There are various types of entities through which businesses operate. These generally consist of corporations, general and limited partnerships, and LLCs. Each type of entity has its own specific operating structure as imposed by state law and provides varying degree of protection to their owners.
For example, in a general partnership, two or more persons are conducting an activity with the motive of generating a profit. In a general partnership, each partner has unlimited liability for the debts of the partnership. Thus, if the general partnership obtains financing to run its business, then its partners are ultimately liable for the repayment of said loan.
Alternatively, a limited partnership can be formed. A limited partnership is similar to that of a general partnership whereby two or more persons are conducting an activity with a profit motive. However, unlike a general partnership, some of the partners are afforded what is known as “limited liability” for the debts and obligations of the partnership. These partners, better known as limited partners, are only liable for the debts of the partnership up to the amount invested in the said partnership.
In continuing with this example, even though both types of partnerships offer varying levels of protection, they are taxed the same for federal tax purposes. Both a general partnership and limited partnership as formed under state law are by default treated as a partnership for tax purposes. An entity formed under state law does not necessarily mean that it will be treated the same as under tax law—these are separate concepts that must be analyzed independently.
In moving on from the differences in state legal liability treatment versus federal tax treatment, there are four general entity types recognized for tax purposes. These consist of the following:
- C Corporation
- S Corporation
- Disregarded Entity
Each of these tax entities is subject to its own set of rules and regulations as to how taxable income is ultimately calculated. Some entities are more advantageous than others depending on the business operating structure and ultimate goals.
Each one of these entities is discussed in turn below.
To put it simply, a C corporation is treated as a separate and distinct entity from its owners. It must calculate its own income and loss and is obligated to pay tax on its own income. No income earned by the C corporation is reportable by its owners unless it makes a distribution to them in the form of a dividend.
The taxable income of a C corporation is subject to a flat 21% rate. Taxable income of a C corporation is calculated similarly to that of an individual (gross income minus allowable deductions), but is subject to its own set of restrictions and exceptions.
While the 21% federal rate is lower than the top marginal rate of an individual (currently at 37%), this is somewhat of a misnomer. Once the income of a C corporation is subject to tax at 21%, and thereafter distributed to its owners in the form of a dividend, its owners must pay tax on said income again. Thus, income of a C corporation is subject to two layers of tax when ultimately returned to its owners. This dual layer of taxation is inefficient method of taxation on income earned by a partnership or an S corporation which is taxed as “flow through” manner (see discussion below).
For example, assume Corporation A earns $100 of taxable income in a given year. The tax due will be equal to $21. The after tax dollars Corporation A holds is now $79 ($100 in taxable income minus the $21 dollars in tax paid). Corporation A there after pays its remaining income of $79 in the form of a dividend to Shareholder S. Assuming that all $79 are subject to the individual top marginal rate of 37%, Shareholder S will have to pay $29.23 in tax to the federal government. If looking at the total income of $100 and the total tax paid of $50.23, the effective tax rate on the income earned is now ~50%–much higher than the supposed 21% corporate tax rate.
With respect to contributions to a corporation, it is easy to contribute assets to a C corporation without incurring tax so long as certain requirements are met. This is better known as an “351 Transaction”, the name of which is based upon Internal Revenue Code Section 351. If the person or group of persons contributing assets (cash or property) to a C corporation own at least 80% of the corporation’s stock immediately after the transaction, no gain or loss is recognized on the contribution.
For example, lets say Bill and Dan decide to form a C corporation, named BD. Bill contributes $100 of cash and Dan contributes a parcel of land he purchased a number of years ago for $50 that is now worth $100. If Bill and Dan are given at least 80% ownership of BD upon the contribution of their assets, no gain or loss is recognized by either on their contribution. However, if Bill and Dan own less than 805 of the corporation combined after their contribution, Dan will be required to recognize $50 of taxable gain on the contribution ($100 fair market value minus $50 of cost basis in the land contributed).
While assets contributed to a C corporation can be tax free, pulling the assets back out of the corporation is not afforded the same favorable tax treatment. If a distribution out of a corporation is not a redemption or other liquidation of a shareholders stock holdings, it is generally treated as a dividend. Distributions of a corporation’s property or cash to a shareholder is treated as a taxable dividends to the shareholder to the extent the corporation has positive current and/or accumulated earnings and profits. If a distribution is greater than the corporation’s current and/or accumulated earnings and profits, then the distribution is treated as a non-taxable return of capital to the extent the receiving shareholder has tax basis in their corporate stock. Finally, if a distribution is in excess of a corporation’s current and/or accumulated earnings and profits and a shareholder’s tax basis in their corporate holdings, then the excess is treated as a capital gain to the shareholder.
The tax consequences of a redemption or liquidation distribution to a shareholder is different than that of a dividend type distribution. The redemption or partial liquidation of a shareholder’s stock is treated as a normal taxable sale or exchange. For example, let’s assume Shareholder A holds 100 shares of Corporation B, of which they have a tax basis equal to $100. Corporation B decides to redeem half of Shareholder’s A stock in order to buy back some of his shares. In redemption of its stock, Corporation B distributes $100 to Shareholder A. In this case, Shareholder A will recognize $50 of gain–$100 of cash received minus Shareholder A’s $50 basis in half of his stock.
The treatment of complete liquidations follows the same tax treatment unless the corporation being liquidated is a subsidiary of another corporation. In this case, the parent corporation will not recognize gain on the liquidation of its subsidiary corporation. Please note this only applies to corporate shareholders, not individual shareholders. In order for a parent corporation to receive this treatment, the parent corporation must hold 80% or more of the subsidiary’s stock at the time of the liquidation.
This is a very high-level overview of the tax consequences of operating a C corporation. There are many more considerations than those mentioned above, and a tax advisor should be consulted before ultimately choosing the entity to conduct your business through. At the least, the tax consequences of a C corporation should be contrasted with that of a flow-through entity, such as those discussed below.
Partnerships—better known as the quintessential “pass-through” entity. The general tax treatment of a partnership is exactly as it sounds—the income, gain, deductions, and losses pass through the partnership entity and are reported on the income tax returns of its partners. Thus, the partnership is generally not seen as a separate and distinct entity from its owner’s, but rather and extension of them. For example, assume Partnership A has four partners. Each partner holds and equivalent 25% share to the partnership’s profit and loss. If Partnership A has $100 of taxable income in a given year, each partner will have to report their 25% share of such income on their tax filing. Thus, each partner would have to report $25 dollars of income from the partnership on their own return.
Due to the flow-through treatment of a partnership, the tax filing of a partnership (i.e. Form 1065) is generally seen as an informational filing to report to the IRS, what the total operations of the partnership was and what each partner’s share of such income or loss will be in a given year. The partnership itself is generally not subject to tax, but rather its individual partners are responsible for paying such tax. This is very unlike a C corporation that is responsible for reporting and paying the tax due on the income that the C corporation generates in a given tax year.
The flow-through nature of the partnership prevents the incidence of double taxation as you normally see in a C corporation. This is because the income flows through the partnership and is ultimately reportable on its partner’s income tax filing. Thus, only the partner is responsible for reporting their share of the partnership’s income and paying tax on such income. If we continue with the example of Partnership A above, Partnership A will not pay any income tax on the $100 of taxable income in a given year. Assuming that each partner is subject to the highest individual marginal tax rate of 37%, each partner will pay $9.25 in tax, for a total of $37 between all partners. This bring the effective tax rate on the partnership’s income to 37%–almost 13% lower than the effective tax rate of income earned by a corporation and thereafter distributed to a shareholder in the form of a dividend.
In greater contrast to a C corporation, a partnership can be very flexible on contributing and distributing assets in and out of the partnership without negative tax consequences. Generally, a partner can contribute an asset to a partnership, in exchange for a partnership interest, without recognizing gain or loss on the contribution, irrespective of their ownership percentage immediately after the contribution. On the flip side, assets can also generally be taken out of the partnership without negative tax consequences. In the context of non-liquidating distributions, If a partner receives cash or other property out of the partnership, the distribution is not taxable to the extent that the cash received is not in excess of the partner’s tax basis in their partnership ownership shares. In the context of liquidating distributions, such as a redemption of a partner’s ownership interest in a partnership, the consequences are the same with the exception that losses can be recognized. To note, a loss cannot be recognized on a non-liquidating distribution.
Lets put these general rules to pay with the use of a simple example. Assume John and Bill form a partnership, Partnership JB. John contributed $100 of cash to the partnership and Bill contributed a parcel of land, of which he had a cost basis of $50 and a fair market value of $100. Let’s assume that in year 1, Partnership JB earns $100 of taxable income. John and Bill will each have to report $50 of income on their personal returns. John now has $150 of tax basis in his partnership shares ($100 basis in initial contribution, plus $50 of allocable earnings) while Bill has $100 of tax basis in his partnership shares ($50 in tax basis from land contributed, plus $50 of allocable earnings). Assume that in year 2, Partnership JB makes a non-liquidating distribution of $50 to both John and Bill. Because neither will have received cash in excess of their respective tax basis, no gain will be recognized on the distribution. However, if we change the hypothetical, and instead Bill is distributed $150 in a non-liquidating distribution, Bill will be required to recognize $50 on such distribution ($150 cash distribution, minus $100 in Bill’s tax basis in Partnership JB ownership shares).
Just as a warning for the wary, these general tax consequences are just that—partnerships are the most complex entity to account for in the tax code and subject to very complex nuances. What we have not covered is the impact of liabilities held by the partnership, contributions and distributions of certain property within two and seven year periods, etc., all of which are subject to very special provisions and could trigger massive tax liabilities.
With that being said, partnerships offer the most amount of flexibility to its owners and prevent the imposition of two layers of tax. Not to mention, the most recent tax reform, formally known as the Tax Cuts and Jobs Act (“TCJA”), passed a very favorable provisions for owner’s of qualifying pass-through owners that provide a 20% deduction to the income that is passed through to them. This provision in contained in IRC 199A, and is informally known as the Qualified Business Income Deduction. In combination with this deduction, income earned and passed through to the partnership’s ultimate owner’s is subject to an effective tax rate of 29% on their income from partnerships.
An S Corporation brings together the worlds of corporations and partnerships. The quintessential line about S corporations is that it provides the benefits of the partnership’s “flow-through” treatment while providing the protection and organization hierarchy that a corporation can provide. One of the major differences between an S corporation and a C corporation or a partnership is the myriad of restrictions on ownership, which is why S corporation is representative of the term “small corporation”.
The restrictions on an S corporation’s ownership are as follows—
- Shareholders can only consist of individual, certain trusts, estates and certain tax-exempt organizations;
- All shareholders must be US citizens or residents;
- There is a maximum of 100 shareholders
- Only one class of stock is allowed;
- Profits and loss must be allocated proportionately amongst all shareholders;
- All shareholders must consent to the election to be treated as an S corporation; and
- The business cannot be an “ineligible corporation” such as an insurance company or a domestic international sales corporation.
In addition to the differences in ownership requirements above, the ownership requirement varies from that of a partnership as an S corporation does not require two or more people to operate. An S corporation can be owned and operated by a single person. Generally, you will see an S corporation used by a sole proprietor to avoid or lessen the impact of self-employment taxes as outlined below.
So, once you decide that you want to operate in the S corporation format, how do you form it? Well, its through the form of an election filed with the IRS on IRS Form 2553. For all new entities formed, an S corporation election must be filed within two months and fifteen days of the date of the entity’s formation to take effect for the first tax year. For existing businesses, the election must be made within a similar time line in order to take effect for a given tax year. If the election is filed late, there is a late election filing procedure put out by the IRS that will allow the late filing of such an election without the incurrence of a penalty. Please note that there are there are very complex rules to account for the conversion of an existing business to an S corporations.
In addition to the flow-through benefits provided by the S corporation structure, it also provides taxpayers relief on payroll and self-employment taxes. Generally, income earned by a self-employed person is subject to a total of 15.3% of Social Security, Medicate, and self-employment taxes on all profits earned. However, with the use of an S-corporation, the amount that is not paid to the S corporation’s owner(s) in the form of a salary is not subject to such taxes. For example, let’s assume a sole proprietor earns $100,000 in taxable income in a given year. In addition to income taxes paid, the sole proprietor will have to pay 15.% of self-employment taxes on the total $100,000 earned, equal to $15,300.
However, if the sole proprietor instead operated through an S corporation, this tax amount would change. Before continuing with the example, there is a concept applicable to S corporation owners and operators that imposes a requirement to pay themselves a “reasonable salary”. This amount of salary is subject to 15.3% of self-employment taxes, while the remainder flows-through to the S corporation’s owner, exempt of the 15.3% in self-employment taxes. Now continuing with the example, let’s assume the sole proprietor pays themselves a $40,000 salary, with the remaining $60,000 flowing through to the sole proprietor. The total amount of self-employment taxes due would equate to $6,120—a total of $9,180 less owed in self-employment taxes than if operating in sole proprietor format.
If you would like to operate in an S corporation format, please contact our team to assist you.
The final structure that we will discuss here is that of the disregarded entity. Just as the name infers, the entity is disregarded for tax purposes and is treated as if it does not exist. All of the income, gain, expenses and losses are reported directly on the return of the disregarded entity’s owner. The entity itself is not responsible to make any tax filings and to pay any taxes due.
Generally, a disregarded entity structure will be found when there is a single individual owner of a state limited liability entity such as an LLC who does not wish to operate a sole proprietorship in either the C corporation or S corporation format, but needs the protection against potential lawsuits or other liabilities borne by the entity.
As outlined above, a disregarded entity is not advantageous when it comes to calculating self-employment taxes in comparison to that of an of an S-corporation. The owner of the disregarded entity (if an individual) will have to report all income as earned from self employment, and be subjected to the full 15.3% of self-employment taxes due on such income.
However, disregarded entities are widely used by corporations or partnerships to provide themselves state limited liability protection when operating in certain states. For example, you will see this in the context of real estate when a company purchases and operates rental real estate in a specific state. The business will form a limited liability company (LLC) to hold ownership of the property to protect themselves from any potential suit, but choose to have the entity treated as disregarded from its parent entity so the activity is directly reported on its return.
If you believe that an disregarded entity is appropriate for use in your business, please contact our team to discuss questions you have as well as for aid in formation and implementation of the entity.