Choice of Entity During Uncertain Times

Transcription

1 Choice of Entity During Uncertain Times By Daniel J. Cooper and Guy A. Schmitz The issue of choice of entity arises with distressing regularity, every time a client wants to start a new business or a client wants to change the way of doing business. This article will address five common entities and the issues which arise in choosing among those five entities: 1. sole proprietorship, 2. disregarded entity, 3. limited liability company, 4. C corporation, and 5. S corporation. Sole Proprietorship A client can certainly operate a business as a sole proprietorship (which is not technically an entity choice), but we do not recommend it. For a modest filing fee (now $ for a paper filing and $50.00 for an online filing), a client can form a limited liability company of which the client is the sole member. See the section of this article on the disregarded entity (which entity is disregarded for certain taxes but not liabilities). Even sole proprietors do not escape regulation completely. If the sole proprietor is to operate under an assumed name, the name must be registered. 1 Any income (or loss) from the operation of the business is reported on the sole proprietor s personal income tax return (with self-employment tax owed). The main problem with operating a business as a sole proprietorship is the issue of liability (tort liability), and that means insurance. 2 Furthermore when the business is sold, the sole proprietor will remain liable for 1. Mo. Rev. Stat (2010). the liabilities of the business. These include not only possible tort liability but any commercial liabilities of the sole proprietor which are not paid at closing. Creditors will often gladly allow for assumption of liability by the buyer but will not necessarily release the old debtor (your sole proprietor client) of such liability. That means, of course, that if the buyer does not pay, the old debtor does. 3 The client should cancel the fictitious name registration filing upon sale of the business. Disregarded Entities Disregarded entities are an important estate, corporate, and tax planning tool for practitioners. If an entity is disregarded for federal tax purposes, its activities are treated in the same manner as a sole proprietor, branch, or division of its owner. 4 Two of the most common 2. We are not suggesting that businesses other than sole proprietorships dispense with liability insurance. The issue is the amount of insurance and the premium thereon. Remember that as a sole proprietor, the sole proprietor s personal assets are clearly at risk, without any argument that there is a disregarded entity in place acting as a blocker. (Obviously, non-tort liabilities, commercial liabilities, are also the liabilities of the sole proprietor, putting such proprietor s personal assets at risk (unless there is agreement to restrict a liability to the business assets)). 3. Financial statements ask whether the person providing the financials is liable for any debt. Unless the creditor releases your client (the old debtor and former sole proprietor), the debts of the former sole proprietorship would have to be listed upon financial statements until paid. Consider the effect of a long-term lease. 4. See below for exclusions to this general rule. Dan Cooper is a member of Armstrong Teasdale s Corporate Services Group concentrating in the areas of tax, public finance, and general corporate law. Mr. Cooper advises on matters concerning business transactions, tax-exempt and private activity bond financings, and various federal and state income, sales, and employment tax issues for individuals and businesses. He earned his J.D. from the University of Florida College of Law and his B.A. from Eckerd College. Guy Schmitz is a tax attorney in the Corporate Services Group of Armstrong Teasdale. He provides tax advice on real estate transactions, limited liability company transactions, and corporate transactions, including acquisitions and reorganizations. Mr. Schmitz has also provided advice during numerous audits by tax authorities. He received his J.D. from Cornell Law School, an LL.M. in Taxation from New York University, and an M.A. in English and an A.B. from Saint Louis University. He clerked for The Honorable Darrell D. Wiles, United States Tax Court. 20 The St. Louis Bar Journal/Fall 2010

2 The St. Louis Bar Journal/Fall

3 types of disregarded entities are the single-member limited liability company ( SMLLC ) and the qualified Subchapter S subsidiary corporation ( QSSS ). The check-the-box Treasury Regulations address the treatment of an SMLLC. 5 Under the check-thebox regulations, an SMLLC is, by default, treated as a disregarded entity separate from its owner. 6 However, an SMLLC can elect to be treated as a corporation if disregarded status is undesirable. 7 An SMLLC treated as a disregarded entity will not be recognized for federal tax purposes and will reflect its profits and losses on its members tax return. The QSSS is a corporate cousin to the SMLLC. Any domestic corporation that is an eligible Subchapter S corporation and that is wholly owned by a Subchapter S corporation will be treated as a QSSS if its parent corporation so elects. 8 When a QSSS election is made, the subsidiary is generally deemed to have liquidated into the S corporation parent without adverse tax consequences. 9 A QSSS is not treated as a separate corporation for federal tax purposes, and all of the QSSS s assets, liabilities, and items of income, deduction, and credit are treated as assets, liabilities, and items of income, deduction, and credit of the Subchapter S corporation parent. 10 Aside from the advantages of limited liability companies and Subchapter S corporations (described later), there are some specific advantages for utilizing a disregarded SMLLC or QSSS. For example, a practitioner should consider forming a disregarded entity when the strategy of the transaction is to isolate the liabilities of a new or existing division without incurring a federal corporatelevel tax. In addition, transactions between disregarded entities and their owners, or between commonly owned disregarded entities, are generally ignored. Therefore, the use of a disregarded entity can simplify the federal income tax reporting of an organization s business operations. Missouri Tax Treatment of Disregarded Entities Missouri conforms to the federal check-the-box rules in determining a limited liability company s classification as a corporation, partnership, or disregarded entity. 11 An SMLLC that is disregarded for federal tax purposes is also disregarded for Missouri income tax and sales and use tax purposes. 12 Similarly, a QSSS is disregarded for Missouri income tax purposes. 13 However, it is important to note that a QSSS is treated as a separate entity for Missouri franchise tax purposes and must file a Form MO-FT separate from its parent. 14 For purposes of Missouri sales and use tax liability, Missouri law is silent with regard to QSSSs. Missouri imposes a tax upon all sellers for the privilege of selling tangible personal property at retail in the State of Missouri. 15 A seller is defined as any person selling tangible personal property. 16 A person includes a corporation. 17 Therefore, until the Missouri Department of 5. Treas. Reg and Treas. Reg (b)(1)(ii). 7. Treas. Reg (a). 8. I.R.C. 1361(b)(3)(B). Revenue issues alternative authority, a QSSS should be treated as a separate entity for Missouri sales and use tax purposes. Exceptions to Disregarded Status There are some federal exceptions to the disregarded status of SMLLCs and QSSSs. Beginning with wages paid on or after January 1, 2009, regulations now provide that SMLLCs and QSSSs with employees are not disregarded for purposes of employment taxes and related filings. 18 As a result, an SMLLC or a QSSS must now obtain its own taxpayer identification number and file and pay its own employment taxes. 19 Employment taxes include taxes imposed under the Federal Insurance Contributions Act ( FICA ) and the Federal Unemployment Tax Act ( FUTA ). The IRS has also issued regulatory exceptions treating an SMLLC or a QSSS as a separate entity for purposes of certain excise tax reporting, registration, and payment obligations I.R.C. 332 and 337; Treas. Reg (a)(2). However, if the QSSS is insolvent at the time of the election, the deemed liquidation will be a taxable event. See Treas. Reg (d), Example Treas. Reg (a)(1). 11. Mo. Rev. Stat (2010). 12. Id. 13. See Frequently Asked Questions at Id. 15. Mo. Rev. Stat (2010). 16. Mo. Rev. Stat (11) (2010). 17. Mo. Rev. Stat (6) (2010). 18. Treas. Reg (c)(2)(iv) and (a)(7). 19. Treas. Reg (c)(2)(iv)(C), Example (ii). 20. See Treas. Reg (c)(2)(v) and (a)(8) for a list of applicable excise taxes. 22 The St. Louis Bar Journal/Fall 2010

4 Limited Liability Company There are numerous entities which can be treated as partnerships for purposes of income taxation. 21 This article will focus on the limited liability company because, despite its relatively recent birth, it combines the limitation on liability of corporations with tax treatment as a partnership. Thus it is a hybrid. Limitation on Liability General partners bear joint and several liability for the debts and obligations of the partnership. A limited liability company, however, has a legal existence separate from its members which provides limitation of liability from the obligations of the limited liability company. 22 Furthermore, neither members nor managers (we will talk about managers below) are liable for the acts or omissions of any other member, manager, agent, or employee of the limited liability company. 23 Of particular note is the filing of the articles of organization with the Missouri Secretary of State. 24 The purpose of such filing is, of course, to put all third parties on public notice that the entity seeks (and enjoys) limitation on liability. The Operating Agreement All limited liability companies should have a written operating agreement. 25 While the statute does not require written operating agreements, they are a good idea. As a profession, attorneys are good at reducing agreements to writing, given the vagaries of memory and, regrettably, in some instances, fraud. Also, if there is not an oral or written agreement regarding certain critical 21. In addition to the limited liability company, consider the general partnership, limited partnership, limited liability partnership, and limited liability limited partnership. Entity choices continue to evolve, particularly the limited liability company, which grows in popularity. For example, as of the date this article was submitted, legislation was pending in the Missouri House of Representatives (HB 1890) allowing for the organization of a low-profit limited liability company (the L3C ). The L3C is a for-profit entity having primarily charitable purposes. Other states, such as Vermont and Illinois, have already enacted the L3C into law. We reference the L3C merely as a cautionary tale to remind you that entity choices continue to evolve and become increasingly complex but may also offer your clients new opportunities. 22. Mo. Rev. Stat (2010). Of course, many lending institutions will require personal guarantees of members for limited liability company obligations. If, however, the financials of the limited liability company are sufficiently strong, members may be able to avoid personal guarantees or put a liability cap on such guarantees. 23. Id. 24. Mo. Rev. Stat (2010). 25. Mo. Rev. Stat (13) and (2010). 26. Mo. Rev. Stat and (2010). 27. Treas. Reg through Remember what we said about the importance of the operating agreement, which should require a distribution of cash sufficient to pay income taxes if the limited liability company can, after such distribution, carry on operations. 29. The rest of the citation is, of Subtitle A (Income Taxes) of Title 26 (Internal Revenue Code) of the United States Code. We suggest you read the Table of Contents of the Internal Revenue Code to get a sense of how the Internal Revenue Code works. The table is long and dull but instructive. issues, the statute defaults to itself, and your client may not like what is in such statute. This is where the practitioner will do the real work, given that filing articles of organization is easy enough. The written operating agreement has two critical aspects -- how the members (not shareholders) manage themselves, and, how they allocate profits and losses (accounting concepts) as opposed to the dollars generated by the business (assuming, of course, that the business is making money and not suffering losses). Management The limited liability company can be managed either by a manager or managers or can be managed by the members. 26 Whether managed by managers or members, the practitioner should consider giving the members significant voting rights over important questions; for example, the sale of the asset of the limited liability company and its liquidatation. Here, a supermajority is important; the question is how super. Twothirds of the voting interests may be too low, and 100% can lead to stalemate. Consider 80% for issues such as liquidation, restrictions on the transfer of interests, and admission of new members. Taxation Limited liability companies are typically treated as partnerships for income tax purposes, although they can elect to be taxed as corporations. 27 The words treated (partnerships) and taxed (corporations) are used advisedly because limited liability companies, if treated as partnerships, are not taxed at all. They are pass-through entities with the income tax burden falling on the members, whether they received a distribution of cash to pay the income tax or not. 28 You will find (generally) the partnership provisions of the Internal Revenue Code ( Code ) in Subchapter K of Chapter 1 (Normal Taxes and Surtaxes). 29 These provisions, as aided and abetted by regulations, rulings, case law, and The St. Louis Bar Journal/Fall

5 other authority, offer great flexibility in allocating profits and losses of the limited liability company among the members. Do not confuse such allocation with the distribution of cash, either during the life of the limited liability company or upon its death (when the assets of the limited liability company are sold, debts paid, and remaining cash distributed among the members (assuming a profitable life)). 30 To use the cliché, such flexibility is both the strength and the weakness of partnership tax law. All that we can do here is to suggest some of the complexity and refer to a couple of the main treatises on this subject. 31 Below is a relatively short list of some issues you should consider: 1. The limited liability company treated as a partnership is both an entity and an aggregate of members (partners). The election, for example, under Code section 754 is made at the entity level (the entity theory) but affects members (the aggregate theory) for the year of election and future years All transfers have potential tax consequences, some favorable and some not (and, admittedly, some neutral). These transfers include transfers in and out of the limited liability company to members, transfers between members of their interests (or transfers to the limited liability company of a member s interest), and transfers of assets held by the limited liability company to third parties. 3. There is both inside basis -- the basis of the assets held by the limited liability company, and outside basis -- the basis of such member s interest in the limited liability company. 4. The debt of the limited liability company will be allocated to the basis of the members interests; there is a distinction between the allocation of recourse liability and nonrecourse liability. In that context if debt basis in a member s interest is absorbed, allowing the member to take losses on his or her personal return, the reallocation of basis among members may result in phantom income to a member; that is, income without cash to pay income taxes. 5. If your client is selling his or her membership interest held for more than a year, gain is going to generally be taxed at long-term capital gain rates, but be sure that the client factors in the effect of any Code section 751 assets, commonly known as hot assets. The sale of an interest holding hot assets will result in some ordinary income. This is a good example of the entity versus aggregate theory. While the entity theory provides for long-term capital gain, the aggregate theory (which, in effect, treats members as owning the underlying limited liability company assets directly) will result, as said, in ordinary income treatment. 6. Review the regulations promulgated under Code section 704. These regulations, long and of stunning complexity, address the issue of the allocation of profits and losses of the limited liability company. While there is an opportunity under the tax laws to allocate profits and losses in other than the percentages of ownership by the members, the described regulations monitor such allocations very carefully. Flexibility is possible; wild abandon is not. 7. If your client is selling his or her interest to the limited liability company, make sure you designate in the transfer document whether the payment is a Code section 736(a)(1) payment (generally ordinary income to your client), a Code section 731(a)(2) payment (ordinary income to your client), or a Code section 731(b) payment (generally capital gain to your client, save for the hot asset issue described in (5) above). 8. There is a difference between a capital member and a service member, and unless the operating agreement is properly drafted, the service member will have immediate (and adverse tax consequences) without necessarily the money to pay the tax If there is the transfer of 50% or more capital and profits in a 12-month period (not a calendar year) between members (or from an old member to a new member), there is a technical termination of the limited liability company under Code section 708. You should review the treatises cited at footnote 31 for the tax consequences of a technical termination. 10. A member can be a member but can also be a lender to the limited liability company, a lessor thereto, or the seller or buyer of limited liability company assets. 11. Consider the passive loss rules, Code section 469, and the at risk rules, Code section 465, in determining whether your client can deduct losses generated by the limited liability company. C Corporations Missouri corporations are created and governed by the General and Business Corporations Law of Missouri, Chapter 351, Mo. Rev. Stat. A C corporation differs from an S cor- 30. Limited liability companies, of course, need not die. The alternative is the sale or other transfer of a member s interest. If all interests of all members are sold to one person (one of the other entities we are discussing, for example), there is indeed a kind of death in that the limited liability company can become a disregarded entity for tax purposes. 31. McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners (Warren, Gorman & Lamont, 4th ed. 2007); Willis & Postlewaite, Partnership Taxation (Warren, Gorman & Lamont, 6th ed. 1997). 32. Consider a supermajority of the members (however supermajority is defined) before this election is made. 33. See Rev. Proc , CB 343, Rev. Proc , CB 191, and Notice , CB The St. Louis Bar Journal/Fall 2010

6 poration in that it is governed generally for tax purposes by Subchapter C of the Internal Revenue Code. 34 Therefore, most of the non-tax attributes of a C corporation and an S corporation will be identical under Missouri law. When determining whether a C corporation is an appropriate choice of entity, a practitioner must consider the full life cycle of the business, including ease and expenses of formation, capitalization, liability exposure, tax treatment, and transferability of interests. Formation and Corporate Formalities As compared to a limited liability company, a corporation is likely costlier to form and requires more time and effort to maintain. Unlike a limited liability company, a corporation must establish a board of directors and hold regular meetings of its board and shareholders. A corporation must also be careful to abide by the corporate formalities to prevent courts from disregarding the corporate form and imposing liability on shareholders for acts of the corporation. 35 (This is not to suggest that a limited liability company not observe its own formalities.) Capitalization The main advantage of a C corporation is the ability to access capital through a public offering and issue multiple classes of stock. In comparison, an S corporation cannot have more than 100 shareholders or more than one class of stock. 36 However, the likelihood of a start-up business going public is very remote. Even if a public offering is the ultimate goal, a practitioner can form the entity as an S corporation and convert to a C corporation, if necessary. 37 Limitation of Liability A corporation is a legal entity separate and distinct from its owners. Therefore, shareholders generally enjoy protection from the debt and obligations of the corporation. Further, corporations benefit from a well-established body of law with respect to both tax and non-tax controversies. Tax Treatment of C Corporations 34. See footnote 29 and text which references footnote 29 for full citation. 35. See Collet v. American National Stores, Inc., 708 S.W.2d 273 (Mo. App. E.D. 1986). 36. I.R.C. 1361(b)(1). 37. See Eustice & Kuntz, Federal Income Taxation of S Corporations, 5.09 (Warren, Gorman & Lamont, 4th ed. 2001) for effect of S corporation termination. 38. See the U.S. Government s Fiscal Year 2011 Budget at gov/omb/budget/fy2011/assets/budget.pdf. 39. But see I.R.C. 469 and A C corporation is thusly called because critical provisions regarding the taxation of C corporations are in Subchapter C of the Code. See full citation in text which continues at footnote 29. As you might have surmised, critical provisions regarding S corporations are in Subchapter S of the Code. 41. I.R.C Be careful if the S corporation does business in another state. Review the law of such other state to determine if such state requires a separate S election. The principal disadvantage of a C corporation is double taxation. C corporation income is taxed first at the corporation level and, second, when earnings are distributed to shareholders in the form of dividends. This second level of tax is likely to increase in the near future, at least for high-income taxpayers. The Obama Administration budget proposal for fiscal year 2011 calls for an increased tax rate on both dividends and capital gains from 15 % to 20 % for taxpayers with taxable income in excess of $200,000 ($250,000 for married taxpayers filing jointly). 38 There is also a possibility that Congress could approve a higher tax rate on dividends in an effort to pay down the federal budget deficit. Another critical disadvantage of a C corporation is that corporate losses do not flow through to the shareholders. Given the current state of the economy, this should be a major consideration given that new business entities are more likely than usual to generate losses. In contrast, both S corporations and limited liability companies allow losses to pass through their owners. 39 Planning Suggestion Given the generally unfavorable tax treatment of a C corporation as opposed to an S corporation or limited liability company, there are few scenarios where a C corporation would be the entity of choice, unless the practitioner anticipates a public offering. Assuming that the corporation is eligible for S status, always address the issue with the client about the advisability of an election. If the client says no, so indicate in the file. S Corporations The S corporation 40 is a variant of the C corporation, at least in that it provides for the same non-tax corporate protection under Missouri law. C status is the default for income tax purposes. There are specific provisions in the Code which require election of S status. 41 The corporation must elect S status on or before the fifteenth day of the third month of the taxable year. The trigger for filing the S election is not the day of incorporation, but the first day the corporation first had shareholders, acquired assets, or began doing business. Because Missouri is a piggyback state, the federal election will apply to a Missouri corporation doing business in Missouri. 42 The St. Louis Bar Journal/Fall

7 The reason for the election is that there is, with a couple of exceptions, only one tax, not two, and such tax is at the shareholder level. 43 Thus, an S corporation avoids the double taxation of the C corporation. There is a price to pay for such status. The kind of shareholders who may be shareholders is limited. 44 Not only will the original shareholders have to be on the favored list, but the client must make sure that only eligible shareholders hold stock for the entire life of the corporation as an S corporation. Thus, we strongly suggest a shareholder agreement restricting transfer of the stock to non-eligible shareholders, which will terminate the S election. Not only should the shareholders sign such an agreement, but the stock certificate should note (on both sides) the existence of the restrictive agreement. In addition to assuring that only eligible shareholders hold stock, it is critical that there be only one class of stock. 45 Code section 1361(c)(4) provides an exception to the general rule of one class of stock by providing that a corporation does not have more than one class of stock solely because of differences in voting rights among classes of stock. Thus an S corporation may have voting and nonvoting stock. The complexity comes with economic rights. Each share must have the same rights to distributions and liquidation proceeds. Consider the effect of the following on economic rights: 1. deferred compensation plans (including phantom stock and stock appreciation rights), 2. agreements and laws regarding distribution and liquidation rights, 3. buy-sell agreements, 4. debt as a second class of stock, 5. options and warrants, and 6. convertible notes. 46 Choices Made The client will choose, with your assistance, the best entity for doing business. It is important in your discussions with the client to explain what will happen if the client decides to change the manner of doing business. Generally, a sole proprietorship or a disregarded entity can take on a member, thus creating a partnership for tax purposes, without adverse tax effect. Furthermore, it is generally possible for a sole proprietor or a disregarded entity to incorporate without adverse effect. Then the complexity comes. See in particular Rev. Rul , CB 88, which provides the client three options when the client, which is a limited liability company treated as a partnership, decides to incorporate. The limited liability company can transfer assets and liabilities to the corporation in exchange for stock which is then distributed to the members, or the limited liability company can distribute the assets and liabilities to the members who then contribute such assets and liabilities to the corporation in exchange for stock, or the members can transfer their interests to the corporation in exchange for stock. You should carefully consider which way the client should effect the incorporation because the tax results can be different. You should indicate the choice made in the transfer documents. The dissolution of a corporation, on the other hand, can have adverse tax effects. There can be two levels of tax if a C corporation is converted to a sole proprietorship, disregarded entity, or limited liability company, and one level of tax (and sometimes two) 47 if an S corporation decides to convert to a sole proprietorship, disregarded entity, or limited liability company. While choosing corporate status may seem like a good idea 43. For the exceptions, see I.R.C and I.R.C I.R.C. 1361(b)(1)(D). 46. See Eustice & Kuntz, supra, I.R.C when the client first sees you, you should warn the client about the adverse tax consequences of converting to a sole proprietorship, disregarded entity, or limited liability company. q q q 26 The St. Louis Bar Journal/Fall 2010