There are a number of important considerations to keep in mind when selecting the best business entity for yourself or your clients. These considerations can be distinguished into two smaller groups, Tax Implications and Non-Tax Implications. In this article, we will discuss the Tax Implications of selecting a business entity.
A closely held business may be organized as a sole proprietorship, a general partnership (GP), a limited partnership(LP), a limited liability company(LLC), a limited liability partnership, and an “S” corporation or a “C” corporation. Deciding which entity works best for you requires consideration of a number of factors. These factors include the “pass-through” entities versus “entity-level tax” entities (“C” corporations), “C” corporations versus “S” corporations, gain and loss recognition, state level taxes, and basis adjustments. Please note, because limited liability partnerships are only used for professionals such as attorneys, architects and accountants, we will not discuss their features in detail. Your attorney can give you more information about these entities if they are applicable to your needs.
In a ‘pass-through’ entity, income, losses, deductions, gains and credits are ‘passed-through’ to the partners or members, and get reported only on their individual tax returns.
A ‘C’ Corporation is the only form of an entity-level taxpayer. A corporation itself pays taxes on income at the corporate tax rates. Then, distributions to shareholders are taxed to the individual shareholder as well, resulting in double taxation of corporate income. Double taxation can be avoided in some instances by paying corporate income to shareholder employees as salaries, paying interest out of corporate earnings on debt owed to the shareholders, or paying rents or royalties out of corporate income on property leased or licensed from the shareholders. However, for most small, closely-held businesses, a pass-through entity is more beneficial from a tax standpoint.
Partnerships, LLC’s and ‘S’ Corporations are all pass-through entities. Multi-member LLC’s are generally treated as partnerships for tax purposes. In both partnerships and LLC’s, income and losses pass through to and are taxed or deducted by partners or members. Most losses are fully deductable by partners (but not in excess of their basis in their partnership or member interest). However, it is unlikely for a multi-member LLC to lose its partnership taxation structure, whereas an “S” corporation may lose its status if it fails to comply with rules.
Many people do not fully understand the difference between a “C” corporation and an “S” corporation. For all intents and purposes, both corporations are the same, with the sole difference is tax treatment by the IRS and state tax authority. A corporation must file an election for “S” corporation treatment which has the effect of making the corporation a pass-through entity for Federal and state tax purposes, but does not impact the nature of the entity for state corporate law purposes. To qualify as an “S” corporation, a corporation may not have more than 100 shareholders, have any other than an individual, estate or certain trusts as shareholder, have a non-resident alien as a shareholder, or have more than one class of stock (except that differences in voting rights are permitted).
No gain or loss is recognized upon the transfer of property to a partnership or LLC in exchange for a partnership or member interest.
Generally, if stock in a corporation is received in exchange for property, the amount by which the value of the stock exceeds the shareholder’s basis in the property transferred would ordinarily be recognizable gain to the shareholder.
“C” corporations only recognize operating losses of the corporation at the corporate tax level. “S” corporations, partnerships and LLCs, as described above, pass-through the losses to be reported on the partner’s or member’s tax filings, up to their basis in the partnership or member interest.
When a partner sells a partnership interest or dies, a Section 754 Election may be made which provides for the “inside” basis of the purchasing or inheriting partner’s share of the partnership assets to be increased or decreased equal to the “outside” basis. This is referred to as a “step-up in basis.” When the basis is stepped up, the purchasing or inheriting partner will recognize less gain on a future sale of the assets, which results in lower taxes. The same principals apply to the LLC.
Conversely, when a shareholder of an ‘S’ corporation dies, the shareholder’s heirs will take a fair market value basis in the stock, but there will be no corresponding step-up in basis of the appreciated corporate property, and gain will generally be recognized on any sale of the property.
Sole proprietorships and general partnerships incur no additional state-level tax in California. Limited partnerships and limited liability companies are each subject to an annual California Franchise Board tax of $800.00 per entity. LLCs are also subject to an annual gross receipts tax for any gross receipts in excess of $25,000.00 per year.
In California, an ‘S’ corporation is taxed on its net income at a rate of 1.5 percent, with a minimum tax of $800 annually. A ‘C’ corporation is taxed on its net income at a rate of 8.84 percent, with a minimum tax of $800.
Based on all of the above, you can see how many important tax considerations one must make before deciding on the best business entity for their needs. For the needs of the majority of small, closely-held business, the LLC or corporation is likely the best option, because they provide the best balance of pass-through taxation and tax flexibility, as well as additional, non-tax advantages. NextGen Law Group will work in conjunction with your CPA to guide you through the tax and non-tax considerations of business entity selection.