By Garrett Sutton, Esq.
If you have been considering forming a corporation or other business entity to provide yourself with limited liability and financing options in your business venture, you have made an important first step.
You may have compared the tax benefits of corporations and limited liability companies or limited partnerships. If you have done so, you likely realized that corporations are taxed twice, while limited liability companies and limited partnerships are taxed once. While a corporation’s profits are taxed once as the corporation’s income and again when the profits are distributed as dividends, a limited liability company or limited partnership’s profits flow through the entity and are only taxed once as personal income to the individual member of the limited liability company or partner in the limited partnership. This is referred to as flow-through taxation.
Based solely on the tax treatment of corporations, you may be prepared to use a limited liability company or limited partnership for your business. While limited liability companies and limited partnerships feature outstanding charging order protection, Nevada has recently extended such protection to corporations with between two and seventy-five shareholders.
Before you decide which business entity to use, there is one more option for you to consider. If you choose to use a limited liability company or a limited partnership, your business may limit its financing options. Financing for a limited liability company or a limited partnership may not be as readily available as financing for a corporation, because interests in such entities are not as transferable as interests, or shares of stock, in a corporation. An S-corporation is the alternative that provides both financing options and flow-through taxation; however, to be treated as an S-corporation, your business must do the following:
- Incorporate the Business – As with a regular corporation, referred to as a C-corporation, an S-corporation must prepare and file Articles of Incorporation with the state, prepare and operate under Bylaws, operate under a Board of Directors and corporate officers, and engage in corporate formalities.
- File an S-Corporation Election Form – To be eligible for S-corporation tax treatment, the corporation must (1) be a corporation organized in any U.S. state, (2) not be an ineligible corporation (certain types of businesses are not eligible), and (3) have only one class of stock. If eligible, the corporation may file an S-corporation election form, Form 2553, with the Internal Revenue Service within forty-five days after incorporating. While this will allow flow-through federal taxation, it is important to note that five states do not recognize S-corporations and may tax the corporation as a C-corporation. It is also important to note that S-corporations are not eligible for certain tax deductions that C-corporations may enjoy.
- Notice and Obey S-Corporation Limitations – Once the corporation has made its S-corporation election, it must notice and obey the limitations on S-corporations to maintain its flow-through tax status. If the corporation violates any of the following limitations, it will lose S-corporation status and will not be eligible for flow-through taxation for five years: (1) it must have one hundred or fewer shareholders; (2) all of its shareholders must be individuals, descendants’ estates, estates of individuals in bankruptcy, or certain trusts, because business entities may not be shareholders; and, (3) all of its shareholders must either be United States citizens or resident aliens in the United States (nonresident aliens may not be shareholders). If the corporation loses its flow-through tax status, the Internal Revenue Service will treat it as a C-corporation.
Every business is unique. Your business’s form should be based on your specific circumstances. While the limitation on the number and types of shareholders allowed in S-corporations may affect financing options, such limitations may have less practical importance than the limitations on financing options created by using a limited liability company or a limited partnership. Accordingly, S-corporations’ tax benefits, management structure and transferability of shares may provide the benefits that your business needs in an entity that also provides you with limited liability.
By considering your business’s options and choosing the best available business form, you will ensure that you take advantage of available opportunities.