November 21, 2011 By Aman Badyal

One of the most common questions that arises in any transactional practice is:  What type of entity should I use for my new business?

The primary options are:  a limited liability company (LLC), an S Corporation or a C Corporation.

What is an S Corporation?

From a non-tax state law perspective there is generally no difference between an S Corporation and a C Corporation.  The S Corporation and the C Corporation each offers limited liability to its shareholders.  An S Corporation is simply a corporation that has filed an election with the Internal Revenue Service to be taxed under Subchapter S of the Internal Revenue Code.

The tax advantage of an S Corporation over a C Corporation is the fact that there is only a single level of federal income tax imposed upon an S Corporation.  That is, income earned by an S Corporation is taxable to its shareholders in the year it is earned (regardless of whether it is distributed to the shareholders).  The S Corporation itself does not pay any federal income tax and there is no second tax when cash is distributed by the S Corporation to its shareholders as dividends (so long as the shareholders have basis in their S Corporation stock equal to or greater than the amount of cash they receive).

In order to qualify as an S Corporation, the entity must satisfy certain requirements.  An S Corporation must have 100 or less shareholders, each of the shareholders generally must be an individual who is a U.S. taxpayer, and the corporation can have no more than one class of stock.

How does that differ from a C Corporation?

As noted above, the primary difference between an S and C Corporation is that C Corporations are subject to two levels of federal income tax.  First, income earned by the C Corporation is taxable to the corporation at rates of up to 35%.  Then, dividends distributed by the corporation to its shareholders are taxable to its shareholders at rates of up to 23.8%.

If you are considering forming your corporation prior to December 31, 2013, shares in your startupmay qualify as Qualified Small Business Stock (QSBS).   If you hold QSBS shares for five years or more, any gain on the sale of such shares will not be subject to income taxes.  Only C Corporations that conduct certain types of businesses may qualify for QSBS treatment; for example, professional service businesses do not qualify.

For various reasons, venture capital and private equity firms prefer to invest in Delaware corporations.  Therefore, if you are considering obtaining financing from either a private equity or venture capital firm, it is advisable to use a Delaware corporation.   Because of the ease with which an S Corporation can convert to a C Corporation, some business owners will operate as an S Corporation until they receive financing through one of these sources.

What about LLCs?

Like a shareholder of a corporation, so long as the formalities of the LLC are respected, a member of an LLC is protected from the liabilities of the entity.  One advantage of the LLC is that its members do not have to be quite as formal when it comes to their relationship with the LLC as do shareholders of a corporation.

LLCs are only subject to one level of tax.  Like a shareholder of an S Corporation, a member of an LLC is subject to federal income tax with respect to the LLC’s income as it is earned by the LLC regardless of whether any amounts are distributed.  However, unlike an S Corporation, anybody can be a member of an LLC.  Additionally, an LLC can have an unlimited number of classes of equity.  In fact, the LLC is the most flexible business entity.

There are various tax reasons why an LLC might be preferable to an S Corporation.  For example, if an LLC incurs a debt, the members increase their adjusted basis in the LLC by an amount equal to the amount of the debt.  This is the primary reason that all new real estate businesses are conducted through LLCs.  To illustrate the advantages of this tax rule, consider an LLC that owns low basis real estate.  The LLC could take out a loan against the real estate and distribute the cash tax-free to its members.  In a similar circumstance, unless the shareholders have sufficient basis in their S Corporation stock, a cash distribution could generate taxable income to an S Corporation shareholder.  However, one tax disadvantage of the LLC versus the S Corporation is that members of an LLC will usually be required to pay self-employment taxes on their entire share of income earned by the LLC.

The above discussion represents only a small sampling of the issues to consider when choosing a business entity.  For a free consultation, you can reach Aman Badyal at 619-500-4540 or by email at [email protected].

Aman Badyal’s Bio

After graduating from Georgetown University Law Center and New York University School of Law (the nation’s #1 rated tax law program), Aman obtained a coveted position as a tax associate with a prestigious New York City tax boutique (Feingold and Alpert LLP). While in New York City, Aman represented various businesses and individuals who are household names. After gaining some very useful experience in New York, Aman went to work in the tax and business departments of two highly regarded California law firms (Allen Matkins Leck Gamble Mallory & Natsis LLP and Farella Braun + Martel LLP). During his time at these large law firms, Aman represented numerous Fortune 500 Corporations and Forbes 200 individuals.

Aman is the founder and owner of Badyal Law, PC.  Badyal Law PC has the breadth and depth of experience to help you regardless of whether you are trying to navigate the morass of the tax laws, fight the IRS, start a business, sell your business, plan for business succession, or enter into a partnership or other joint venture.  http://www.badyallaw.com/