To help determine whether to form as a C corporation, limited liability company (LLC) or S corporation, below are certain potential tax implications for each company type.
C Corporations
| Double Tax: | C Corporations are subject to income tax on income and gains; shareholders are alsom taxed on distributions. |
| Generally no viable tax-free exit strategy for asset transactions: | Gain is recognized on asset sales and liquidating distributions at the corporate and shareholder level, so generally there is no tax-free way to get assets out of a C corporation. |
| Net operating loss (NOL) carry over: | C corporations can carry over losses in excess of income to reduce income (and therefore tax)Under current law losses can be caried forward indefinitely for federal income tax purposes. State laws are often more restrictive Use of NOLs is limited after certain changes in ownership under Section 382 of the Internal Revenue Code of 1986, as amended. |
| Debt financing: | C corporations can deduct interest payments, subject to certain limitations. In certain circumstances, debt may be re-characterized as equity, thus causing deductible interest to be re-classified as a non-deductible dividend. |
LLCs
Generally allows for more flexibility in how allocations and distributions can be apportioned among owners.| “Flow-through” tax treatment: | Unless an election is made to the contrary, members, not the entity itself, are subject to income tax, so only one level of tax imposed on operating income and in connection with asset sales. |
| Flexibility: | Generally allows for more flexibility in how allocations and distributions can be apportioned among owners. |
| Complexity: | Overlapping layers of anti-tax shelter statutes and regulations make LLC operating agreements very dense reading and there are significant compliance hurdles. A good accounting firm is important. |
| Debt financing: | The use of debt in LLCs can add additional complexity and can result in taxable income in connection with conversions to C corporations. Cancelation of indebtedness income is taxable to the LLC members.. |
S Corporations
| Shareholder limitations: | S corporations are limited to 100 shareholders (natural persons and certain trusts) and only one class of stock. Shareholders cannot be non-resident aliens. |
| Modified Flow-through tax treatment: | No federal income tax is imposed at the corporation level for federal income tax purposes, and corporation’s income, credits, gains and losses flow through to shareholders. Not every state treats an S corporation as a flow through. Distributions of appreciated property can result in gain allocated to shareholders. |
| Shareholder’s “flow-through” loss deductions: | Shareholder loss deductions are limited to the aggregate tax basis of (i) the shareholder’s S Corp. stock and (ii) the debt of the S Corp. to shareholder. |
| No special allocations: | All income and loss is shared in proportion to stock ownership. |
| Venture capital termination: | Venture capital investment usually terminates S Corp. status because venture capital preferred stock violates rules against multiple classes of stock and VCs are disqualified shareholders. |
