Exit Considerations – Transferability of Interests
Most business owners do not have their eyes set on an exit from a business when they are just starting it. It, however, is an important consideration to be taken when forming an entity. The ability to sell and transfer your interests of an entity needs to be considered so you are not restricted in how much, who, and/or when you can sell your ownership interests.
Stock is easily transferable unless the bylaws of the corporation provide a restrictive right.
The same rules apply as for a C corporation.
NOTE: The corporate charter should provide that a transfer cannot be made to an ineligible shareholder unless agreed to by other shareholders so as to not jeopardize the S corporation status upon a transfer of ownership interests in the entity.
A membership interest consists of two classes of rights: financial rights and management rights. In order for a transferee of a membership interest to become a full member, unanimous consent is required in some states.
Normally, the transfer of an interest will require the approval of all partners and may cause termination of the old partnership and the creation of a new partnership. Limited partners may be allowed to freely assign their interests.
Tax Return Due Date Considerations
While we briefly discussed the tax consequences of owning each different type of entity, an owner should keep in mind their tax return due dates.
C corporation returns (Form 1120) are due on the 15th day of the fourth month after the close of the tax year. Until 2026, however, C corporations with a June 30th fiscal year-end will have an original due date of the 15th day of the third month after the close of the tax year, or September 15th.
For tax years before 2026, the extension for calendar-year C corporations is five months, resulting in an extended due date of September 15th. However, the maximum extension period for corporations with a June 30th fiscal year-end is seven months. For later tax years, a six-month extension to file Form 1120 is available.
S corporation returns (Form 1120S) are due on the 15th day of the third month after the close of the tax year. A six-month extension of time to file is available.
LLC returns (Form 1065) are due on the 15th day of the third month after the close of the tax year. A six-month extension of time to file is available.
Partnership returns (Form 1065) are due on the 15th day of the third month after the close of the tax year. A six-month extension of time to file is available.
Accounting Method Considerations for Choice of Entity
Generally, most owners are not aware (or maybe don’t care) of the accounting methods that are applicable to various entities formed. For the most part, entities can utilize the “cash” method of accounting (e.g. record income and expense when income or expenses are actually received or paid) versus the “accrual” method of accounting (e.g. recognize income and expense when all events have occurred to establish your legal right to receive income or be obligated to pay an expense, even though not yet received or paid). After the passage of the 2017 tax act, only entities with average gross receipts over $25 million are subjected to using the “accrual” method of accounting.
For tax years before 2018, a C corporation is restricted to the accrual method unless the average gross receipts for the previous three tax years are less than $5 million.
An S corporation is generally not restricted to the accrual method unless it is required to maintain inventory.
An LLC may be restricted to the accrual method if it has a corporate partner.
A partnership may be restricted to the accrual method if it has a corporate partner.
Considering Who is Taxed on the Income of an Entity
In addition to the normal tax attributes of the various entities discussed, it is also worth considering who will be taxed on the operations of the business for the year (e.g. the owner of the business or the business itself).
A C corporation is taxed on its income at the entity level, regardless of any distributions to shareholders.
An S corporation generally does not pay tax at the entity level (but see the built-in gain tax and tax on excess net passive income); rather, the income or loss is allocated among the shareholders, who report the income and pay the tax at the shareholder level. Losses may only be deducted by the shareholders to the extent of the shareholder’s basis in the stock and debt of the S corporation.
An LLC does not pay tax at the entity level; rather, the income or loss is allocated among the members, who report the income and pay the tax at the shareholder level. Losses may only be deducted by the partners to the extent of the shareholder’s basis in the stock and debt of the S corporation.
A partnership does not pay federal income tax at the entity level; rather, the income, gain, loss, or deduction of the partnership is allocated among its partners, who report the items and pay any corresponding tax in their separate capacity. The partners must report their share of the partnership’s income, even if the income is not distributed.