Choice of Entity

By:
Dean L. Surkin, JD, LLM
Published Date:
Jan 1, 2018

When entering a new business transaction (or significantly changing an existing one), clients should consider their choices of entity and business structure. They must consider the requirements of the business, the extent or liability protection, and the tax effects, and we, as their principal tax advisors, should work closely with their attorneys in making informed choices.

The Tax Cuts and Jobs Act of 2017 was recently signed into law; however, the new law doesn't affect the tax planning discussed in this article.

Types of Entities

Options for individuals

Individuals generally can choose among four options: a sole proprietorship, a single member limited liability company (LLP), an S corporation, or a C corporation. See below for limitations on S corporations.

A licensed professional, such as a CPA, who wants to practice as a limited liability company must use a professional service limited liability company (PLLC). Similarly, a licensed professional who wants to practice in the corporate form (whether S corporation or C corporation) must use a professional corporation (P.C. in New York—some states use the abbreviation P.A. for professional association). Forming a professional entity is more complicated than forming a general business entity because it requires advance clearance from the state licensing authority (e.g., for New York CPAs, the New York State Education Department).

Options for multiple members

Multiple member businesses can choose among a general partnership, a limited partnership, limited liability company, S corporation, or C corporation.

Licensed professionals may use a limited liability partnership. The LLP’s trade or business must be the practice of a profession, and pursuant to New York Partnership Law section 121−1500, each member must be an individual licensed in that profession. If any members are entities (such as PLLCs or P.C.s), then the members must use a PLLC, not an LLP.

An S corporation, pursuant to IRC section 1361(b)(1), has certain limits on its shareholders and classes of stock. It may have no more than 100 shareholders, no entity other than certain trusts may be a shareholder, there may be no nonresident alien shareholders, and the corporation may have only one class of stock (there may be different classes of voting rights, but all the stock must have the same distribution rights). Green Card holders, as well as U.S. citizens, qualify to be shareholders.

U.S. businesses with foreign members face special issues:

  • If a pass-through entity with a U.S. trade or business has a foreign member, then pursuant to IRC section 1446, it must withhold income tax on the foreign member’s allocated share of income, whether or not distributed.
  • A nonresident alien engaged in trade or business in the United States must file a U.S. tax return. Pursuant to Treasury Regulations section 1.6012-1(b)(1)(i), a foreign member of a pass-through entity is deemed to be engaged in the trade or business of the pass-through entity.
  • If a nonresident alien is not engaged in a U.S. trade or business, and withholding tax fully covers his, her, or its United States income tax obligation, then the nonresident alien is not required to file a U.S. tax return, under Treasury Regulations section 1.6012-1(b)(2)(i). For example, a shareholder in a C corporation who only receives dividends that are either subject to withholding or exempt from withholding under a treaty provision, does not have to file a U.S. tax return. Such an individual’s tax obligation are fully covered by withholding.

Formation

A general partnership is the easiest entity to form. In New York, the members merely need an agreement—which doesn’t even have to be in writing—followed by filing a business name certificate (also called a fictitious name certificate, or a doing-business-as (dba) certificate) in the county in which it is located.

All the other entities must file their organization certificate with the secretary of state in the appropriate state. New York, in addition, has a publication requirement that applies to limited partnerships, LLCs, LLPs, and PLLCs: once a week for six consecutive weeks in two publications selected by the county clerk for the county where the main office is located.

Pursuant to IRC section 721 for partnerships and IRC section 351 for corporations, transferring property to the entity in return for an ownership interest is a non-taxable transaction.

Choosing the taxable year

The IRC limits the choice of taxable year for a pass-through entity such as a partnership or LLC. Under IRC section 706(b)(1)(B), the entity must use one of the following:

  • majority interest taxable year
  • taxable year of all the principal partners
  • calendar year
  • pursuant to IRC section 444 election, electing up to three-month deferral from its required year
  • IRS approval needed for other taxable year

A C corporation must use the same year it uses in its books and records, pursuant to IRC section 441(c); however, a personal service corporation must use the calendar year, pursuant to IRC section 441(i)(1) (three-month deferral under IRC section 444 allowed), and a domestic international sales corporation, under IRC section 441(h), uses the same rules that apply to a partnership.

Method of accounting

A business selects a method of accounting appropriate for the business, and it need not be the same method of accounting as that of its members. A partnership with a corporate partner may not use the cash method, pursuant to IRC section 448(a)(2). There is an exception for farms, personal service corporations, or entities with gross receipts not exceeding $5 million under IRC section 448(b).

Venue

An entity doing business in a particular state must be authorized in that state. See, for example, New York LLC Law section 802(a): “Before doing business in this state, a foreign limited liability company shall apply for authority to do business in this state….” Almost identical provisions appear in the laws relating to other entities. See, for example, the New York Partnership Law section 121-902; section 121-1502; New York Limited Liability Company Law section 1305; and New York Business Corporation Law section 1301(a) and section1528.

New York has issued guidelines on what constitutes doing business in the state. It includes having a regular place of business in the state, having employees in the state, or owning real estate in the state. Storing goods in a public warehouse is generally not doing business in the state. Certain items are specifically excluded from doing business in the state, such as suing or being sued, holding meetings of members or managers in the state, maintaining bank accounts in the state, and maintaining offices only for the transfers of membership interests.

Liability issues

A sole proprietor, a member of a general partnership, and a general partner in a limited partnership have no limit on their liability. In other entities, a member’s liability is limited to his, her, or its contribution to the entity.

There’s a special rule for professional malpractice—see, for example, NY LLC Law section 1205(a):

  • A professional is always responsible for his or her own malpractice; and
  • A professional is always responsible for the malpractice of a person he or she supervises; and
  • A professional is not responsible for the malpractice of other members.

The owners should separate their personal bank accounts from their business accounts. If they commingle their accounts, creditors of the companies could argue that the entities are mere alter egos of the owners, and they could persuade a court to “pierce the veil” and let a creditor of the entity go after the entity’s owner.

Debt, equity, basis

Generally, a partner or S corporation shareholder may only deduct pass-through losses to the extent of his or her basis in the membership interest or the stock, plus basis in debt. Partnerships (including LLCs, etc.) differ from S corporations in calculating the basis.

A partner’s basis equals the partner’s contribution plus his or her allocated share of partnership liabilities. There are special rules for allocating recourse versus qualified non-recourse versus recourse that are beyond the scope of this article.

An S corporation shareholder’s basis equals the shareholder’s contribution plus the loan, if any, that the shareholder made to the corporation. It does not include any portion of corporate debt to third parties. A shareholder who guarantees S corporation debt does not obtain basis in debt; however, actually making a payment on the guaranteed debt increases his or her basis, pursuant to Treasury Regulations section 1.1366-2(a)(2)(ii).

Distributions

An S corporation may only have one class of stock. According to Treasury Regulations section 1.1361-1(l)(1), this means that each share of stock must have an identical right of distribution. In other words, all distributions must be pro rata to shareholdings. At first blush, this provision prohibits unequal distributions; however, Treasury Regulations section 1.1361-1(l)(2) provides that the corporation’s governing provisions, such as its articles of incorporation, bylaws, state law, among others, determine the distribution rights. Therefore, an S corporation may make unequal distributions, with the understanding that it will make up the difference in a subsequent year. See Treasury Regulations section 1.1361-1(l)(2)(vi), Ex. 2. There are no cases giving a time limit for the make-up distributions.

Net Investment Income Tax

The rationale behind the Net Investment Income (NII) Tax is to be equivalent to the Medicare portion of self-employment tax, designed to cover income that otherwise isn’t subject to FICA or Medicare taxes or self-employment tax. Obviously, NII doesn’t include income subject to self-employment tax. Pursuant to IRC section 1411(c), NII includes:

  • interest, dividends, annuities, royalties, and rents other than income from a trade or business not described in paragraph 2
  • the trade or business as described in paragraph 2 is a passive activity or the activity of trading financial instruments or commodities

Therefore, the pass-through income received by an S Corporation shareholder who materially participates in the business is not subject to the NII tax. (See https://www.thetaxadviser.com/issues/2014/apr/clinic-story-10.html.)

Self-Employment tax

The general rule is that a partner in a general partnership or a general partner in a limited partnership pays self-employment (SE) tax on partnership income, plus trade or business income of the partnership, whether or not distributed, pursuant to Treasury Regulations section 1.1402(a)-1(a)(2). Treasury Regulations section 1.1402(a)-1(b) explains that partnership income not from a trade or business is not subject to SE tax.

A limited partner does not pay SE tax, pursuant to IRC section 1402(a)(13). But Treasury Regulations section 1.1402(a)-2(g) provides that if the partner actually renders services to the partnership, his or her income attributable to the services is subject to SE tax no matter what type of partner he or she is. Furthermore, under state law—for example, NY Partnership Law section 121-303—a limited partner who actively participates may lose protections of limited liability.

This leads to one of the big advantages of entities such as LLCs, LLPs, and PLLCs over limited partnerships: The members have limited liability, like limited partners, but they can actively participate without jeopardizing their limited liability.

An S corporation shareholder is subject to payroll tax on his or her salary, but there is not only no payroll tax on allocated corporate profits (over expenses including the salaries), there is no SE tax on the allocated corporate profits. Note that the IRS will dispute unreasonable salaries (for example, those that are too low). Also note: If the shareholder or officers never report salaries and never file payroll returns, statute of limitations never starts, so it never ends.

Conclusion

These are some of the issues that advisors should consider when their clients are choosing the appropriate business structure for any transaction. There are other issues, such as succession planning (for example, estate planning) that bring in a host of other concerns, such as whether one or more children have the skills or interest to continue a business into the next generation, but these issues are beyond the scope of this article.

We should all keep in mind that after the passage of the Tax Cuts and Jobs Acts of 2017, the Treasury Department will issue new regulations implementing the new rules, giving us a whole new set of issues to discuss with our clients.


surkin1Dean L. Surkin, JD, LLM, is a principal at Gettry Marcus CPA P.C. He is a tax attorney with broad-based experience in tax planning and research; has litigated major cases in the fields of taxation, probate, and general commercial matters; and has been peer -reviewed by Martindale-Hubbell. He holds the highest rating for legal ability and ethical standards, AV. Mr. Surkin received his BA from the University of Pennsylvania in 1973 (double major in mathematics and political science), his JD from New York University School of Law in 1976, and his LLM in taxation from New York University School of Law in 1985. He is admitted to the New York State Bar, the federal district courts of the Southern and Eastern Districts of New York, the Second Circuit Court of Appeals, and the U.S. Tax Court. Mr. Surkin also holds the faculty appointment of professor (adjunct) at Pace University Graduate School of Business, where he currently teaches tax procedure, research, writing, and ethics. 

 
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