Tax and other Entity Choice Considerations
As indicated, tax considerations play an important role in the choice of entity decision. These present a particular challenge for law school clinics that do not have tax expertise. In such a situation, it is prudent to advise the client that the clinic’s recommendations should be double-checked with the client’s tax advisor.
It is probably enough for the general transactional clinic to understand that for-profit corporations are subject to “double taxation,” i.e., a tax on corporate profits when earned and a second tax on the profits when distributed to shareholders in the form of dividends. If the business does not expect to generate any profits over and above what is paid to the founders as compensation, this may not be much of a concern. However, if profits are expected to be generated, serious thought should be given to forming the entity as a limited liability company. Unlike a corporation, an LLC is not subject to federal income tax; instead, the income of the LLC “flows through” to the owners and is included in their own personal taxable income. Thus, use of the LLC avoids the problem of double taxation. In addition, any losses incurred by an LLC also flow through to the owners, where they may be available to reduce the tax liabilities of the owners on income from other sources, subject to several important limitations. The state income tax treatment of LLCs is generally similar to the federal income tax treatment, although some states impose entity-level taxes on LLCs. In Illinois, for example, this tax is the “personal property replacement tax.” It lessens, but does not eliminate, the tax advantage of the LLC over the corporation.
An alternative form of organization for the profitable business is the “S corporation,” so named for the subchapter of the Internal Revenue Code that governs its taxation. Although S corporations are subject to a form of flow-through taxation that generally eliminates the problem of double taxation, there are several limitations on which corporations can make Subchapter S elections. In addition, S corporations are subject to federal income tax in certain circumstances and are always subject to certain state income taxes like the Illinois personal property replacement tax referred to above. Thus, formation of an LLC is usually the more satisfactory approach. A Subchapter S election may be ideal, however, for an existing corporation that is already subject to double taxation, as discussed below.
General and limited partnerships are taxed in the same manner as LLCs. As earlier noted, general partnerships provide no liability shield for the owners, and limited partnerships provide liability protection for limited partners only, not general partners. Thus, the LLC is usually the better choice.
Another important consideration in choosing between a corporation, an S corporation, an LLC, and a partnership is the income tax implications of converting from one form of entity to another as the business matures and its situation changes. The conversion of a partnership or an LLC into a corporation is not a taxable event, except in the somewhat unusual case of an owner who has a “negative capital account” in the partnership or LLC. The conversion of a corporation into an LLC or a partnership, on the other hand, is a taxable event, for both the entity and its owners. A Subchapter S election may be particularly useful in this case. Making this election does not subject either the corporation or its owners to tax, but it allows the corporation to begin to enjoy most of the benefits of pass-through taxation.
The tax-free conversion feature of an LLC has the additional advantage of protecting the clinic from criticism from subsequent advisors who may ask the client “who ever advised you to form a corporation?”
In addition to the tax issues outlined above, the choice of entity analysis should take other considerations into account. For example, a corporation is frequently preferred over an LLC in situations where the founder’s “exit strategy” is to build up the business and then sell it, where third party capital investments are likely to be sought, and where it is contemplated that it may be necessary to grant stock options in order to attract key employees. Membership interests in an LLC can make it more difficult to achieve these objectives.