Jump into Business with These Entity-Formation Tax Considerations in Mind
Your first step in forming a business is to decide what type of entity is the best form for your particular business (for example, a corporation, partnership or limited liability company (LLC)). Determining the best entity depends on a lot of things including structure, liability, management and tax considerations.
Tax concerns are often at the forefront of business owners' minds when forming an entity. This blog post discusses the California state and US federal income tax classification rules applicable to various entities without getting into detail of specific tax rules applicable to trusts and specialized industries. For more information about these rules, please get in touch!
Key Takeaways
One of the most important considerations in forming a business entity is how it will be taxed
Business entities are taxed at the entity level, stockholder level or both
Eligible entities can choose to be taxed in a way that is most beneficial to the business and its owners
While tax concerns are one of the first issues that come up for business owners in determining whether they should choose this entity over that entity, it is actually the non-tax considerations that often become of primary concern because in many instances an entity can choose how it is treated for tax purposes. That said, tax concerns should be covered and understood in their entirety to the extent they are applicable. To get a hold of the basics, let's jump right in.
HOW ARE BUSINESS ENTITIES TAXED?
California businesses are generally formed under state law as corporations, partnerships (as general partnerships, limited partnerships, limited liability partnerships, or limited liability limited partnerships), or limited liability companies (LLCs). For tax purposes, a business entity is treated as either a disregarded entity, C-corporation, S-corporation, or partnership.
How a business entity is classified from a tax perspective is important because the tax rules that apply to each specific entity form are not the same, and in fact are very different. Unlike partnerships and corporations, LLCs do not have a specific set of tax rules that apply only to LLCs. How the state of California classifies a business entity for tax purposes is not always the same as the non-tax classification of a business entity. For example, a state law partnership can elect to be taxed as a partnership or corporation.
Disregarded Entity
While LLCs are a recognized type of business entity under California state corporate law, federal law does not carve out a separate tax regime for LLCs. For tax purposes, an LLC is classified as a disregarded entity, C-corporation, S-corporation or partnership. A single-member LLC is treated as a disregarded entity and a multiple-member LLC is treated as a partnership for tax purposes unless the LLC elects C- or S-corporation tax status.
A disregarded entity is much like a sole proprietorship in that for tax purposes, a business entity that elects to be treated as a disregarded entity reports the entity's income and expenses on the owner's personal income tax return (normally an individual and separate business entity would have their own income tax returns). Essentially, an entity that only has a single owner and elects to be treated as a disregarded entity is ignored by federal and state authorities from a tax perspective. Because there is only a single owner and tax authorities do not recognize the entity from a tax perspective, the owner is considered to be the owner of assets and is personally liable for the entity's liabilities by and through the owner's reporting on his or her own personal income tax return.
C-Corporation
All corporations that do not elect to become S-corporations are C-corporations. C-corporations are the most common corporate form and generally are subject to two levels of tax on their income:
At the entity level when earned.
At the stockholder level when distributed.
Two levels of taxation can obviously become burdensome to businesses. However, this burden is somewhat reduced by the now 21% corporate income tax rate that went into effect beginning in 2018.
To avoid double taxation, an eligible C-corporation can elect at the time of formation of the entity to be treated as an S-corporation if it meets the Internal Revenue Code (IRC) requirements for an S-corporation election. These requirements pertain to the number, type and residency of stockholders, which we'll discuss below) (see also IRC §§ 1361 and 1362). One thing to keep in mind here is that if a C-corporation makes an S-corporation election after the time of formation (rather than at the outset of entity formation), there are potential adverse tax consequences.
S-Corporation
S-corporations are less common than C-corporations because there are substantial limitations of making as S-corporation election. For example, an S-corporation can have only one class of stock, it can have no more than 100 stockholders, and only US individuals (citizens or residents) can be stockholders (with some limited exceptions) (see also IRC § 1361). There are also limitations as to the type of entity that can make an S-corporation election. Eligible US entities that can make the election are generally US C-corporations or another US business entity eligible to elect C-corporation tax status) (see IRC § 1361 and Treas. Reg. § 1.1361-1(c)). There are also timing limitations. Specifically, in order for an eligible US entity to make a timely S-corporation election, it must do so on IRS Form 2553 no more than two months and 15 days after the beginning of the tax year the election is to take effect (see IRC § 1362).
Beyond the limitations of S-corporations, there are some benefits to making the election for certain businesses. Specifically, an S-corporation is considered a "pass-through" entity for tax purposes, which means it generally does not pay an entity level tax like a C-corporation. Because S-corporations are treated as pass-through entities, the S-corporation's profits and losses generally pass-through to its stockholders. These stockholders in turn include their respective share of ownership of the S-corporation on their personal income tax returns (whether or not these shares are distributed), and as a result, only pay income tax at the individual level.
Partnership
A business entity taxed as a partnership is a pass-through entity for tax purposes (like an S-corporation), which again means it does not pay an entity level tax. The general structure of taxation is the same as the S-Corporation for the owners. Because S-corporations are treated as pass-through entities, the partnership's profits and losses generally pass-through to its stockholders. These stockholders in turn include their respective share of ownership of the partnership on their personal income tax returns (whether or not these shares are distributed), and as a result, only pay income tax at the individual level.
There are differences between a partnership and S-corporation, however. For instance, there are fewer limitations on partnerships than there are on S-corporations, such as a partnership does not have any restrictions on the number of owners (other than the requirement that in order to be a partnership, there must at least be two or more owners). Partnerships also do not have restrictions on the type or residency of its owners, meaning owners do not have to be US individuals. Because there are fewer limitations, business entities that desire pass-through taxation often choose partnership tax status.
Another difference between a partnership and S-corporation lies in the tax rules that apply to them. While the structure of taxation is the same in that they are both pass-through entities, the logistics are different. For instance, an S-corporation must divide profits according to share ownership. Partnerships on the other hand generally can divide profits for tax purposes in any way they choose.
Partnerships also do not qualify for certain statutory benefits available only to C-corporations and S-corporations. For example, a partnership cannot issue incentive stock options. However, a partnership can often use a profits interest (meaning, a share of future profits and appreciation, but none of the existing value of the partnership) to achieve the same or better tax result for its holders.
SELF-EMPLOYMENT TAXES AND THE SALARY VS. DISTRIBUTION CONUNDRUM
S-corporations are also subject to self-employment tax. This tax is added because all trade or business income that the partnership generates is considered self-employment income to the partners, and self-employment income is subject to self-employment tax. On the other hand, S-corporation owners must only pay self-employment tax on the compensation income paid to the stockholder-employee. This allows for substantial employment tax savings for owners as any other income is not subject to employment tax.
Business owners of S-corporations can choose to classify some of their income as salary, and some of their income as a distribution (which is not self-employment income) to take advantage of the above tax savings. However, the IRS pays close attention to this as there is often abuse of the rules to limit tax obligations. In order to remain compliant, we recommend consulting a tax professional because the risk of misclassifying income can be devastating to a small business. Tax professionals will likely consider a number of factors to determine the line at which income can cease to be classified as salary and begin to classified as a distribution.
These factors include the nature of the business, qualifications/training/experience/time of the individual in question, compensation paid non-stockholder employees, what other businesses do in similar circumstances, compensation as a percentage of sales or profits, and compensation compared to distributions. A good rule of thumb may be to characterize just enough of the income as salary to ensure that compensation exceeds the Social Security wage base for the year in question. For 2018, it is $128,400.
Again, make sure to work with a tax professional if you are thinking of taking advantage of this S-corporation benefit.
For information regarding eligible entities and choosing how your business is taxed, stay tuned or get in touch!
Entity formation and tax considerations that come along with it can be a complex field and only an attorney skilled in asset protection planning can adequately assist you. If you're ready, and you have assets that you would like individually-tailored advice regarding entity formation tax concerns, we're happy to help. Please not that we are not tax experts, CPAs, accountants or otherwise tax professionals. Because of this, we recommend any tax-specific decisions be made in conjunction with a business attorney and a tax professional.
If you're ready to move forward, but are operating on a tight budget, ask about our Layaway Payment Plan! It's essentially a pay-as-you-go option for those on a tight budget. If you’d like guidance and assistance with creating an entity, schedule a strategy session today; we're happy to help.
Matthew Schlau is a co-founding principal of Schlau|Rogers and an estate and business planning lawyer practicing in Orange, San Diego, Los Angeles and Riverside counties. He is a husband, father, blogger, crossfitter, and really good at helping people achieve their goals.
At Schlau|Rogers, we do more than just estate and business planning, probate and trust administration. Our objective is to provide individually-tailored plans that allow you the opportunity to reach your goals, all while minimizing headaches and risk, and maximizing peace of mind.
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