you will limit your personal exposure to the assets of the corporation unless you personally cause the injury or guarantee its debt. Corporations can also deduct 100% of their health insurance premiums and 100% of any disability insurance premiums, which are tax-free benefits to the employees.
Corporations also can have many different classes of stock, which is advantageous for estate planning and for raising capital.
I trust this has helped clarify your understanding of the advantages and disadvantages of various legal entities. Due to the rapidly changing nature of the law, information contained in this description can become outdated. This oversimplified description is intended solely for educational and informational purposes. The information contained herein is general in nature and should not be a substitute for seeking the advice of an accountant and an attorney. Please remember that individual circumstances may affect the manner in which the law applies to each situation.