You have three basic choices when selecting the tax structure of a start-up business: C corporation, S corporation or an entity taxed as a partnership.
“Don’t be a C corporation unless you absolutely have to,” says John Ransom, a partner and head of the Corporate Practice Group and Tax Section at Porter & Hedges, LLP. “To maximize your after-tax value, you need to be a flow-through entity.”
Smart Business spoke with Ransom about the all-important tax issues that affect the choice of entity.
What is the process for selecting your new business entity?
The first thing I ask is, ‘What’s your exit strategy?’ This will in large part drive your choice of entity for tax purposes. Becoming a corporation is a one-way street; its easy to get in but getting out can be very expensive. Think about your exit strategy when you start a business, because the choices you make today are very difficult to reverse or have a high price tag if you change course in the future.
Knowing your exit strategy will likely drive you to an entity that is a flow-through for federal tax purposes, such as an S corporation or an entity that is taxed as a partnership, which generally includes a limited liability company (LLC), limited partnership (LP) and limited liability partnership (LLP).
Why not a C corporation?
A lot of small businesses default to a C corporation because there is a reduced tax rate on the first $100,000 or so of taxable income, some other ancillary tax benefits, and it’s easy.
For a C corporation, the entity pays a tax on its earnings and the shareholders are also taxed when they receive a distribution. This is a terrible choice when you get ready to sell the business. In addition to the double layer of tax, you leave a huge amount of value on the table because you cannot effectively deliver certain tax attributes to the buyer, mainly a step-up in tax basis of the assets of the business.
What are the advantages of choosing a flow-through entity?
In the sale of a flow-through entity you can deliver future tax benefits to a buyer with little or no increased tax cost to you, the seller. Specifically, you can provide the buyer an increased cost basis in the underlying assets of the business equal to the premium paid. This generates higher future tax deductions for the buyer which provides it future tax savings which means the buyer can pay more for your business. This feature is one of the things that fuels the success of master limited partnerships.
For example, if a buyer is looking at the purchase of stock of two identical companies, one a C corporation and one an S corporation, a deemed sale of the assets of an S corporation will yield more tax benefits to the buyer in the future, so the buyer is willing to pay more for the stock of the S corporation than for that of the C corporation. The net present value of the tax benefit to the buyer can exceed 20 percent of the premium paid, which can be a big number.
A seller may have slightly higher taxes in this situation due to depreciation recapture and the like, but I typically find that buyers are willing to compensate sellers for such incremental taxes as the future tax benefit to the buyer is so substantial.
What’s the difference between S corporations and partnerships?
S corporations work fine in certain simple situations, but they have limitations on the classes of stock and types of shareholders you can have. They are not very flexible, but they’re easy to understand. For a real simple deal where there are no back-in or carried interests, where all the owners are U.S. citizens and individuals and they don’t ever expect to have any kind of investment by funds, an S corporation works well.
Partnerships are much more flexible, but they are often more complicated and harder to understand. If you think you may have some kind of funds or other types of entities investing in you, or you want to have back-in interests for certain people, you probably want to use an LLC or LP.
Partnerships can also provide significant tax benefits to a buyer of a partial interest in the business, where at least eighty percent of an S corporation must be purchased to generate the tax basis step-up benefits discussed above. Also, a partnership can provide similar tax benefits if an owner or his or her spouse dies. If you think you might sell to a master limited partnership, you almost certainly need to be an LLC or LP.
What’s the different between LLCs and LPs?
An LLC operates similar to a corporation with corporate authority and management control centered in a board of managers. In LPs, the general partner who typically owns a pretty small interest has most of the management authority. The limited partners have a financial and economic stake but not much management say-so.
If it’s a deal where all the investors can participate proportionally in management choices and decisions, an LLC works great. If you have a situation where you want to focus management in a single person or a small group, an LP works well.
JOHN RANSOM is a partner and head of the Corporate Practice Group and Tax Section at Porter & Hedges LLP, Houston. Reach him at (713) 226-6696 or firstname.lastname@example.org.