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 [email protected].