Choice of Entity
The owners of a closely held business will confront many difficult decisions during the life of the business. Among the earliest of these decisions – and one with which the business may have to contend for many years to come[i] – is the so-called “choice of entity”: in what legal form should the business be organized, its assets held, and its activities conducted?
In the case of only one owner, the assets of the business may be held directly by the owner as a sole proprietor; or the business may be organized as single member LLC which, if disregarded for tax purposes,[ii] is treated as a sole proprietorship. Alternatively, it may be organized as a corporation under state law, which will be treated as a C corporation[iii] unless the shareholder elects to treat the corporation as an S corporation.[iv]
Where there are at least two owners, they may decide to own and operate the business as an unincorporated entity – a partnership[v] – or as a corporation.
The form of entity selected for a business may have far-reaching tax and economic consequences, both for the business and for its owners. For example, a decision to operate as a partnership will offer the owners the greatest flexibility in terms of how they share the profits of the business,[vi] but it may subject them to self-employment tax; a decision to operate as an S corporation may require the payment of reasonable compensation to those owners who work in the business,[vii] and will require that the corporation issue only one class of stock and have only individuals as shareholders,[viii] which may limit its ability to raise capital.
In both of these cases, the entity itself is generally not subject to income tax; rather, its annual profits and gains pass through, and are taxed directly, to the entity’s owners whether or not distributed to them – in other words, the owners do not enjoy any tax deferral with respect to the entity.[ix]
By contrast, the profits and gains of a C corporation are taxed to the corporation; in general, they are not taxed to the corporation’s owners until they are distributed to the owners as a dividend. At that point, the corporation’s after-tax profits will be subject to a second level of federal tax; in the case of an individual owner, the dividends will be taxed at the same 20 percent rate generally applicable to capital gains,[x] plus an additional net investment income surtax of 3.8 percent.[xi]
Enter the TCJA
If the choice of entity decision was not already daunting enough for the owners of a business in its infancy, the Tax Cuts and Jobs Act[xii] has added another layer of factors to consider, thus making the decision even more challenging.
For example, the Act reduced the corporate income tax rate by 40 percent – from a maximum graduated rate of 35 percent to a flat rate of 21 percent[xiii] – while also providing the non-corporate owners (basically, individuals) of a pass-through entity (partnerships and S corporations) with a special deduction of up to 20 percent of their share of the entity’s “qualified business income.”[xiv]
In light of this development, the owners of many partnerships, LLCs and S corporations may be considering whether to incorporate,[xv] or to revoke their “S” election,[xvi] in order to take advantage of the much lower corporate tax rate.
Such a change may be especially attractive to a business that is planning to reinvest its profits (for example, in order fund expansion plans) rather than distribute them to the owners.[xvii]
On the other hand, if the partners or S corporation shareholders are planning to sell the business in the next few years, it may not be good idea to convert into a C corporation.[xviii]
Choices, choices, choices. Right, wrong, indifferent?
Regretting the Choice
While taxpayers are free to organize their business in whatever form they choose, once having done so, they must accept the tax consequences of that choice, whether contemplated or not.[xix]
A recent decision by a federal district court considered the strained arguments advanced by one taxpayer in a futile effort to escape the tax consequences of their choice of entity.[xx]
Taxpayer operated his business as a sole proprietorship for several years before incorporating it (the “Corporation”). As the sole shareholder of the corporation, Taxpayer then elected to treat it as an S corporation for federal income tax purposes.
For the next several years, Taxpayer caused Corporation to file a Form 1120S, U.S. Income Tax Return for an S Corporation (“Form 1120S”), to report the income earned and the expenses incurred by the business.
During Tax Year, a second shareholder was admitted to Corporation. Taxpayer and the new shareholder entered into a shareholders’ agreement (the “Agreement”) pursuant to which they agreed that any income earned by Corporation prior to the admission of the second shareholder (“Pre-Existing Business”) would belong to Taxpayer and not to Corporation.[xxi]
On his individual income tax return for Tax Year, Taxpayer attached a Schedule C, Profit and Loss from Business (Sole Proprietorship), to his personal income tax return (Form 1040), on which he claimed deductions for expenses paid or incurred with respect to Pre-Existing Business. These deductions included amounts paid out of Corporation’s bank account. In addition, Taxpayer claimed a deduction for amounts that he paid, out of his personal bank account, to certain employees of Corporation for work they performed with respect to Pre-Existing Business.
After examining Taxpayer’s return for Tax Year, the IRS disallowed each of these deductions, and assessed an income tax deficiency against Taxpayer.
Taxpayer paid the tax liability and then filed a claim for refund, which the IRS denied. Taxpayer then brought a proceeding in a federal district court in which he sought relief from the IRS’s denial of his refund claim.[xxii]
The IRS moved for summary judgment.[xxiii]
“Live With It”
The Court explained that, in a refund action, the complaining taxpayer bears the burden of proving that the challenged IRS tax assessment was erroneous. Specifically, the taxpayer has the burden of proving: his right to a deduction; the amount of the deduction; and, as the nonmoving party, definite and competent evidence to survive summary judgment.
Taxpayer argued that he was entitled to the deductions claimed because the payments on the Pre-Existing Business were not related to Corporation but, instead, were from a separate business operation that he classified as a sole proprietorship. In so arguing, Taxpayer identified the steps he took to separate this Pre-Existing Business from Corporation. He stated that, although there was no formal dissolution of Corporation prior to the admission of the second shareholder, there was a withdrawal of corporate funds, an insertion of new funds, the issuance of new stock to an additional stockholder, and the appointment of an additional officer to the corporation.
The Court pointed out, however, that although Taxpayer claimed that the fees belonged to him personally, and not to Corporation, he also admitted that the funds were deposited into, and paid from, Corporation’s account. Further, Taxpayer admitted that the clients compromising the Pre-Existing Business had not formally retained him individually; rather, they had contracted with Corporation.
The Court observed that Taxpayer’s argument was essentially that he “intended” to form a new business. The Court stated that, notwithstanding Taxpayer’s intentions, a corporation exists for tax purposes if it is formed for a business purpose or if it carries on a business after incorporation. The choice of incorporating to do business, the Court continued, required the acceptance of the tax advantages and disadvantages.
Taxpayer chose to incorporate his business and elected to treat it as an “S” corporation for tax purposes. The Court explained that “S” corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. When the shareholders of a corporation make an S election, they switch from a two-level taxation system to a flow-through taxation system under which income is subjected to only one level of taxation.
The corporation’s profits and losses pass through directly to its shareholders on a pro rata basis and are reported on the shareholders’ individual tax returns, allowing an “S” corporation and its shareholders to avoid double taxation on its corporate income.
The Court stated that, since its formation, Corporation properly filed a Form 1120S to report its income and deductions. When a new a shareholder was added during Tax Year, Corporation amended its name, but it retained its employer identification number and continued to file tax returns using that number.
Taxpayer, however, filed a Schedule C claiming deductions from the Pre-Existing Business. In doing so, he attempted to report income and deductions stemming from a business operated as a sole proprietorship. A sole proprietor, however, is someone who owns an unincorporated business by themselves.
The Court found that Taxpayer could not establish that he operated as a sole proprietor entitling him to take deductions on a Schedule C. Corporation was not dissolved; rather, it continued to operate as an S corporation. Thus, Taxpayer should not have filed Schedule C, and the IRS properly disallowed the deductions on that form.
Though Taxpayer contended, with respect to the Pre-Existing Business, that he operated a separate business apart from Corporation. Notwithstanding that he paid the fees therefor out of Corporation’s account, he argued that he, individually, paid them because the Pre-Existing Business was not associated with Corporation.[xxiv]
The Court rejected Taxpayer’s argument, stating that he failed to establish that he operated any business other than through Corporation. As such, his payments of Corporation’s expenses constituted either a loan or a capital contribution, and were deductible, if at all, not by Taxpayer, but by Corporation.
Therefore, Taxpayer was not personally entitled to take deductions.
Additionally, Taxpayer contended that he was entitled to a deduction for the amount that he paid as bonuses to certain employees of Corporation because the payment was made for work separate and apart from that of Corporation. Taxpayer asserted that he personally, not Corporation, paid these employees and filed Forms 1099 on their behalf.
However, the clients of the Pre-Existing Business had contracted with Corporation, and the payments made in respect thereof were deposited into Corporation’s account. Taxpayer subsequently paid himself from that account. According to the Court, the fact that he did so, and personally made bonus payments to the employees for work associated with the Pre-Existing Business, was immaterial. Again, Taxpayer did not operate as a sole proprietor and, therefore, could not take deductions on a Schedule C. The payments, whether properly made or not, stemmed from Corporation’s business, that never ceased to exist, and “[b ]ecause the expenditures in issue were made on behalf of [Corporation’s] business, we conclude that [Taxpayer] may not claim these expenses as business expense deductions.”
Finally, Taxpayer argued that he entered the Agreement that carved out the Pre-Existing Business from the benefit and the liability of the newly formed corporation. As such, he argued that the work for this Pre-Existing Business was conducted as a separate business from Corporation, and he conducted that business as a sole proprietor entitling him to claim those fees as deductions on a Schedule C.
However, the Court responded, “[a] shareholder cannot convert a business expense of his corporation into a business expense of his own simply by agreeing to bear such an expense.”
“Agreements entered into between individuals may not prevail as against the provisions of the revenue laws in conflict,” the Court stated. Parties are free to contract and, when they agree to a transaction, federal law then governs the tax consequences of their agreement, whether those consequences were contemplated or not.
The Court found that Taxpayer could not establish that he was entitled to the disallowed deductions on his Schedule C – there was no clear evidence that he operated a business separate from that of Corporation.
Accordingly, the Court granted the IRS’s motion for summary judgment.
What to Do?
Taxes play a significant part in a business owner’s choice of entity decision. The selection made will result in tax consequences of which a business owner should be aware before making that decision; thus, the decision should be made only after consulting with one’s tax advisers.
It is also important that the decision be made with an understanding of the economics of the business. Among the items to be considered are the following: who will invest in the business, will the business have to borrow funds, is it expected to generate losses, will it be reinvesting its profits or distributing them?
Of course, the responses to these questions may depend upon the stage in the life of the business at which they are being considered. Likewise, the owners of the business may decide to change the form of their business entity when it makes sense to do so. In other words, the choice of entity decision should not be treated as a “make-it-and-forget-it” decision; rather, it should be viewed as one that evolves over the life of the business.[xxv]
For example, a simple evolution of a business’s form of entity may go something like this: it may start out as a sole proprietorship or partnership in order to pass through losses, it may convert to a C corporation as it becomes profitable and starts to retain earnings to fund the growth of the business,[xxvi] and it may elect S corporation status when it is ready to distribute profits or when its owners begin to consider the sale of the business.[xxvii]
What’s more, the choice of one form of entity does not necessarily preclude the concurrent use of another form for a specific purpose. Thus, for example, an S corporation that operates two lines of business may form an LLC (treated as a partnership) to serve as an investment vehicle to which it and a corporate or foreign investor[xxviii] may contribute the assets of one line of business and funds, respectively.[xxix]
However, whatever the form of entity chosen, it is imperative that the business owners respect their chosen form, lest they invite an audit. For one thing, it is certain that the IRS and the courts will hold them to their form (as the Taxpayer learned in the case described above); moreover, an audit will often entail other unexpected goodies for the IRS.
That being said, in the event the chosen form generates unexpected and adverse tax consequences, the business and its owners, in consultation with their tax advisers, may be able to mitigate them, provided they act quickly.
[i] No pressure.
[ii] Its default status in the absence of an election to be treated as an association taxable as a corporation. Reg. Sec. 301.7701-3.
[iii] Reg. Sec. 301.7701-2.
[iv] IRC Sec. 1361 and 1362.
[v] Reg. Sec. 301-7701-3; IRC Sec. 761. This includes an LLC that does not elect to be treated as an association.
[vi] For example, some owners may be issued preferred interests, or they may have special allocations of income and loss.
[vii] There is no comparable tax rule for partners.
[viii] Plus their estates and certain trusts created by these shareholders. IRC Sec. 1361(c).
[ix] The maximum federal income tax rate applicable to individuals is now set at 37 percent. If the individual partner or shareholder does not materially participate in the entity’s business, the 3.8 percent surtax on net investment income will also apply.
[x] IRC Sec. 1(h).
[xi] IRC Sec. 1411. Of course, I am assuming that the shareholder’s modified adjusted gross income exceeds the threshold amount.
[xii] P.L. 115-97 (the “Act”).
[xiii] IRC Sec. 11.
[xiv] IRC Sec. 199A.
[xv] IRC Sec. 351. Beware IRC Sec. 357(c). See Rev. Rul. 84-111.
[xvi] IRC Sec. 1362. Once the S election is revoked, the shareholders may not re-elect “S” status for five years.
It should also be noted that the conversion from “S” to “C” may require that the corporation change its accounting method from cash to accrual. This change may cause the immediate recognition of significant amounts of income. Thankfully, the Act provides for a 6-year period over which this income may be recognized by the C corporation, provided certain conditions are met. IRC Sec. 481(d).
[xvii] Although it is conceivable that a corporation may consider converting into a partnership or a disregarded entity, such a conversion, however effected, will be treated as a liquidation of the corporation, which will be taxable to both the corporation and its shareholders. Reg. Sec. 301.7701-3(g).
[xviii] Of course, I am referring to the two levels of tax attendant on the sale of C corporation. In most cases, the buyer of a closely held business will choose to structure the purchase as an acquisition of assets; not only does this allow the buyer to cherry pick the target assets to be acquired and the liabilities to be assumed, it also gives the buyer a stepped-up basis in these assets which the buyer may then expense, amortize or depreciate (depending on the asset), which enables the buyer to recover its investment faster than if it had just acquired the stock of the target corporation. Unfortunately for the target shareholders, the asset sale is taxable to the corporation and, when the remaining sale proceeds are distributed to the shareholders, those proceeds are taxable to the shareholders.
[xx] Morowitz v. United States, No 1:17-CV-00291 (D.R.I. Mar. 7, 2019).
[xxi] Interestingly, neither the IRS nor the Court raised the issue of a prohibited second class of stock. IRC Sec. 1361(b); Reg. Sec. 1.1361-1(l). If the entity had been formed as a partnership with the admission of the new owner, the Taxpayer’s initial capital account would have reflected the value operational results of the business prior to the creation of the partnership; if the entity had already been a partnership, Taxpayer’s capital account would have been similarly adjusted prior to the admission of the new partner. Reg. Sec. 1.704(b)-1(b)(2)(iv).
[xxii] IRC Sec. 7422. It is unclear why the Taxpayer chose to pay the tax and then apply for a refund, rather than file a petition with the Tax Court. The Tax Court’s jurisdiction is not dependent on the tax having been paid.
[xxiii] Summary judgment is appropriate where the pleadings, depositions, etc., show that there is no genuine issue as to any material fact and that the moving party is entitled to judgment as a matter of law. The substantive law identifies the facts that are material; only disputes over facts that might affect the outcome of the suit under the governing law will preclude the entry of summary judgment.
[xxiv] This comes under the category of “you can’t make this shit up.”
[xxv] Complete non sequitur: life insurance also falls into this category – it should be reviewed periodically.
[xxvi] The current 21 percent flat corporate rate is key.
[xxvii] Of course, a sale structured as an actual or deemed sale of assets must consider the built-in gains tax. IRC Sec. 1374.
[xxviii] Neither of which may own shares of stock in an S corporation. IRC Sec. 1361(b).
[xxix] See the partnership anti-abuse rules in Reg. Sec. 1.701-2, in which the IRS accepted an S corporation’s bona fide business use of a partnership.