Seeing the future isn’t always easy, but one doesn’t have to be clairvoyant to make smart decisions early in a company’s life. Making the right decisions early can save time, money, and some serious headaches. Decisions like “should I be an LLC or a Corporation” can seem like they aren’t all that important early on, but the consequences of not thinking ahead and making the wrong decision can be costly.
Here’s an example. Two individuals chose S-Corporation status for their start-up company. The individual with the technological know-how received 80% of the S-Corporation’s stock while contributing no capital. The other individual received the remaining 20% of the company’s stock and funded the company in the very early stages by contributing 100% of the capital. Like many start-up companies in the first two years, they operated at a loss. In the third year, an event occurred that required them to change their entity structure to a C-Corporation (they received venture capital).
For tax purposes, the income and losses of an S-Corporation pass through to the owners based on their share of the company’s stock. So in this case 80% of the losses went to the individual who had contributed no capital. However, shareholders cannot deduct losses that are passed through to them from the S-Corporation until they have created basis in the S-Corporation. Methods of creating basis include contributing capital, leaving prior earnings in the company, and personally assuming the debt of the company (also note that losses passed through will decrease basis). Additionally, when an S-Corporation converts to a C-Corporation, any losses that have not been taken by the shareholders are lost (some exceptions apply). To put it in perspective, if the company had losses of $100,000 in each of its first two years, then the 80% owner would have had $160,000 in losses that could not be deducted (due to a lack of basis) and those losses would be lost when the company converted to a C-Corporation. On the other hand, the 20% owner who had funded the company during the early stages with a cash contribution of $200,000 to keep the company operating was allocated $40,000 of those losses, which were deductible because the individual had basis.
As the saying goes, hindsight is 20/20. The better choice would have been to create an LLC, not an S-Corporation. This is because an LLC has tremendous flexibility. An LLC is taxed as a Partnership by default and it provides the flexibility to allocate income and losses in any manner deemed appropriate by the owners. If the situation above occurred in an LLC, the owners could have chosen to allocate 100% of the losses to the owner that had been contributing cash to keep the business operating. That owner contributed $200,000 and would have been allocated the entire $200,000 of losses and would have had sufficient basis to deduct those losses. Assuming a tax rate of 35%, that is a $70,000 savings. Additionally, being an LLC isn’t permanent; one can always convert to an S or a C-Corporation later. The bottom line is that an LLC provides more flexibility to allocate income and losses and to change to other forms of taxable entities if it turns out to be more beneficial later on.
This information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice. Any tax advice contained in this communication is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Please contact our office (603-627-3838) for more information on this subject and how it pertains to your specific tax or financial situation. Howe, Riley & Howe, PLLC would be happy to answer your tax and financial questions regarding these issues or other matters that may be of interest to you or your business.