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THE FERNANDES LAW FIRM

MEMO TO CLIENT REGARDING CHOICE OF BUSINESS ENTITY

I understand that you would like to create a new business entity to operate your business.
This document outlines some of the considerations relevant to the decision about what type of
entity to use. Although we will need to discuss these considerations in more detail before you
select a form of entity, this Memo will introduce you to the issues as well as facilitate our
discussions and proceed more efficiently.

1. Alternatives Available

There are a number of forms of business entity available—sole proprietorships, general


partnerships, limited partnerships, limited liability companies, S corporations and C corporations.
Although there are businesses in existence that use all of these forms, almost all new small
businesses today choose to be organized as sole proprietorships, LLCs, or S corporations. These
three forms are the most popular because they have features that are advantageous to start-up
businesses and lack features that can be disadvantageous to such businesses.

a. Sole Proprietorship

Sole proprietorships are businesses owned by one individual that have not adopted another
form of business entity. No formalities or filings are required to create or operate a sole
proprietorship, so using a sole proprietorship to run a business is simple and inexpensive. Since
many start-up businesses operate on a shoestring and have concerns about future viability, saving
organizational and operating costs is attractive.

The tax treatment of a sole proprietorship is also attractive. The profit or loss of the
business is reported on the owner’s individual tax return, so if the business incurs losses in its
formative years, the owner will be in a position to offset these losses against other income.

Sole proprietorships, however, have two disadvantages. The first is that a sole
proprietorship is available only if a business has one owner. If there are two or more owners,
another form of business must be used. The second disadvantage is that the owner of a business
organized as a sole proprietorship is personally responsible for all of the debts and liabilities of the
business. If the business fails or if a customer or other person is injured by the operations or
products of the business, the personal assets of the owner, including his or her personal bank
accounts and investments, are at risk for payment of the resulting claims.

b. Limited Liability Company

Limited liability companies avoid both of the disadvantages of sole proprietorships. An


LLC is an entity that is separate from its owners, so ownership of a business operated by an LLC
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can be divided between two or more owners, or an LLC can be owned by a one person. As a
separate entity, the LLC, rather than its owners, is responsible for the debts and liabilities arising
out of its business. If the business fails or if claims are made against the businesses that exceed its
assets, the members may lose their investment in the LLC, but their personal assets are generally
not at risk.

An LLC also provides the same favorable income tax treatment as a sole proprietorship.
All income or loss of an LLC passes through the entity and is reported on the members’ individual
income tax returns. If an LLC’s business incurs losses in its formative years, its members are in a
position to offset these losses against other income.

The primary disadvantage of an LLC as compared to a sole proprietorship is that an LLC


is more difficult and expensive to create. An LLC is created by filing articles of organization with
a state, and annual reports must be filed to keep the LLC in existence. There are fees, and
sometimes taxes, payable when an LLC is created and when it files its annual reports. These fees
and taxes vary considerably from state to state, so we will need to talk about where your business
will be operating before I can advise you about what to expect in this regard.

c. Subchapter S Corporation

The advantages and disadvantages of an S corporation as compared to a sole proprietorship


are similar to those of an LLC. Both S corporations and LLCs can have one or more owners, and
both are treated as separate entities responsible for their own debts and liabilities, so owners enjoy
limited liability. An S corporation is also more difficult and expensive to create and maintain than
a sole proprietorship. But the process used to create and the processes necessary to maintain an S
corporation are similar to those of an LLC. The costs of creation and maintenance are comparable
for both types of entities.

Like a sole proprietorship and an LLC, the income tax attributes of an S corporation pass
through to its owners and are reported on their individual income tax returns. There are, however,
some differences in the tax treatment S corporations and LLCs. These differences are discussed
below.

d. C Corporation

Before turning to the differences between S corporations and LLCs, a word should be said
about C corporations. C corporations also provide limited liability for their owners and are
comparable to LLCs and S corporations in terms of their costs of creation and maintenance. The
big disadvantage of C corporations for small businesses, and particularly small businesses in the
start-up phase, is that the income or loss of a C corporation is taxable to the corporation and does
not pass through to shareholders. As a result, shareholders cannot use a C corporation’s start-up
or other losses to apply against income received by the shareholders from sources other than the
corporation.
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2. Selecting a Form of Entity

A sole proprietorship will be a viable alternative for operating your business if you will be
the only owner and the business is not a type that involves significant risks of liability to third
parties. This form of entity may also be appropriate if you feel you can adequately insure against
what liability exposure there is or are willing to accept the personal liability exposure in order to
avoid the organizational and operational costs of another form of business entity.

If a sole proprietorship is not a viable alternative, you will need to decide between an LLC
and an S corporation. Both forms of business entity share some common attributes, but there are
important differences, and these differences may make one form of entity or the other a better
choice for your business. The choice between an LLC and an S corporation is best made by
comparing the advantages of each and deciding which advantages are most important in your
situation.

3. Advantages of LLCs

a. Transparent Income Tax Treatment

Although both LLCs and S corporations feature pass-through tax treatment, an LLC is
more transparent for tax purposes than an S corporation. For example, property can generally be
transferred tax-free by a member to an LLC, and property can generally be withdrawn from an
LLC tax-free by a member. In the case of an S corporation, property can generally be transferred
tax-free to the corporation at the time of its organization, but later transfers may result in the
recognition of gain unless they are made by a shareholder who owns 80% or more of the stock of
the S corporation. In addition, the withdrawal of property from an S corporation by a shareholder
will generally be a taxable event. Their lack of transparency for tax purposes makes S corporations
particularly unsuitable for the ownership of investment real estate or other property that is likely
to appreciate in value. Once such property is transferred to an S corporation, it may be difficult to
restructure the ownership of the property without incurring a tax.

b. Inclusion of LLC Debt in Basis

The amount of losses of an LLC or S corporation that can be deducted by an owner in any
given year cannot exceed the owner’s tax basis in his or her interest in the business. The amount
of an LLC’s indebtedness to banks or other third parties is considered in computing the tax basis
of its members, whereas this indebtedness is not included in the tax basis of an S corporation’s
shareholders even if they have personally guaranteed the indebtedness. Since many businesses
incur losses in their early years, the ability of owners to use a greater amount of these losses makes
an LLC more attractive than an S corporation, particularly if owners are in high tax brackets.

c. Disproportionate Allocations and Distributions


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Owners of a business sometimes have differing tax or cash needs, and an LLC provides
more flexibility than an S corporation in addressing these needs. An LLC can, for example, attract
investor owners by offering interests that have the attributes of preferred stock. Investors can be
given a right to a minimum rate of return on their investment (as long as profits are adequate for
its payment) and also a preferential right to both current and liquidating distributions. An S
corporation can issue only one class of stock, so it cannot issue common stock to working
shareholders and preferred stock to investing shareholders.

If some owners of a business are in higher income tax brackets than others, an LLC can in
some cases use special allocations to allocate a disproportionate share of its losses to these owners,
thus minimizing the taxes of its owners as a group. Special allocations cannot be made by S
corporations.

d. No Limits on Owners

Not only can an LLC facilitate the varying needs of its members, it can also have more
owners and more diverse owners than an S corporation. An S corporation cannot have more than
100 shareholders, and all shareholders must be individuals who are citizens or residents of the
United States, estates, or certain types of trusts. Corporations, partnerships and LLCs cannot own
stock in an S corporation. These restrictions can limit the ability of an S corporation to bring in
outside investors and can limit the ability of S corporation shareholders to transfer their stock to
family members during life or upon death.

There are no such restrictions on the persons who may be members of an LLC. An LLC
may have one, or any other number, of members, and there are no restrictions on the types of
individuals or entities that can be LLC members.

e. Flexible Management Structure

An LLC provides greater flexibility in management structure than an S corporation. An


LLC can be organized as a member managed entity, in which case it is managed like a partnership,
with each member having a vote on all management decisions and the ability to act for the LLC
without the need for board of director approval. An LLC can also be organized as a manager
managed entity, in which case one or more individuals have all the management powers, and other
members have no right to participate in management.

Since an S corporation is like any other corporation for state law purposes, it must be
managed like a corporation. This means that the shareholders must elect directors who are
responsible for the management of the corporation, and the directors must appoint officers who
execute their management directions. The corporate form of management is familiar to many
people, but some find it rigid, particularly in the context of a small business with a limited number
of shareholders who may prefer to operate the business more like a partnership. The corporate
form may also be cumbersome in a situation where one or more of the owners of a business will
be primarily responsible for its management and other owners will be mere investors.

f. Securities Law Exemption


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For securities law purposes, stock of a corporation, including an S corporation, is always


considered to be a security. Accordingly, transfers of stock of S corporations must be made in
compliance with applicable federal and state securities laws, which often require registration of
securities offerings unless an exemption is available. Interests of members in LLCs that are
managed by managers are also considered to be securities. But the interests of members in member
managed LLCs can avoid securities classification in some cases, which allows the transfer of these
interests without registration.

4. Advantages of S Corporations

a. Employment Tax Treatment

S corporations are treated more favorably than LLCs for employment tax purposes. This
is an important consideration that can be controlling in the decision of many businesses about
whether to operate as an LLC or S corporation.

If all members of an LLC are individuals and participate in management of the LLC’s
business, all of the LLC’s income is subject to self-employment tax. What’s more, the income is
subject to self-employment tax in the year the LLC earns it even if the income is not distributed to
members but is retained by the LLC to provide working capital or to acquire capital assets. Only
certain limited types of LLC income, such as capital gains and rentals from real property, are
exempt from self-employment tax. If an LLC is organized as a manger managed entity and has
members who do not participate in management, income allocated to members who do not
participate in management may also be exempt from self-employment tax.

In comparison, income of an S corporation is never subject to self-employment tax in the


hands of its shareholders. Wages and salaries paid by S corporations to their shareholders are,
however, subject to employment taxes in the same manner as compensation paid by to any other
employee. The combined rate of employment taxes imposed on the employer and employee is the
same as the rate of the self-employment tax, so the difference in tax systems does not create any
savings. But what does create a savings is that employment taxes are only imposed on amounts
paid out by an S corporation as compensation. Income of an S corporation that is retained by the
business or is paid out as dividends is not subject to employment tax.

Self-employment tax is not a nickel and dime issue. The tax is imposed at a rate of 15.3%
on self-employment income of up to $90,000 received by an individual in 2005, and is imposed at
the rate of 2.9% on self-employment income in excess of that amount. Although one-half of an
individual’s self-employment tax is deductible for income tax purposes, the imposition of self-
employment tax as well as income tax on LLC income allocated to a member can significantly
increase the rate of tax on the income.

b. Cash Basis Accounting

If a business has owners who do not participate in the operation and management of the
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business, it may be required to use accrual basis accounting if it is organized as an LLC, even if it
does not have inventories or does not have a member that is a C corporation. This is the result of
tax rules designed to prevent certain syndications from using cash accounting. These rules
generally do not apply to S corporations.

c. Familiar Management Structure

Most states base their corporate laws on model legislation that has been widely adopted or
base their corporate laws on long-standing concepts recognized in other states. As a result, there
is a large body of law relating to the management and operations of S corporations, and this may
reduce the number of potential areas for conflict between shareholders, directors and officers.

In contrast, the LLC laws of many states differ significantly from those of other states, and
all LLC statutes are of relatively recent origin. Consequently, there may be more questions about
the proper way to operate or manage an LLC.

5. Choosing Between an LLC and S Corporation

Neither an LLC nor an S corporation is the best choice for all businesses—both have
advantages and disadvantages. The form of entity that is appropriate for your business will depend
upon which of these advantages is most important to you. For example, if you plan to seek outside
investors who may have differing tax and cash needs, or if your business will pay out most of its
income currently to the owners, you may want to select an LLC. On the other hand, if you do not
expect to bring in outside investors and have a business that will retain substantial income for
working capital or other purposes, the employment tax advantages of an S corporation may make
that form of entity the logical choice.

I hope that this Memo will assist you in getting started on the process of making the
decision about the form of entity that is most appropriate for your business. This Memo is for
information purposes and not legal advice.