If you’re a company owner that’s buying another business to operate, there are some options that you can consider when proceeding.
TYPES OF ACQUIRING ENTITIES
Normally, there are four basic types of entities that can be used to buy and operate the business of the acquired corporation:
- C Corporations;
- S Corporations;
- Partnerships – General or Limited;
- Limited Liability Company (LLC) – a hybrid entity authorized in 1988 by the IRS that offers the legal insulation of a corporation and the preferred tax treatment of a limited partnership, which all 50 states and the District of Columbia allow.
This is defined in the Internal Revenue Code as any corporation that excludes those granted special tax status under the Code such as life insurance and regulated investment companies that handle mutual funds; or corporations that qualify as real estate investment trusts – otherwise known as REITs.
This is simply a regular corporation that meets certain requirements and elects to be taxed under Subchapter S of the Code. Originally called a small business corporation, the S corporation was designed to permit small, closely-held businesses to be conducted in corporate form, while continuing to be taxed generally as if operated as a partnership or a collection of individuals. As it happens, the eligibility requirements under Subchapter S, keyed to the criterion of simplicity, impose no limitation on the actual size of the business enterprise.
Some key points to remember about having an S corporation:
- You may not have more than 75 shareholders;
- You may not have as a shareholder any person who is not an individual – other than an estate and very limited class of trust;
- You may not have a nonresident alien as a shareholder;
- You may not have more than one class of stock;
- You may not be a member of an affiliated group with other corporations;
- You may be a bank, thrift, insurance company or certain other types of business entity.
As an alternative to the S corporation, the partnership has several notable advantages.
- It’s always available without restriction on the structure or composition of the acquired corporation’s ownership; therefore, it can be used when the S corporation is unavailable for technical reasons;
- The partnership is unique in enabling the partners to receive distributions of loan proceeds free of tax;
- If the acquired corporation is expected to generate tax losses, a partnership is better suited than an S corporation to pass these losses through to the owners.
The last two advantages result from the fact that partners, unlike S corporation shareholders, may generally include liabilities of the partnership in their basis in the partnership.
Qualifying as a Partnership
It is important to emphasize that if you use a partnership for tax purposes, it must a bona fide general or limited partnership under applicable state law – except under rare circumstances.
When Acquiring as an LLC
Under most state laws, an LLC may merge with or into a stock corporation, limited partnership, business trust or another LLC. All members of one must approve the merger unless they agree otherwise. Filing of articles and the effective date operate the same as for corporate mergers.
WHAT SEPARATES ONE ENTITY FROM ANOTHER
What separates the four types of business entities from one another come down to how the earnings are taxed.
Distribution of Earnings and Taxes
A regular (C) corporation is a separate taxpaying entity, which means it’s earnings are taxed to the corporation when earned and again to its shareholders upon distribution. The three other business entities are generally not separate – S Corporations, Partnerships and LLC’s.
With partnerships and S corporations, earnings are taxed directly to the partners and/or shareholders, whether or not distributed or otherwise made available. Additionally, these two entities may generally distribute their earnings to the equity owners free of tax.
Because S corporations, partnerships and LLC’s are generally exempt from tax but pass the tax liability with respect to such earnings directly through to their owners, these entities are commonly referred to as pass-through entities.
When Income is Subjected to Corporate Tax
If practicable, a business should not have to pay a single level of corporate tax on generated income. For this reason, a pass-through entity owned by individuals should be the structure wherever possible.
Determining the Acquisition Vehicle
C Corporation – Here, the acquired business, whether bought through an asset or stock purchase, should be operated as:
- A division of the buyer or;
- Through a separate company that’s included in the buyer’s consolidated return.
Regardless, the income of the business will be subjugated to only one level of corporate tax to dividend distributions from the buyer to its shareholders.
S Corporation – When acquiring assets or stock by individuals, or the acquired business can become a freestanding domestic operating corporation owned by 75 or fewer U.S. individual shareholders. Because the S corporation requirements are designed to ensure that such entities will have relatively simple structures, they are not inherently user-friendly vehicles for larger complex operations.
Keep in mind; however, it is often possible to plan around obstacles to qualification under Subchapter S and to use the S corporation because there is no limit on the size of the business that may be in conducted with this entity.
Partnership – Like an S corporation, you would consider this when acquiring assets by individuals.
Consulting the Right Counsel
Regardless of what entity is formed for the acquisition of a company, it is always important to seek advice from an accountant or tax attorney who has a strong background in corporate structure before settling on a proper entity.