Entrepreneurship is a hallmark of a free market. Starting a business is high risk but also high reward. One of the first questions an entrepreneur should ask an experienced Tax Attorney is, “What type of entity should I choose for my business?” Choosing a C-Corporation, Partnership, LLC, or S-Corporation should be carefully considered. The type of business entity you select for your business structure greatly impacts what you could be liable for personally, as well as the federal tax treatment of earnings and profits.
Here are a few very basic distinctions between business entities that you should be familiar with in advance of meeting with an experienced Tax Attorney:
Sole Proprietorships: A Sole Proprietorship may be an attractive choice to some entrepreneurs because of the ease of formation. Its structure is very simple as the business is not separate from the owner. There is only one level of taxation as taxes on revenue are “passed-through” to the business owner. Sole Proprietorships are eligible for the IRC §199A 20% Qualified Business Income deduction, which can reduce taxable income. Business owners have unlimited liability, meaning they are personally liable for all business debts and liabilities.
Partnerships: A Partnership is formed when there is a non-corporate business entity with two or more owners. Partnerships have pass-through tax treatment with one level of taxation at the Partner level. Partner distributions are reported on a K-1, which is separate from a 1040. Partnerships can have disproportionate distributions. Partners do not receive wages; however, self-employment tax will be imposed on guaranteed payments from the Partnership to Partners who provide services. Partners can utilize losses to reduce taxable income (some limitations apply). The character of these pass-through losses can be either capital losses or ordinary losses. Partnerships are also eligible for the IRC § 199A 20% Qualified Business Income deduction. Within the Partnership framework, liability varies. General Partners are held personally liable for business debts with unlimited liability. While a Limited Partner enjoys limited liability. Of note, an election can be made to tax a Partnership as a corporation.
Limited Liability Company’s “LLCs”: An LLC also has one level of taxation that passes through to the Member. Unlike Partnerships, LLC Members are not required to file a separate income tax form apart from a 1040. Similar to Partnerships, LLC Members can receive disproportionate distributions. However, distributions from LLCs are considered wages. As a result, self-employment tax applies to wages of LLC Members who perform substantial services or who are active in management. LLC Members who closely resemble passive investors are treated as Limited Partners. LLC Members can also utilize losses to reduce taxable income (some limitations apply). Similar to Partnerships, the character of pass- through losses can be either capital or ordinary. Additionally, LLCs are eligible for the IRC § 199A 20% Qualified Business Income deduction. Liability for LLC business debts are limited. LLCs can also be treated as a disregarded entity for tax purposes or elect to be taxed as a Corporation.
Corporations: Corporations are separate entities that are taxed separately from its owners (shareholders). Shareholders are not liable for the Corporation’s liabilities and debts. Corporations cannot make disproportionate distributions, as distributions must be pro-rata (equal).
There are two types of Corporations that should be distinguished, a Subchapter C-Corporation (C-Corp), and a Subchapter S-Corporation (S-Corp).
- C-Corps: The Tax Cuts and Jobs Act (TCJA) made C-Corps an attractive option as the corporate tax rate was reduced from 35% to 21%. However, there are other factors to consider besides the lower corporate tax rate. For example, C-Corps are subject to double taxation. This means that C-Corps as a separate entity pays taxes on its normal operations of the Corporation, and taxes are paid at the shareholder level on distributions of property, cash, stock, or dividends. Because both the entity and the shareholders are taxed, the 21% corporate tax rate may not be the best option for your business. Moreover, C-Corps are limited on use of losses as they can only offset capital losses against capital gains and these losses do not pass to shareholders. Also, keep in mind that applying Subchapter C to an entity is determined by check the box regulations.
- S-Corps: S-Corps are separate entities but unlike C-Corps an S-Corp has only one level of taxation. Similar to a Partnership an S-Corp gives pass-through tax treatment to its shareholders. However, the formation of an S-Corp can present some challenges. An S-Corp election involves timing requirements as the election must be filed by the 3rd month to be effective January 1st of the current taxable year. Moreover, maintenance of an S-Corp is complicated as only certain persons are eligible to be shareholders. Further restrictions include only one class of stock, a 100 shareholder limit, and the business must be domestic. Similar to a Partnership, S-Corp shareholder distributions are reported on a K-1. There’s no self-employment tax on S-Corp profits over and above wages (subject to a reasonableness test). Also, shareholders can utilize losses to reduce taxable income (some limitations apply). Similar to Partnerships and LLCs, the character of these pass-through losses can be either capital or ordinary. S-Corps are also eligible for the IRC § 199A 20% Qualified Business Income deduction. Typically an S-Corp election is ideal for closely held (not publicly traded), very profitable companies. An S-Corp election is not ideal if your company is highly leveraged or possesses large net operating losses.
Let Us Help with Your Business Formation Needs
Business formation involves many different moving parts. Entrepreneurs must be advised of the income tax consequences and the effect of liabilities on the business as well as the individual owners. Let the legal team at TEPS LAW, LLC assist you in selecting the right entity to achieve success in your business objectives. Contact us today to schedule a Business Formation Strategy Session. We offer virtual and telephonic consultations by appointment.