April 22, 2023

MEMO TO CLIENT REGARDING CHOICE OF BUSINESS ENTITYI

understand that you would like to create a new business entity to operate your business.

This letter outlines some of the considerations bearing on 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 letter will introduce you to the issues and may

allow our discussions to proceed more quickly.

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

The Fernandes Law FirmTel 414.915.6599 50o W Silver Spring

Dr.K-200 Milwaukee, WI 53217

jpfernandes@msn.com

ToPotential Clients

FromJ.P. Fernandes, Esq.

ReStarting a Business

April 22, 2023 Pg.2

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 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 business 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.

April 22, 2023 Pg.3

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.

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

April 22, 2023 Pg.4

corporation is best made by comparing the advantages of each and deciding which

advantages are most important in your situation.

3. Advantages of LLC’s

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.

April 22, 2023 Pg.5

c. Disproportionate Allocations and Distributions. 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

April 22, 2023 Pg.6

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. 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

April 22, 2023 Pg.7

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 business, it may be required to use accrual basis

April 22, 2023 Pg.8

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 letter 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.