By Sean L. Robertson
Non-Tax Factors
1. Limited Liability
Business owners want to protect their personal assets from business creditors’ claims.
2. Management Control Arrangements
Corporations are centrally-managed by a board of directors that acts in a representative capacity for the shareholders who elect them.
In contrast, LLCs and partnerships have more flexibility than corporations in structuring management and control arrangements.
Partners/members (owners of LLCs) can specify each party’s managerial role through appropriate provisions in the LLC operating agreement or partnership agreement.
3. Capital Structure
With corporations (including S &C), shareholders must allocate profits, losses, deductions, and capital proportionally to their shareholder’s interest.
With Partnerships and LLCs, partners or members may allocate profits, losses, deductions, and capital in accordance with their specific needs as long as they meet the IRS guidelines.
4. Transferability of Interests
Generally, shareholders of a Corporation may transfer their interest of a company freely to interested buyers unless they are a closely held corporation (owned by a few individuals).
With partnerships and LLCs, transferability of interests is determined by the operating agreement or partnership agreement. Typically, transferability of interests is restricted.
5. Death or Withdrawal of an Owner
A corporation does not dissolve or terminate when a shareholder dies or withdraws.
In contrast, a partner’s withdrawal causes a dissolution that negates every partner’s authority to act as the partnership’s agent except in matters relating to the wind up of its affairs in a partnership. Beware: If there is not a partnership written agreement, any partner can cause a dissolution of the partnership by giving notice to the other partner. With a partnership agreement, the partners plan for each other’s death or withdrawal from the partnership.
6. Tax Consequences of Capital Contributions
The tax treatment of cash to a corporation and partnership is treated equally. Thus, if you contribute $10,000 cash to a partnership or a corporation, your basis or investment in the company is $10,000. If property is contributed (i.e. stock, bonds, equipment), the tax consequences to corporations and partnerships can differ a lot.
In a partnership, any gain or loss inherent in contributed property is deferred until the partnership or LLC sells the asset or the contributing partner sells his partnership interest (i.e., IBM stock bought at $25/share is transferred to ABC LLC on June 1 with a Fair Market Value of $100/share. A gain of $75/share is not recognized if done correctly until the LLC or partnership sells the IBM stock. Partnership or LLC takes a basis of $25/share and when ABC LLC sells IBM stock, it has a gain of Sale Price-Basis=Gain Recognized).
In contrast, a transfer of appreciated property (i.e. IBM stock) to an S Corporation in exchange for stock is a taxable transaction unless the transferor, together with other parties making contributions at the same time, controls the corporation through ownership of at least 80 percent of its stock. With partnerships and LLCs, it is easier to get a non-taxable transaction when transferring appreciated property in exchange for a partnership/ownership interest.
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For example, assume that you have David Smith who is an investor that will contribute appreciated property worth $20,000 in exchange for a 20 percent interest in an S Corporation. If Mr. Smith is the only person transferring appreciated property to the S Corporation, the IRS will tax this transaction because Mr. Smith only owns 20% of the S Corporation (not 80% as required). In contrast, assume the same facts as above but a majority shareholder holding 60% of the shares of S Corporation contributes appreciated property worth $10. Mr. Smith is not taxed by the IRS.
7. Ownership Restrictions
With an S Corporation, there are ownership restrictions- no more than one class of stock, no more than 75 shareholders, and all shareholders must be U.S. citizens or residents.
With partnerships and LLCs, there are no ownership restrictions imposed on the nature and number of shareholders.
8. Taxability of Income and Loss
For tax purposes, an S Corporation is not a taxable entity. It is a pass through conduit through which its income and losses pass through to shareholders. Each shareholder reports his share of each tax item on his tax return.
For tax purposes, a partnership (LLC is taxed as partnership unless indicated otherwise) is also a pass through entity where each partner/member reports his/her share of each tax item on his/her tax return.
9. Allocations of Income or Loss Items
Little flexibility is available to S Corporations. Each shareholder must share profits, losses, deductions, and credits according to their ownership interest in the corporation. Unlike C Corporations, S Corporations are permitted only one class of common stock. Although voting stock may differ, preferred stock cannot be used to create different interests in corporate capital and income.
Partnerships and LLCs provide the most flexibility for allocating income, losses, deductions, and credits among the partners or members in accordance with their individual investment and tax goals. This is a huge benefit and where smart tax planning adds value by saving business owners money. These tax savings can be re-invested into the business towards sales and marketing, which grows the business.
10. Basis Limitation on Deductibility of Losses
Small Business Owners who wish to use losses from a business or investment activity to offset their income from other sources must structure the venture to be taxable as an LLC.
A partner or member may generally deduct his losses up to the basis of his partnership interest. A partial owner of an S Corporation may deduct losses up to the basis of his/her stock.
For ventures that use significant amounts of borrowed funds, a partnership or LLC is the preferred organization form because the basis of a partner’s interest increases by his share of the partnership’s liabilities. Each partner is treated as if he personally borrowed his share of the partnership’s obligations and contributed that amount of cash to the partnership, even if the partnership debt is non-recourse (i.e. no partner is personally liable for repayment of the debt). With an S Corporation, a shareholder’s basis is not increased by his/her share of the corporation’s liabilities.
Sean L. Robertson is an Attorney and Counselor with Law Office of Sean L. Robertson (SLR). He can be reached at 312-570-5506.
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