Choice of Business Entity Considerations (Part II)
By Michael D. Cross, Jr., J.D.
An important decision in considering which business entity to choose are the various tax implications upon the business and the owners. This article is a brief discussion of some of the tax implications that a business owner should consider.
Generally, the Internal Revenue Code treats a corporation as a separate entity for tax purposes. Accordingly, the corporation experiences a taxable event when it recognizes gain or loss. The corporate tax rate is somewhat graduated, but for the purpose of the following examples, we shall assume the corporate tax rate is a flat 35% of the corporation’s adjusted gross income. Accordingly, if the corporation generates $100,000 in AGI, it would incur $35,000 in tax liability. After paying the tax, the corporation would have $65,000. At this point, the corporation’s shareholders have not received any money from the corporation (except for salaries if they are also employees of the corporation).
If the corporation then issues all its net profit to the shareholders as a dividend, the shareholders will treat the dividend as ordinary income and report it as such on their personal tax return. Until recently, shareholders were each taxed on dividends at a rate equal to their marginal tax rate, which often was 39.6%. Beginning in 2003, however, Congress reduced this tax. Generally, shareholders now pay taxes on dividends at the rate of 15% on the first $50,000 of annual dividends. After this, shareholders generally pay tax on dividends at a rate equal to that individual shareholder’s marginal tax rate, which now does not exceed 35%. Assuming that there are two equal shareholders of the above corporation and that the corporation issues $65,000.00 in dividends, each shareholder will incur tax liability in the amount of $4,,875. Accordingly, the corporation and its shareholders will have paid $44,750 in tax, nearly 45% of the corporation’s net profit. This excludes the impact of employment taxes and state and local taxes.
The treatment of the tax on both the corporation and its shareholders is commonly referred to as “double taxation”, and it is a very important part of the tax code. Generally, publicly held corporations are not so severely affected by double taxation, because they re-invest a large amount of their net profit in expansion and product development. The owners of small, privately held corporations, however, often seek ways to avoid this double taxation.
The code provides that a small business corporation may elect to be taxed under subchapter S of the Internal Revenue Code (commonly referred to as the “S” election). A corporation that makes its “S” election generally may avoid double taxation. As a result, the profits and losses of an S corporation are not taxed at the corporate level. Rather, they flow through the corporation to its shareholders (in a manner similar to that of a partnership). In such a situation, the S corporation files an informational tax return with the IRS and allocates the profits and losses to the shareholders in accordance with their ownership interests. The shareholders then pick up the profits and losses of the S corporation on their individual tax returns.
Not all corporations can make an “S” election. The Internal Revenue Code generally provides that an S corporation must not (i) have more than 75 shareholders, (ii) have as a shareholder a person that is not an individual, (iii) have a nonresident alien as a shareholder, or (iv) have more than one class of stock. Accordingly, S corporations may not have shareholders that are corporations or LLCs, and must allocate profits and losses strictly according to the number of shares owned. In Part I of “Choice of Business Entity Considerations” regarding LLCs, we noted that the members of an LLC that is taxed as a partnership may elect to allocate profits and losses in any manner they desire, so long as the allocation has substantial economic effect. This is not the case for an S corporation, where profits and losses must be allocated according to ownership interest. The foregoing provisions illustrate yet another reason for a corporation that wishes to make its “S” election to have a shareholder agreement. An S corporation should make certain its shareholder agreement provides that no shareholder may sell all or a portion of his or her shares to a non-individual or to individuals so that the corporation begins to have more than 75 shareholders.
It is important to note, however, one drawback of making an S election. In a pass through entity such as an S corporation, all profit and loss of the S corporation passes through to the shareholders regardless whether the corporation ever distributes any money to the shareholders. Suppose that the S corporation has five shareholders who each own 20% of the shares and a net profit of $100,000. Suppose further that the S corporation determines it should reinvest all its net profit in further development and expansion. Each shareholder must pay tax on $20,000 even though none received any money from the corporation. For this reason, the shareholder agreements of many S corporation require that the S corporation actually distribute enough money to the shareholders so they may pay the tax liability they incur on their share of the corporation’s net profits.
Limited Liability Companies
LLCs have substantially more flexibility then do corporations in tax matters as well as in general operating matters. First, a multiple member LLC may elect to be taxed either as a corporation or as a partnership. A single member LLC may be taxed as a corporation or as a sole proprietorship. LLCs often choose to be taxed under the partnership tax regime. For this reason, the following discussion will refer to LLCs as partnerships. Please note that this reference does not have any effect on the treatment of the LLC for state law and limited liability purposes.
The Internal Revenue Code treats entities taxed as partnerships in a manner similar to S corporations in that all profits and losses of the partnership flow through to the partners (or members). One of the important differences between partnership tax and S corporation tax is that the members may allocate profits and losses in a manner independent of the member’s ownership interest, so long as the allocation has substantial economic effect (as defined by federal tax law). Additionally, although several limitations apply, another advantage of the partnership tax regime over corporate taxation is that generally a contribution to an LLC or distribution from the LLC is not a taxable event. Accordingly, the LLC may distribute property (whether real property or personal property) to its members without the distribution being a taxable event, whereas such a distribution to a shareholder in a C corporation or S corporation is almost always a taxable event. For this reason, real estate investors often prefer to operate their business through an LLC taxed under the partnership tax regime.
It is extremely important to note that federal tax law imposes several restrictions on such a distribution. Moreover, the tax code treats distributions differently depending upon whether the distribution is made during the course of business of the partnership or upon the dissolution and liquidation of the partnership. For this reason, it is imperative that any company, whether it be an LLC or a corporation, seeking to distribute all or a portion of its assets seek professional tax advice before doing so.
Other Tax Issues
To this point, we have addressed only federal income tax issues. Owners of a company must consider employment tax matters as well. In particular, current tax law provides one advantage for S corporations that does not exist for entities (such as LLCs) treated as partnerships or sole proprietorships. The advantage works as follows.
Generally, employers engaged in an active trade or business must pay a federal employment tax of 15.3% on net income. One-half this amount (i.e., 7.65%) is paid by the employer. One-half is withheld from the employee’s paycheck. Generally, an individual who is self-employed (i.e., the whole or partial owner of an S corporation or LLC) is taxed both as an employer and an employee on all annual income up to $84,900, after which only the portion of the employment tax applicable to Medicare (2.9% total) applies. Current tax law provides no exception for the member of an LLC, however, it does provide an exception for owner of an entity taxed as an S corporation (which may be a corporation or an LLC). So long as the shareholder takes a reasonable salary for the shareholder’s employment with the S corporation, any amount over and above that reasonable salary is distributed to the shareholder without being subject to one-half the withholding tax (i.e., 7.65%). Accordingly, the owner/employee of an S corporation can avoid being taxed on 7.65% of the company’s net profit up to $84,900 and upon 1.45% percent of the company’s net profit thereafter.
For this reason, many LLCs, especially those engaged in an active trade or business, elect to be treated as a corporation for tax purposes. They then take their “S” election, thus avoiding some unnecessary employment tax. Often, this advantage is not sufficient to justify taxation as a corporation for a multiple member LLC, however, it is very important for those forming an LLC to discuss this option with a tax professional.
The above discussion is not meant to be an exhaustive overview of the tax implications of choosing an appropriate entity nor does it address the many technicalities of the tax code and Treasury regulations. Rather, it is intended to provide basic information that business owners and advisors should consider so they may ask appropriate questions of tax professionals. Choice as to the proper entity should not be made without discussing the business’ specific objectives and method of operation with legal, tax, and accounting professionals.
The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.