A publisher—small, medium, or large—should operate as a legal business entity for countless reasons. The most basic goal is limiting the owner’s liability for business operations to the owner’s investment in the business. After all, no one goes into business with the intent to put their house, car, and children’s college savings at risk.
Some publishing risks can be mitigated through general liability insurance and media-perils insurance, but creating a business entity such as an S corporation or an LLC serves several other purposes. Specifically, a properly constructed entity can help its owner or owners:
• raise capital
• plan for business succession
• promote retention of key employees
• control the owner’s tax liabilities
• create structuring opportunities for ownership of multiple business lines
• help the owner prepare for a sale of the business
Operating as an entity will create some additional reporting requirements, but the burden is often minimal and may have the benefit of forcing an owner to pay more attention to details.
With these considerations in mind, most if not all publishers should operate their businesses in a legal entity separate from the owner.
Choosing to operate as a separate legal entity is an easy and obvious choice. Selecting the best possible entity is harder. While some owners may choose to operate their business within some type of partnership structure or as a C corporation, for most independent publishers the best choice will be either a limited liability company (LLC) or a Subchapter S corporation (S corporation).
Here are highlights of some issues to examine when choosing between them.
As you consider the pros and cons, bear in mind that this article reflects my interpretation of general tax principles. It is not intended to provide legal analysis or conclusions for individual issues or fact patterns, and it should not be relied upon when completing tax returns of any kind.
LLCs: The Advantages
Ask around, and someone will tell you that they have a friend or family member with a limited liability company. They may not know what an LLC is, but many of your peers will assure you that the LLC is the best and only choice for your publishing operations. While this statement is overly broad, the LLC does have numerous advantages.
The LLC is an entity that is treated as a company separate from its owner for state law purposes, but for most federal purposes and in many cases for state law purposes, it achieves passthrough taxation (much as a partnership does) for its owners (who are called “members”). This means that while many LLCs file informational tax returns with the IRS, they do not pay a federal corporate-level tax. Instead, the LLC members pay tax on all LLC income (whether it is distributed or not) at the members’ individual tax rates.
For a fledgling business with only one owner, a single-member LLC offers liability protection and passthrough taxation with minimal costs for setup and administration. Filing forms and most state reporting documents is very straightforward and quick. And for federal tax purposes, the single-member LLC is treated like a sole proprietorship (i.e., an unincorporated business) and does not have to file a separate informational return. Instead, the member reports the LLC’s financial results directly on the member’s Schedule C of Form 1040.
Given the existence of single-member LLCs, there is little or no reason to operate a publishing business as a sole proprietor.
A business with two owners can have a multimember LLC that will report its taxes as a partnership (under the default rules of the Internal Revenue Code). This means that the LLC will file a separate federal informational tax return with no federal tax due and with the tax consequences passing through to the individual returns of the members.
A multimember LLC offers members countless ways to structure a business or an economic deal. For instance, if one member contributes skills, knowledge, and reputation but no cash, and a second member contributes cash, and a third member contributes valuable intellectual property, these members can divide their management rights and voting rights in a variety of ways based on each one’s bargaining position.
New members can often be added to a multimember LLC with limited tax consequences to the parties. This makes it an attractive vehicle for offering key employees equity positions with economic rights that may be different than the economic rights of the current members.
Members of an LLC may also benefit from the fact that they can move most capital into the LLC with no tax consequences and may later withdraw some appreciated capital from it with no tax consequences. This could be advantageous to a member who contributes an intangible with a low value and decides to withdraw it later when its value has appreciated greatly.
Ownership structure rules for multiple business lines or different types of owners (e.g., partnerships, trusts corporations, or nonresident aliens) are also very flexible for an LLC, and there is no limitation on the maximum number of members.
This has advantages for estate planning. Taking advantage of LLCs’ liberal structuring rules, estate planners can divide valuable business assets among family members or place certain ownership rights into trusts so that management rights and voting rights pass (often separately) to family members.
Estate planners may also develop ownership classes that allow differing economic rights and management rights to family members who will and will not participate in the business. Carefully drafted provisions may also support powerful discounts for valuation purposes for lifetime gifts and after-death transfers.
Exiting an LLC is often relatively painless. Many sales transactions, whether crafted as a sale of equity or as a sale of the underlying assets, result in one layer of tax to the members. And most states have fairly simple dissolution filing requirements for LLCs.
Potential LLC Downsides
While there are many reasons to like LLCs, they do have a few potential drawbacks. For instance, all LLC income flows through to the tax returns of the members even if all the income is plowed back into business operations and no cash distributions are made to them. Therefore, an LLC member could owe taxes on LLC income even if the member didn’t receive any cash.
Also, members who actively work in an LLC may have to treat all their LLC income as self-employment earnings, which often results in higher employment taxes; LLC members may need to file estimated tax payments for their passthrough income; and the tradeoff for flexibility in structuring rights and liabilities of members can be higher setup costs and ongoing accounting fees.
S Corporations: The Negatives
Before there were LLCs, business owners seeking passthrough taxation with liability protection looked to S corporations. An S corporation is a state-law corporation that files a special election with the Internal Revenue Service in order to be taxed as a passthrough entity for federal tax purposes. Therefore the owners (called “shareholders”) still face the risk of paying taxes on income they do not receive, just as LLC members do.
Unlike choosing to make a company an LLC, choosing to make it an S corporation involves several structural limitations. For example, the S corporation may have no more than 100 shareholders. Also, only U.S. citizens, resident aliens, and certain qualifying trusts may own shares in an S corporation, which obviously may limit investment opportunities for foreign investors or for other partnerships, LLCs, trusts, or corporations.
While LLCs allow members to have differing economic rights, all S corporation shares must have similar economic rights (although shares may distinguish between voting and nonvoting status). This requirement may limit some of the structuring options of estate planners and may force shareholders to share valuable economic rights with key employees that they might otherwise prefer to keep to themselves (for instance, shareholders might prefer making payouts to original investors before distributing dividends to all shareholders). Also, while a key employee in an LLC may receive equity positions tax free, it is more difficult to achieve this result for an employee of an S corporation.
Violations of the S corporation structuring requirements can lead to the automatic termination of the S election and potentially devastating tax consequences such as double taxation. This risk does not exist for an LLC. Therefore, S corporations may have additional documentation like buy-sell agreements that limit who may acquire stock.
S corporations have a few additional characteristics that shareholders must watch. For instance, while LLCs are often able to distribute appreciated assets to members with limited current tax consequences, S corporation shareholders must typically recognize gain on the distribution of appreciated assets to shareholders in their tax returns.
Like members of LLCs, S corporation shareholders often pay one layer of tax if the business is sold. However, the filing and wind-up provisions of an S corporation can be burdensome, time consuming, and somewhat costly. This is particularly true in states that have detailed notice procedures for potential creditors and claimants.
S Corporations: The Pluses
While LLCs have some advantages over the S corporation, the S corporation has its own benefits. For instance, while LLC members who work for the LLC are self-employed, shareholders working for an S corporation may be employees and draw a salary reportable on a W-2. This allows the S corporation to withhold and pay taxes for the employee and limits the burden of making estimated tax payments that LLC members bear.
As long as the salary is reasonable, each shareholder must still report the remaining income on an individual tax return on a passthrough basis but may avoid certain employment taxes on this remaining income. A shareholder working for the business might save several thousand dollars in employment taxes.
Further, the fact that S corporations split their earnings (after salaries) based on percentage of shares owned makes many allocation and reporting issues much simpler for S corporations and their shareholders than for LLCs and their members.
Another advantage is that case law may be more predictable for an S corporation since S corporations have been around longer. Unlike LLCs, which often rely on highly negotiated and sometimes confusing operating agreements for management and voting rights, S corporations have many operating procedures that are dictated by state statutes and that establish how and when shareholders, officers, and directors must act. This can provide some comfort to investors and lenders.
And although typical corporate formalities such as required director and shareholder meetings do add a certain hassle factor for an S corporation, these same provisions often force shareholders, directors, and officers to meet to discuss critical issues that might otherwise get pushed off.
Why to Access Expertise
While the Internet and articles like this can provide background on choice-of-entity issues, a publisher should not select an entity without first meeting with an attorney or an accountant—or both—who practice in this area. As with all things legal, there is no obvious right choice; the right one will vary based on a business owner’s specific goals and fact situation.
This is even more true if an owner is considering changing entity forms, because change can result in unexpected tax burdens. Yes, most owners will likely choose an LLC or an S corporation, but don’t make this choice alone.
Matthew B. Lake, a partner with Graydon Head & Ritchey LLP, focuses his practice on corporate structuring and tax.
|
