Choice of Entity Considerations – Part II
3. Limited Liability of Owners
In general, the owners of a C or an S corporation are not personally liable for the entity’s obligations. However, an owner who guarantees a debt or commits a tort while acting on behalf of the entity may lose this protection. This protection may also be lost if the corporate veil is “pierced.” This can occur if the entity either is poorly capitalized or fails to maintain a separate identity from its owners.
A limited liability company also provides its owners with limited liability.
Unlike a corporation or limited liability company, a general partnership does not afford its owners limited personal liability. The owners are personally liable for partnership debts and for the acts of fellow owners performed in furtherance of partnership business. General partners in a limited partnership have the same type of personal liability as do their counterparts in a general partnership. However, the liability of limited partners who do not manage the business is limited to the extent of their respective investment in the enterprise.
4. Taxation as Separate Entity versus Pass-Through Entity
One of the biggest factors affecting the choice of entity decision is whether the entity should be taxed as a separate entity or whether its items of income, credit, loss, and deduction should pass through and be reported by the owners on their personal tax returns. C corporations are taxed as separate entities. One disadvantage to a C corporation is that its earnings can be taxed twice—once when earned at the corporate level and again when distributed to shareholders. This double taxation often can be minimized in the context of closely held corporations, however, if the entity pays out most or all of its earnings as deductible salary (the amount must be reasonable) or rent.
S corporations, partnerships, and limited liability companies taxed as partnerships provide pass-through treatment. In general, there is no entity-level tax so the earnings are only taxed once—at the owners’ marginal rates. Unlike S corporations, partnerships permit special allocations of tax attributes provided such allocations have substantial economic effect. Such allocations can often help a business raise equity capital from outside investors while enabling the general partners to maintain control of the business.
5. Owner Compensation
An owner of a C corporation can be compensated through salary, fringe benefits, pension and profit sharing plans, and dividends. Of these types of compensation, dividends are usually the least preferred because they are subject to tax at both the entity and shareholder levels. The excess is treated as a return of capital. Salaries, to the extent they are reasonable in amount, are effectively taxed only once (as income to the owner) because they are deductible by the entity. Most types of fringe benefits and pension and profit sharing plans receive tax-favored treatment in that they can be funded with pre-tax dollars and often do not generate current income to the recipient.
Because S corporations, partnerships, and limited liability companies taxed as partnerships are pass-through entities, each owner is allocated a share of the entity’s income and other tax attributes based on the owner’s ownership interest. These items are then reported on the owner’s individual return. When an S corporation distributes property, the owner-recipient generally recognizes gain only to the extent the value of the property exceeds the owner’s stock basis. An S corporation may also compensate its owners through salary. Salary is includible in the owner’s income and is deductible by the corporation.
A partner (or LLC member) generally recognizes no gain or loss on a current distribution of property by the partnership. There is an exception with regard to the receipt of certain ordinary income assets often referred to as “hot assets.” Also, a partner receiving a cash distribution must recognize gain to the extent that the amount received exceeds his basis in his partnership interest.