Are some accountants automatically organizing new business clients as limited liability companies (LLCs) without seriously analyzing all of the pros and cons of other forms of business organizations? And for existing businesses, how many accountants periodically evaluate their clients’ form of doing business in light of changing situations?

"There’s no slam dunk on which is the best choice," says Edward Mendlowitz, partner in the East Brunswick, N.J. accounting firm of Mendlowitz Weitsen LLP, CPAs, that performs engagements involving entity selection.

"We just did one involving a Swiss corporation starting an American business. We were examining their worldwide activities, looking at what kind of activities they would do in America and how they want to take the money out of America, if they make a profit. What’s the cheapest way to pay the tax?" he says.

Bruce Panock, partner and director of tax services at George R. Funaro & Co, in New York City, explains entity selection can arise for both new and existing operations. "We as tax advisors should be helping our clients use the structure that best suits their overall tax issues while not standing in the way of the operation of their business. It may be seen as a value-added service if a company is already in place, and you may help quantify the costs versus the benefits of restructuring the existing structure and whether the revised structure aids both the tax and business planning, and the development of the business enterprise. It is important that we recognize that the planning must address the difference in the top tax bracket rates for individuals versus corporations in the planning for choice of entity."

Evaluation of entity selection should be ongoing. "I’m continually looking at all of my clients and determining if they’re in the right entity, not just when they first organize, but as they continue through business," notes Emery Sheer, senior partner with Berenfeld, Spritzer, Shechter & Sheer in Miami.

Echoing this sentiment is Howard Klein, officer in the tax department of Amper, Politziner & Mattia in Edison, N.J.: "Accountants should always look at the type of entity structure your client is doing business in."

LLC Compass

Over the past few years, LLCs have become popular to the point where it’s almost a default option, like North on a compass. Barring special circumstances, LLCs will be the entity of choice for most new businesses. "We’re finding that much more people are using LLCs, for new businesses, than S corporations or partnerships. We’re finding almost no new partnerships are being started, they’re all LLCs," agrees Mendlowitz. He adds that he hasn’t seen anymore limited partnerships either except in estate planning situations.

But the fact of the matter is that there are a host of issues to be considered that may lead to the conclusion that the LLC is not the best choice. Mendlowitz explains that the LLC (or LLP in the case of professionals in some states) can be more costly than a partnership, because in some states you have to take out an advertisement, or there’s an annual fee, as in New York for LLPs, where it is equal to the minimum corporate tax.

He also notes that some states tax LLCs differently than partnerships. For example, California has a strange formula for calculating the income for an LLC that doesn’t allow certain deductions such as for cost of sales for a merchandising business. "Each state has its own rules for LLCs that are different than the rules for partnerships so that makes the selection a little harder in certain states," says Mendlowitz.

According to Panock, the benefit of LLC status depends on the client that is setting up its own enterprise. For example, some clients are from outside the U.S., "so that the use of LLCs or partnership vehicles is problematic in the sense that it could create unpleasant U.S. tax results versus the use of a C corporation for the foreign members."

He notes that an S corp, in addition to not being allowed to have corporate shareholders, is not permitted to have nonresident alien shareholders, and also points out that with partnerships and LLCs, you have to be careful about withholding tax problems when you merely allocate income to a foreign partner as compared to actually making distributions.

"You have to be conscious as to whether or not for federal purposes, the existence of a partnership interest or a membership interest in an LLC creates a U.S. operating branch which could create significant tax problems for a foreign shareholder that happens to be a corporation," adds Panock.

As to domestic entities, Panock explains that whether they be corporate or individual shareholders that are not foreigners, he has been suggesting to clients of substantial size, that they consider the LLC format. His reasoning is that state tax issues are frequently more easily addressed and minimized with an LLC in contrast to a corporate structure where combined or consolidated returns might be more difficult to use.

Panock gives the following example. If you have a corporation doing business in N.J. and that corporation forms a subsidiary, and the sub has a net loss for a tax year and the parent has a profit for the same tax year, on the federal level you would probably file a consolidated return and offset the loss company against the profit company, suggests Panock.

But for N.J. purposes, except in very unusual cases, N.J. does not permit the filing of a consolidated income tax return for corporate tax filing purposes. So to the extent you have a corporate group, you have a difficult problem in N.J. because one company will pay tax and one company will not, and that’s bad cash management.

If the N.J. corporation formed either a single-member LLC or an LLC with another partner, all of the losses of the subsidiary, now a flow-through entity, pass directly up to the parent company, he explains. There would still be separation of the two entities for liability purposes.

S Corp vs LLC

About half of new businesses are forming as LLCs and half as S corps, estimates Mendlowitz. He notes that in New Jersey, it’s cheaper to set up an LLC than an S corp. In N.Y., the S corp is cheaper because in N.Y. an LLC has to advertise and an S corp does not. He adds that a pension plan is better with an S corp than with an LLC. You have to follow the Keogh limits with an LLC which require a reduction in the earned income to account for some employment tax and the pension contribution. In an S corp, the people get a salary and a W-2 form, and it’s easier to administer.

Disadvantages of the S corp include the fact that distributions must be in proportion to ownership percentages and you can’t have two classes of distributions or two classes of stock. "In an LLC, you can switch the percentages pretty much year to year at will. It’s not as rigid and you can have different classes of profits and partners. An LLC is more flexible than an S corporation, and is far better than a regular partnership. So LLCs I feel have replaced general partnerships, but not S corps," says Mendlowitz.

In this regard, Sheer considers as an example, a beauty parlor and two unrelated owners. If they want to become an S corp, it can become difficult where the distributions are going to be unequal. With an S corp, the distributions have to be in the same percentage as the stock ownership. So you may have to equalize it through salary. In an LLC, you can give unequal distributions.

"My specialty is family-owned businesses. It’s usually an S corp or LLC because they don’t want the double level of taxation on eventual liquidation. When we get involved in transitioning to the next generation, you get involved with distributions and allocation of profits that have to be based in an S corp on stock ownership percentages, whereas in an LLC, you don’t run into those requirements. It’s easier to be in the LLC format if it meets the business needs of the client," says Klein.

"You have restrictions on who can be an owner which you don’t have with an LLC. S corps must have U.S. citizens or resident aliens which rules out a long list of potential investors or owners," says Klein. An S shareholder can’t be a C corp, an investment banker, or venture capital firm, or even foreign nationals. LLCs can, however, have any type of owner including a foreign person.

Klein also explains that in an S corp, you can only take losses to the extent of your basis, which is usually money you contribute or loan to the company or any income earned through the life of the S corp.

If the owner guarantees company debt, this would not create basis for the S corp shareholder. However, it would create basis for the member of the LLC. Therefore, the LLC owner would have a larger basis to take losses.

You can have single-member LLCs in a lot of states now. For tax purposes, there’s no partnership return. Klein suggests that if you have a building and you want to protect yourself from liability, you can contribute it to an LLC, and you now have limited liability. You can’t do this with a general or limited partnership because they require more than one partner.

There is another important aspect of LLC status. Whether LLCs are set up as a one-person entity or with many members, your allocable share of ordinary income is subject to self-employment tax if you are considered an active member. If you have an S corp, you file an S corp return, then the net income is not subject to self-employment tax.

Mendlowitz notes that you have to weigh the factors in deciding between S corp and LLC status. "A small company run by one person is different from a larger company with 18 owners some of whom are foreigners. You may have a business that takes three years to develop. Everything has to be considered," he says. While S corps are still popular, Panock says he tends to use LLCs, especially if he has single-state activities because there’s a greater level of flexibility.

Time for a Switch

If the business is ongoing, once you’re a corporation, it can be expensive to end it. A C wanting to switch to an S corp would have to deal with exposure to the built-in-gains tax for 10 years, says Mendlowitz.

He points out that if a C corporation wants to liquidate and be an LLC or an unicorporated entity, there could be taxes to be paid on the liquidation. "If you’re an S corp and liquidate, you still might have to deal with liquidating dividends especially if there are assets in the corporation that have appreciated. So I have not seen people that are corporations switch to LLCs," he says.

For an existing business, notes Sheer, sometimes there are reasons to change. One of the greatest professional liability risk areas against CPAs is not advising clients to convert from a C corp to an S corp.

If it is not done, the client has a major liquidation and has double taxation on the sale of the business, the client may ask why you didn’t recommend the conversion where there would only be one layer of taxation.

"The main point is you have to advise your client. I have some clients that I’ve recommended they switch to S corps. In situations where I see the business is gaining in value, that’s a prime reason to switch to an S corp from a C corp," says Sheer. For one reason or another, if the client doesn’t do it, Sheer notes that he always puts it in writing stating his reasons why he recommended the switch.

"There are some owners that prefer to be a C corp because they have very large health insurance costs. They want to deduct that cost but you can’t in an S corp. It would be a deductible fringe benefit in a C corp. Once you see a format isn’t working anymore for a client, the question is how do you get them moved to something that is more beneficial without triggering tax effects," says Sheer.

Layering Strategy

"For small groups, I like to use a general partnership in combination with S corporations where the S corporations are the partners of the general partnership. It gives each partner limited liability protection and flexibility within the S corp to do what he or she wants to do," suggests Sheer.

It gets unwieldy, however, if there are too many partners. Sheer notes that when you have a large group, over seven to 10 members, if the group is growing and you are continuing to add members, then it’s easier to make the partner an LLC member.

He believes this approach can resolve many partner disputes. For example, if some partners incur significant business travel and entertainment expenses and use their cars for business, while other partners don’t agree that all the entertainment or travel expenses incurred are really necessary for the business, then the general partnership can adopt a policy that each partner will be responsible for his or her own costs.

From the general partnership, each partner gets a distribution to his S corp for all his or her own business expenses and salary. This gives each partner the flexibility for auto expenses, entertainment expenses, membership to professional organizations, salary, etc., and then there’s no argument with other partners because it’s out of his or her own distribution. In the LLC, everyone has to agree on what expenses the LLC will pay for each partner.

On Guard

While scrambling to provide more and more services, accountants should remain vigilant to the more basic needs of clients including a periodic evaluation of each business client’s form of organization.