2:4 Letter to client regarding choice between LLC and S corporation Dear [Client]: I understand that you are interested in creating a new business entity for a [type of business] business. This letter is designed to introduce you to some of the considerations bearing on the type of entity that is best for your business. We will need to meet to discuss these considerations in greater detail and to analyze how they relate to your particular business. But I hope our discussions can move more quickly if you have the background set forth in this letter. 1. Available Alternatives There are number of forms of business entity available sole proprietorships, general partnerships, limited partnerships, limited liability companies, S corporations, and C corporations. And while there are businesses in existence using each of these forms, almost all new small businesses being started today are either sole proprietorships, limited liability companies, or S corporations. Sole proprietorships are a popular alternative because they are easy to form and operate. No formalities are required for their creation, and if an individual starts a business and does not create another form of business organization, he or she will have a sole proprietorship. There are, however, two disadvantages of sole proprietorships. The first disadvantage is that a sole proprietorship can only have one owner, and if a business will have two or more owners, another form of entity must be selected. The second disadvantage of a sole proprietorship is that the owner is personally responsible for all of the debts and liabilities of the business. If the business encounters financial difficulties or customers or others are harmed by the activities of the business, the owner's personal assets as well as the assets of the business must be used to pay any resulting claims. Partnerships and limited partnerships must have two or more owners, so they do not suffer from the first disadvantage of a sole proprietorship. But all owners in a general partnership and at least one of the owners in a limited partnership are personally responsible for the debts and liabilities of the partnership. Limited liability companies and S corporations, on the other hand, avoid both of the disadvantages of a sole proprietorship. While all states permit S corporations to have only one owner and limited liability companies may have one owner in most states, these forms of entity work with two or more owners as well. In addition, both limited liability companies and corporations offer their owners the protection of limited liability. A limited liability company or corporation is a separate entity, and the entity alone is responsible for the debts and liabilities of the business. If the assets of the business are insufficient to pay these debts and liabilities, the business may fail, and the owner will lose his or her investment. But the owner's home, personal investments, and other assets are not available for payment of the debts and liabilities as they are with a sole proprietorship, partnership, or limited partnership. Limited liability companies and S corporation also share an additional attribute with sole proprietorships that is desirable for start-up businesses. This attribute is pass-through treatment for income tax purposes. With pass-through treatment, the income and loss of the business is not taxed to the entity but is passed through to the owners for them to report on their individual income tax returns. Pass-through tax treatment is desirable for start-up businesses because they often generate tax losses during their early years of operation, and the owners can offset these losses against income from other sources.
C corporations, which are corporations that have not elected to be taxed as S corporations, do not feature pass-through income tax treatment. As a result, the C corporation form of business entity is not used by many new small businesses. Because they provide flexibility in terms of the number of members, limited liability protections, and pass-through income tax treatment, limited liability companies and S corporations are currently the most popular forms of business entity for small businesses with more than one owner, and these two forms are used by many one owner small businesses as well. 2. Differences Between Limited Liability Companies and S Corporations Although limited liability companies and S corporations share some common attributes, there are important differences, and these differences may make one form of entity or the other a better choice for a particular business. The choice can best be made by comparing the advantages of each form of business entity and deciding which advantages are most important to your particular business. 3. Advantages of Limited Liability Companies a. Income Tax Treatment Although both limited liability companies and S corporations are accorded pass-through treatment for income tax purposes, limited liability companies are more transparent than S corporations. For example, property can generally be transferred tax free by a member to a limited liability company, and property can generally be withdrawn tax free by a member from a limited liability company. In the case of an S corporation, property can generally be transferred tax free to the corporation at the time of its organization, but later transfers may result in the recognition of gain unless they are made by a shareholder who owns 80 percent or more of the stock of the S corporation. Moreover, the withdrawal of property from an S corporation by a shareholder will generally be a taxable event, resulting in the recognition of gain or loss by the S corporation, regardless of the amount of stock owned by the shareholder. Since an S corporation may be required to recognize gain on the distribution of property to its shareholders, an S corporation is not a good form of entity for a business that owns real property or other assets that are likely to appreciate. Once such property is transferred to an S corporation, it may be impossible to get it back out without tax cost, which limits the flexibility to change the form of ownership of business assets. b. Inclusion of Limited Liability Company Debt in Basis The amount of losses of a limited liability company or S corporation that may be passed through to the entity's members or shareholders and reported on their personal income tax returns is limited to the amount of the tax basis of the members or shareholders in their interests in the business. In computing the tax basis of a limited liability company member, the amount of the limited liability company's indebtedness to banks or other third parties is considered. An S corporation shareholder's basis does not include any amount by reason of indebtedness of the S corporation to persons other than the shareholder. As a result, the losses that may be passed through to the owners in the early years of a business may be greater if the business is organized as a limited liability company rather than as an S corporation. c. Special Allocations Sometimes owners of a business have differing needs relating to cash distributions and tax allocations. For example, if one owner is contributing a larger portion of the assets of a business
than the other, the first owner may expect a preferential distribution of available cash flow until the owners' invested capital has been equalized. Even if the owners make equal contributions, it may be desirable to be able to allocate start-up losses to an owner who has income from outside sources rather than allocating these losses to an owner who has no outside income against which the losses may be applied. Accommodating the differing needs of owners requires special allocations, and special allocations can only be made by limited liability companies and other entities taxed as partnerships. S corporations cannot make special allocations. With an S corporation, all income, loss, and cash flow must be allocated proportionately among shareholders based on their stock ownership. d. Greater Number and Types of Equity Owners Not only can a limited liability company facilitate the varying needs of its members, it can also have more members and more diverse members than an S corporation. Under federal income tax rules, an S corporation may not have more than 75 shareholders, and all S corporation shareholders must be individuals who are citizens or residents of the United States or must be estates or certain types of trusts. Corporations, partnerships, and limited liability companies generally cannot own stock in an S corporation. These restrictions can limit the ability of an S corporation to bring in outside investors and can limit the ability of S corporation shareholders to transfer their stock to family members during life or upon death. There are no such restrictions on the number or type of individuals or entities who can be members of a limited liability company. Although the laws of a few states require that there be two members of a limited liability company, single member limited liability companies organized in other states can operate in these states. e. Favorable Treatment of Future Sale Individuals and partnerships who own stock in certain types of small business corporations are entitled to exclude 50 percent of any gain realized on the sale of the stock after it has been held for at least five years. This exclusion may be important to the owner of a start-up business who expects to build the business for possible future sale. The exclusion is available only for stock in C corporations, and the stock must be part of an original issue. Since the stock must have been issued by a C corporation, the original issuance of stock by a corporation that is initially organized as an S corporation and later converted to a C corporation will not qualify. If the business is initially organized as a limited liability company and is later converted to a C corporation, stock issued at the time of the conversion will qualify. f. Flexible Management Structure Since an S corporation is organized as a corporation under state law, it must be managed like any other corporation. This means that the shareholders elect directors who are responsible for the management of the corporation, and the directors appoint officers who execute their management directions. The corporate form of management is familiar to many business people but can be considered unduly rigid, particularly in the context of a small business with few shareholders who may prefer to operate the business as a partnership. A limited liability company provides greater flexibility in management structure. A limited liability company can be organized as a member-managed entity, in which case it is managed like a partnership, with each member having a vote on all management decisions and the ability to act for the limited liability company without the need for board of director approval. A limited
liability company can also be organized as a manager-managed entity, in which case one or more individuals have all the management powers and other members have no right to participate in management. g. Exemption from Securities Laws Both state and federal securities laws prohibit offering or selling securities without registration. Certain types of transactions are exempted from the registration requirements, which allows many small businesses to sell stock or membership interests without complying with the sometimes burdensome registration requirements. But limited liability companies that are managed by their members have an additional advantage because their membership interests may not be classified securities and may never need to be registered, even if no transactional exemption is available. 4. Advantages of S Corporations a. Employment Tax Treatment Although limited liability companies have a number of advantages, S corporations have one very important advantage that is enough to cause many businesses to select this form of business organization. The advantage is that a portion of the income of an S corporation may escape employment tax whereas all of the income of a limited liability company is often subject to this tax. If the members of a limited liability company participate in management of the limited liability company's business, all income of the limited liability company is treated as income from self employment and is subject to self-employment tax. This means that the members must pay self-employment tax on a current basis on all income of the limited liability company, including income retained by the limited liability company to provide working capital or to acquire capital assets. Self-employment tax is imposed at a rate of 15.3 percent on the first $80,400 of selfemployment income received by an individual in 2001, and the rate on self-employment income of greater amounts is 2.9 percent. Self-employment taxes can represent a significant cost, particularly for business owners who do not have significant outside sources of income. If a business is organized as an S corporation rather than a limited liability company, it may be possible to avoid some of the self-employment tax cost. Income of an S corporation is not subject to self-employment tax in the hands of its shareholders, but amounts paid out by the S corporation as compensation to its shareholders are subject to employment taxes. Employment taxes are paid in part by the employer and in part by the employee, but the combined rate is the same a the rate of the self-employment tax, so the fact that S corporation income is subject to a different type of tax does not create any tax savings. Tax savings do, however, result from the fact that employment tax is only imposed on amounts paid out by an S corporation as compensation. This means that S corporation income that is retained as working capital, is used to acquire capital assets, or is paid out as dividends escapes employment tax. This can provide substantial tax savings, and for some businesses, this savings is enough to outweigh all of the advantages of a limited liability company. b. Cash Basis Accounting If a business has owners who do not participate in the operation and management of the business, it may be required to use accrual basis accounting if it is organized as a limited liability company, even if it does not have inventories, or is not otherwise required to use accrual
accounting. This results under tax rules designed to prevent certain syndications from using cash accounting. These rules generally do not apply to S corporations. c. Familiar Management Structure Most states base their corporate laws on model legislation that has been widely adopted, and corporate law concepts have been around a long time. As a result, there is a large body of law relating to the management and operations of corporations, and this body of law may reduce the opportunities for conflict between shareholders and with the corporation. In contrast, the limited liability company laws of many states differ significantly from those of other states, and all limited liability company statutes are of relatively recent origin. As a result, there may be more questions about the proper way to operate or manage a limited liability company and more opportunity for conflict. d. Single Owner Businesses The law of a small number of states requires a limited liability company to have two or more members, which precludes the use of this form of business entity for a business with only one owner. In such a state, a single owner businesses must either be organized as an S corporation or must be organized as a limited liability company in another state. Although not generally a major issue, it can be inconvenient to organize a business in a state other than the one in which it will operate. 5. Selection of Alternative As you can see, limited liability companies have certain advantages, and S corporations have others. The form of business entity that is appropriate for your business will depend upon which of these advantages is most important. For example, if you expect to have a number of owners who have differing tax and cash needs or your business will have property that is likely to appreciate in value, you may want to select a limited liability company. On the other hand, if your business will require substantial working capital thus limiting the ability to distribute income currently, the employment tax advantages of an S corporation may make that form of entity the better choice. I hope that this letter will assist you in getting started on the process of making the decision about the form of entity that is most appropriate for your business, and I look forward to working with you to create a new entity for your business. cc: Certified Public Accountant Yours truly, [Signature of Attorney]