Tax Considerations for Different Types of Business Entities
Aug. 15, 2022
1. Single Level of Tax
a. Shareholders are taxed on their pro rata share (% of) ownership; losses are allocated the same way, by shareholdings.
b. Subsequent distributions to the shareholders are not again subject to income tax – special rules apply, however, to tax as dividends a portion of the distributions by an “S” corporation that was previously a “C” corporation.
c. Exceptions to the single-level of tax – these exceptions apply only if the “S” Corporation was previously a “C” corporation:
i. 10-year built-in gains tax on the appreciation in any assets at the time of the “S” election – this corporate level tax only applies upon taxable sales of the assets during the first 10 years as an “S” corporation.
ii. “S” corporations with excessive interest, dividend and other passive income that also have “C” corporation earnings and profits can be subject to a corporate level tax and possible termination of “S” corporation status.
2. Single Class of Stock Requirement
a. All stock must have the same distribution rights.
b. No liquidation preferences are permitted.
c. Differences in voting rights are permitted – voting and non voting stock are permitted.
3. Limit on Number and Type of Shareholders
a. No more than 35 shareholders.
b. The only permitted shareholders are individuals, estates, certain trusts, employee benefit plans (ESOPs) and 501(c)(3) organizations.
c. Ineligible shareholders include partnerships, corporations, LLCs and non- US resident aliens.
a. Articles of Incorporation filed with the Secretary of State.
b. Other documentation required/desirable are (i) Bylaws, (ii) Subscription Agreements, (iii) Stock Certificates, (iv) Shareholders Agreements and (v) Board of Director minutes.
c. IMPORTANT: An “S” election (IRS Form 2553) must be filed with the IRS within 75 days of the start of the tax year. DON’T MISS THIS DEADLINE.
5. “S” corporations can now own more than 80% of the stock of another corporation. If the “S” corporation owns 100% of the stock of another corporation, the subsidiary may elect to be treated as a “Qualified
Subchapter ‘S’ Subsidiary” or “QSSS.” A QSSS is ignored for federal and (in most states) state income tax purposes and, instead, treated as a division of the “S” corporation. An election to be a QSSS must be filed with the IRS, and care must be taken in making the election to avoid unexpected income tax consequences.
6. WARNING: A judgment against an “S” corporation can sometimes be collected by seizing the personal assets of the corporate officers through a legal procedure known as “piercing the corporate veil.” This can be done by the opponent showing the court, if possible, that the officers of the corporation are not properly carrying out correct corporate procedures (keeping minutes of meetings, following all bylaws, keeping proper corporate records, correctly holding annual corporate meetings and elections of officers, etc..) This situation can usually be avoided by incorporating as a “close” or “closely held” corporation, which your attorney can arrange.
B. “C” CORPORATION BASICS
1. Two levels of tax: corporation pays taxes on its income, and (a) shareholders pay tax on dividends and other distributions received from the corporation, (b) any salaried workers pay both income and SS taxes.
2. Consolidated returns are available for 80%-owned subsidiaries.
3. Before Congress passed the 2003 Bush tax cut, dividends from closely held corporations were taxed as ordinary income (with the top federal tax rate being 35%.) Now, the top rate on dividends is 15%. Therefore, owners of closely held corporations might want to consider taking some of their compensation as dividends instead of as salary. But be careful. You can’t take your entire salary, or even a large chunk of it, as dividends. It appears that the IRS is especially on the lookout for small corporations that try to use alternative forms of compensation as a way to avoid paying employment taxes. Consult with your CPA for the best current tax strategies.
4. Formation – the same as for “S” corporations, except an “S” election is not filed.
5. WARNING: A judgment against a “C” corporation can sometimes be collected by seizing the personal assets of the corporate officers through a legal procedure known as “piercing the corporate veil.” This can be done by the opponent showing the court, if possible, that the officers of the corporation are not properly carrying out correct corporate procedures (keeping minutes of meetings, following all bylaws, keeping proper corporate records, correctly holding annual corporate meetings and elections of officers, etc..) This situation can usually be avoided by incorporating as a “close” or “closely held” corporation, which your attorney can arrange.
C. PARTNERSHIP BASICS
1. Entities treated as a partnership for income tax purposes include:
a. Limited Liability Company (“LLC”) with more than one member – limited liability for all members.
b. General Partnership/Joint Venture (“GP”) – unlimited liability for all partners. Also, you are100% legally bound by any contracts, agreements, or indebtedness which any of your partners may agree to, with or without your agreement, approval, or knowledge.
c. Limited Partnership (“LP”) – unlimited liability for the general partner(s) but limited liability for the limited partner(s).
d. Limited Liability Partnership (“LLP”) – a form of GP that provides some liability protection to the general partners.
e. Limited Liability Limited Partnership (“LLLP”) – a form of LP that provides some liability protection to the general partners.2. A single level of tax – partners (or members, in the case of LLCs) are taxed on their allocable share of the entity’s income.
2. Federal taxation of multiple-member LLCs – If an LLC has two or more members, it may choose to be taxed either as a partnership (“flow-through,” each member reporting their respective share of income on their 1040) or as a corporation. Unless the LLC specifically elects to be taxed as a corporation, it will automatically be taxed by the IRS as if it were a partnership. Which choice is best for your situation should be discussed with your CPA, who is familiar with your tax situation and goals.
3. State taxation of multiple-member LLCs – Only Texas taxes LLCs as a corporation. All other states either always tax LLCs as a partnership, or follow the federal “check the box” regulations.
a. LLCs, LP, and LLPs require filings with the Secretary of State, while GPs require no filing to be created.
b. An operating (for LLCs) or partnership agreement is needed to set forth the agreement among the owners concerning management, distributions, allocations, transferability of interests, and other matters concerning the entity.
D. SINGLE-MEMBER LLC BASICS
1. For federal income tax purposes, the single member is treated as engaging directly in the activities of the LLC and reports all income/loss on the member’s tax return.
2. For tax purposes, the IRS does not regard a single-member LLC as an entity separate from its owner. Hence, if the sole member of an LLC is an individual, the LLC is treated as a sole proprietorship for tax purposes- i.e., it cannot be taxed separately from the owner; its income is taxed at individual rates, reported on a Schedule “C” attached to the owner’s 1040. If the sole member is a corporation or another LLC, then the LLC is treated as a division or branch of the owning corporation or LLC for tax purposes.
3. Nearly every state follows the federal income tax treatment of single member LLCs for state income taxes.
a. LLCs require filing with the Secretary of State.
b. An operating agreement is needed to spell out management, distributions, allocations, transferability of interests, and other matters concerning the entity.
II. INHERITANCE TAX CONSIDERATIONS
“S” or “C” corporation stocks, or LLC membership interests, are only subject to inheritance tax when the person owning them passes away; none of the stock or interests held by other owners are subject to inheritance tax as a result of the other owners’ death. For example, a parent could form an LLC with three children, and arrange for each of them to have a 30% ownership interest, retaining 10% and full control under an “All-Powerful Manager for Life” operating agreement. Even if the LLC is worth many millions, the 90% of that value owned by the sons would be totally free from estate tax upon the death of the parent. The same could be done with stock ownership in an “S” or “C” corporation.
III. COMPARISON OF ENTITY CHOICES
A. CORPORATION (“S” OR “C”) VS. PARTNERSHIP
1. Contributions of Appreciated Property
a. To avoid gain recognition on a contribution of appreciated property to a corporation, the contributing shareholders must own 80% or more of the corporation. No such rule applies to a partnership – a contributing partner could own 5% (or less) of the partnership and still avoid gain recognition.
b. Pursuant to IRC §704(c), however, a partner contributing appreciated property ultimately pays tax on 100% of the appreciation (either over time or when the property is sold by the partnership). With an “S” corporation, the burden of appreciation is shared by the shareholders pro rata when the property is sold. With a “C” corporation, the corporation pays the tax when the property is sold.
2. Exit Strategies – Distribution of Appreciated Property and Tax-Free Reorganizations
a. Subject to certain limitations, partnerships can distribute appreciated property to partners tax free, while a distribution of such property by a corporation (“S” or “C”) is a taxable event.
b. Corporations (“S” or “C”) can participate in tax free reorganizations, with their shareholders receiving stock of another corporation (e.g. a public company) as nontaxable consideration – not so for a partnership.
3. Equity Ownership by Employees
a. The special tax rules governing incentive stock options, employee stock purchase plans and ESOPs only apply to corporations.
b. The exercise of an option to acquire an interest in a partnership is always a taxable event to the optionee and can result in complicated tax considerations for the partnership and the other partners.
c. Special equity interests in a partnership which only share in any future increases in the value of the partnership can be crafted and avoid current income recognition by the employee receiving such an interest – these interests are called “profits interests.”
B. PASSTHROUGH ENTITY (“S” CORPORATION, PARTNERSHIP, OR TWO OR MORE MEMBER LLC) VS. “C” CORPORATION
1. Two levels of tax vs. one level of tax (people with passthrough entities pay taxes once; with a “C” Corporation, you pay taxes at the corporate level, then pay taxes on your individual 1040.)
2. What if all income will be reinvested in the business?
a. If the owners are individuals, the income of the flow through entity is taxed at the individuals’ tax rates of up to 39.5%.
b. The highest rate for a “C” corporation, however, is 34% (for income up to $10,000,000). This 5.5% differential is $55,000 per million dollars of income – this savings could be significant, particularly if the “exit strategy” involves an IPO, a stock sale or a reorganization (where the “single level” of tax for a flow through entity is not a benefit) and not an asset sale.
3. Losses flow through to the owners of a passthrough entity – but can the owners use them? (The passive loss and at risk rules, as well as certain “basis” requirements, limit the owner’s ability to currently use passthrough losses to offset other income.)
4. Certain employee benefits, such as cafeteria plans, can only be provided on a tax-favorable basis to employee-shareholders of a “C” corporation – they cannot be provided to partners or employee- shareholders of an “S” corporation.
C. PARTNERSHIP VS. “S” CORPORATION
1. Flexibility (in owners and ownership interests)
a. Anyone can own an interest in a partnership without jeopardizing the flowthrough tax treatment.
b. Partnerships can have complicated/flexible economic sharing arrangements.
2. Basis for Debt –
a. Basis is important for both partnerships and “S” corporations:
i. losses can only be used to the extent of the owner’s tax basis in the ownership interest.
ii. distributions are not taxable to the extent they do not exceed the owner’s tax basis in the ownership interest.
b. A partner can include debt of the partnership in basis – a shareholder of an “S” corporation cannot – another reason why real estate investments should rarely be done through an “S” corporation.
3. Purchase of Interests
a. Through a Section 754 election, the purchaser of a partnership interest can increase his/her allocable share of depreciation/amortization deductions for partnership property which has increased in value.
b. No such “step-up” in depreciation is available to the purchaser of stock of an “S” corporation.
4. Self Employment Taxes.
a. If a partner is actively involved in managing the business of a partnership, and the partnership generates income subject to the self-employment tax (that is, income other than rents, royalties, dividends or interest) the partner’s allocable share of all such income is subject to self-employment taxes.
b. A shareholder’s share of the income of an “S” corporation is not subject to self- employment taxes. If the shareholder works in the business, however, a “reasonable” salary (subject to all employment taxes) should be paid or the IRS will impute one. But any “S” corporation earnings in excess of such a “reasonable salary” will avoid any employment taxes.
D. “S” CORPORATION VS. “C” CORPORATION
1. IRC § 1202 permits the exclusion of 50% of the gain from the sale of “qualified small business stock” (or “QSBS”) held for more than five years, and IRC § 1045 permits a rollover of gain from the sale of QSBS held for at least 6 months to the extent the proceeds are reinvested in other QSBS within 60 days of the sale.
2. QSBS is stock of a “C” corporation which is acquired from the corporation if:
a. the corporation is engaged in an “active business”
b. the corporation’s aggregate gross assets (by tax basis) did not exceed $50 million at the time the stock was issued or any time after August 10, 1993; and
c. numerous technical requirements are satisfied.
E. PARTNERSHIP (GP OR LLC) VS. “C” CORPORATION
1. A partnership cannot be publicly traded 2. Foreign owners
a. Sale of stock of a “C” corporation by a non-resident US person is not subject to any US income tax (absent FIRPTA for real estate companies).
b. A partner can be deemed to be engaged in the partnership’s business and must file and pay US income taxes – foreigners generally seek to avoid being engaged in a US trade or business.
3. An LLC (which is treated as a partnership for tax purposes by the IRS unless the LLC elects otherwise) is simpler to operate and file tax returns for than a “C” corporation.
F. SINGLE MEMBER LLC VS. “S” CORPORATION
1. All income of the LLC is subject to self-employment taxes where the business generates income subject to self-employment taxes and the owner is actively involved.
2. Income of an “S” corporation is not subject to self-employment taxes – as discussed above, however, a reasonable salary (subject to employment taxes) should be paid to a shareholder who works in the business.
3. A single member LLC is simpler to operate and file tax returns for than an “S” Corporation.
4. A single member LLC may not elect to be taxed as a corporation, as an LLC with two or more
members may; the IRS requires that a single-member LLC be taxed as a sole proprietorship, usually on a Schedule “C” attached to the owner’s 1040. ______________________________________________________________
NOTICE: This information is of a general nature for informational purposes only, and may be altered or superseded by specific factors, circumstances, or conditions unique to your particular situation. Hence, it is not to be considered as or relied upon as legal advice. Also, tax laws, policies, and interpretations change frequently, hence the information may not be up to date, despite our best efforts. We recommend you obtain advice from both your C.P.A. and your attorney before making any final decision based on any information herein.