Considerations When Choosing a Corporate Structure

Abstracted from: The S Corporation: Your Best Choice For An Established Small Business

By: Steven Alberty

Practical Lawyer - Vol. 49, No. 6, Pgs. 11-19

Overview:

Evaluates the choices for a business structure available to a small business owner, based on objectives and business history. Recommends the long-available S corporation entity for profitable businesses in fields other than real estate and investments. Focuses on tax considerations, finding that these mitigate against use of an S corporation when planning to go public.

Surprise savings.

One little-recognized benefit of the profitable S corporation­whose profits and losses flow directly to its shareholders’ tax returns­is that the Internal Revenue Code does not require the shareholders to pay self-employment tax on the profits, as it does for proprietors, partners, and owners of limited liability companies. For smaller businesses, attorney Steven Alberty emphasizes, this could represent a significant portion of the owners’ receipts from the business, although the S-corp and any shareholder/employees must pay the usual FICA and Medicare taxes on amounts paid as compensation. This is one of several factors the author cites as a reason why the owner of a profitable, established small business should prefer the S-corp structure over other types of business entity. The calculus of tax benefits and costs, however, varies greatly, depending on what business the enterprise pursues and whether the owner contemplates major structural changes, such as going public, reorganizing to spin off units, or being acquired.

Convert to the LLC or C-corp before going public. To obtain the pass-through benefits of the S corporation, the company can have no more than 75 shareholders, who must be individual US citizens or residents, or certain kinds of trusts and estates; consequently, share transfers are explicitly limited. The assets of an S-corp are effectively locked into the corporation by the tax penalties imposed on withdrawal and liquidation. This limitation is not significant for ongoing commercial ventures, but it can severely disadvantage real estate businesses, which must routinely divest appreciated assets. The ownership limitations also strongly suggest that companies planning to go public should avoid S corp. election, since potential investment must be limited to qualifying persons. To enjoy pass-through tax treatment during a business’s early, loss-making stages yet remain eligible to secure public market financing later, the author advises that owners choose a limited liability form, which they can convert tax-free to a standard C corporation before the public offering.

When to avoid the S corp.

The business model best suited for an S corporation is an ongoing commercial company whose owners work within the company. Owner/employees seldom require dividend income to generate cash and thus display a common investment and tax posture. Real estate firms, companies planning a public issue, and other business arrangements falling outside the paradigm will find the S corporation less suitable than other forms.

When some owners are passive investors, suggests the author, a partnership (general or limited) or an LLC offers more flexibility than the S-corp, since it is limited to a single class of stock. It is also not the best choice when owners want to allocate income and losses unevenly or split income between salary and dividends to optimize their returns and cash flow. Similarly, owners whose business is investment may wish to avoid the S-corp lest they pay entity-level taxes on passive income exceeding 25% of the company’s earnings and profits. Since only C corporations generate retained earnings under the Code, the penalties associated with this limit only affect S-corps that were C-corps at some point or that acquired the earnings from mergers with some C-corps.

Abstracted from Practical Lawyer, published by ALI-ABA Committee on Continuing Professional Education, 4025 Chestnut Street, Philadelphia PA 19104-3099.

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