Firm Articles

Some Tax Considerations Affecting the Choice of Business Entity

by Arthur J. McDaniel

The most tax-efficient structure for continuing operations is a flow-through entity such as a Limited Liability Company or Partnership, or an S corporation. Such entities eliminate the double taxation present with a C corporation—whereby the corporation pays tax on its profits and the shareholder pays tax on the profits again when received as dividends. However, there are certain tax disadvantages to some of these flow-through entities, and particularly so if one plans to sell the entity in the near future.

Taxation of Gain on Sale

When an entrepreneur projects vigorous appreciation, then the ability to sell the interest after holding it for more than one year and receive long-term capital gain treatment on the entire gain is a significant part of the tax-efficiency. A sale of a Limited Liability Company or Partnership interest would normally qualify for long-term capital gain treatment if held for more than one year. However, it most likely would have part of the gain taxed as ordinary income due to its “hot assets” such as depreciation recapture, and unrealized receivables if the business is on the cash method. This argues strongly for a corporation because a sale of stock in a C corporation or an S corporation would qualify for such treatment if held for more than one year.

Shareholders of an S corporation receive and report allocations of net profits from operations based simply on the number of shares that they hold. The allocated income (net of any cash distributions) increases the basis of the shares and reduces the amount of the gain upon the eventual sale of the shares—gain that would be long-term capital gain for stock held for more than one year.

The basis increase for undistributed profits does not occur in a C corporation. Therefore, the sale of C corporation stock of the same business would result in greater net gain—again, gain that would be long-term capital gain for stock held for more than one year. However, through 2010, the profits of a C corporation, if distributed as dividends, also receive long-term capital gain treatment.

Taxation of Operations

The entrepreneur and perhaps other key employees would likely be manager-members of a Limited Liability Company or partners of a Partnership. As such, all would face the 2.9% Medicare tax, in addition to income tax, on their allocation of net profits from the entity—an exposure not currently faced by holders of S corporation stock on their allocations of net profit. However, Congress is looking to change this.

Finally, an additional, albeit minor, consideration concerning tax efficiency arises from the interest one may have in using the cash method of accounting for the business. An S corporation may use the cash method if its gross receipts are $5 Million or more—a C corporation may not—and, a Limited Liability Company or Partnership may encounter obstacles. Moreover a cash method Limited Liability Company or Partnership will likely have unrealized receivables, which means that part of the gain on the sale of the entity will be ordinary income.

DISCLAIMER

As provided in Treasury Department Circular 230, this article is not intended or written by Lobb Cliff & Lester, LLP to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

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