Anyone starting a business today has an increasing number of structures from which to choose. And with the check-the-box rules, you can select whichever one you want without worrying about the complicated four-factor test that once applied. Selecting the one that will best suit your needs involves weighing the advantages and disadvantages of each.
Your options fall into three categories:
- Those that “pass through” taxation to the individual owners without liability protection (sole proprietorships and general partnerships)
- Those that pass through taxation with liability protection (limited partnerships, limited liability companies [LLCs], limited liability partnerships [LLPs] and S corporations), and
- Those that are taxed as a separate entity with liability protection for shareholders (C corporations).
The advantage of pass through status is that income tax is generally paid at the shareholder level only. In contrast, C corporation income tax is paid at both the corporate and the shareholder level. Dividends are paid from funds that have been taxed at the corporate level, and shareholders pay tax on the dividends they receive. And even though the second tax on dividends is now reduced to 15%, it’s still an additional level of tax. To avoid this double tax on amounts that exceed reasonable salaries, a C corporation may retain earnings. But if it does so without a business purpose — other than avoiding tax on the dividends — the IRS may assess an additional accumulated earnings tax.
In recent years the IRS recognized that a properly structured LLC could be taxed as a partnership. Meanwhile, this new business form has exploded in popularity, and all 50 states recognize it. An LLC provides the advantages of an S corporation while avoiding its restrictions and limitations. And today, many states allow single-member LLCs to be treated like a sole proprietorship and don’t even require them to file an additional income tax return. Thus, single-member LLCs can be the simplest form of liability protection.For many existing corporations that have built up value, the LLC form is not a viable option because the conversion is a taxable event, often carrying with it a substantial tax cost. However, existing entities may be able to use the LLC form for new ventures within their businesses, or for joint ventures with other businesses.
As the owner of an existing business, you may want to review your business structure periodically to weigh its advantages and disadvantages and how they relate to your company’s future profitability and your objectives. Even more important, you need to know how these advantages and disadvantages offset each other.
The top individual tax rate and the top corporate rate are now the same, at 35%. At lower income levels, the C corporation (with the exception of personal service corporations) may have an advantage because it can benefit from lower corporate rates on the first $75,000 of taxable income.
But income tax considerations go beyond a comparison of the top federal income tax rates. First, you must also consider the impact of state income taxes in the various states where your company does business. In some states, the combined federal and state rates may be higher for C corporations while in others, individuals are still taxed at higher rates.
Second, a different income tax consideration applies to businesses that are expecting losses. If owners have enough tax basis in the entity, organizing as an S corporation, LLC or partnership may be beneficial. Why? Because these entities allow losses to be passed through to the owners. Thus, owners may realize current tax savings by taking the losses individually. A new C corporation, on the other hand, generally can only carry forward losses against future corporate income.
Finally, you need to consider whether income or loss that is passed through to an owner is active or passive. Passive losses are deductible only against passive income or when the passive activity is disposed of. Generally, if an owner does not materially participate in the business (according to certain participation tests), the income or loss is passive.
If a business could generate passive income for any owner, a structure that allows passthrough treatment can be advantageous because it may allow the owner to deduct passive losses from other activities.
Conversely, if a business generates passive losses for any owner, pass-through treatment may be a disadvantage be because the owner may not be able to currently deduct the losses. By contrast, a C corporation is not subject to the same passive loss limitations.
Sale of the Business
The way you structure your business has implications that affect how you will be taxed if you sell it later on. When considering these implications, you need to examine two areas: the impact on the shareholders and the impact on the corporation.
Shareholder level. A key advantage of a passthrough structure is that it may avoid or reduce any capital gains tax on the sale of a business interest. When an S corporation retains earnings over the years by earning income and not distributing all of it to shareholders, then shareholders’ tax basis stock increases, reducing or eliminating their capital gain on a sale.
For example, assume a sole owner of an S corporation has an original investment of $100,000. The business retains earnings of $500,000 over a period of years, so the owner’s tax basis increases to $600,000. If the owner then sells the company’s stock for $1 million, the owner’s gain would be $400,000.
In contrast, if the business is a C corporation, the gain would be $900,000 because the owner’s tax basis would remain the $100,000 initially invested. In general, the current maximum tax rate on long term capital gains (for assets held longer than 12 months) is 15%. The tax law reduces the capital gains tax to a maximum 14% on investments in qualified small businesses, but this only applies to original issue stock of certain C corporations purchased after Aug. 10, 1993, and held for at least five years.
The capital gains question has another side. If an owner plans to keep the business in the family and bequeath his or her interest at death, the capital gains tax may never apply. Currently, when heirs sell inherited property, they don’t pay capital gains tax on appreciation that occurred before their their loved one’s death. But when the estate tax is repealed in 2010 under EGTRRA, this stepup in basis will be limited to $1.3 million plus another $3 million for assets going to a spouse. The limits are adjusted for builtin losses and loss carryover amounts. The law is complex; consult your advisor on how this might affect your estate plan.
Corporate level. On a sale of C corporation assets, there may be a substantial corporate level tax if they are sold for more than their tax basis. Take an example of a building that was purchased for $1 million and depreciated over a period of years, reducing the tax basis to $400,000. If the building is sold for $2 million, the corporation pays tax on a gain of $1.6 million. If the corporation is then liquidated, the shareholders pay a second level of tax. In contrast, an S corporation usually pays no corporate level federal tax, and sole proprietorships, partnerships and LLCs never do.
The cost of providing many fringe benefits is a deductible business expense, regardless of your business structure. But if your business is an S corporation, LLC or partnership, the cost of certain benefits provided to most owners (except S shareholders owning less than 2%), is taxable to the owners.
The elimination of the wage cap on the Medicare portion of FICA taxes hits general partners, or LLC members who work in the business, especially hard. Their entire share of business income — whether paid out or not — is subject to a 2.9% Medicare tax.
The FICA tax rules create a tradeoff for C corporations. Many C corporation owners prefer to take money out of the company as salary, to the extent reasonable, to avoid the double tax on dividends. But they are faced with an additional 2.9% Medicare tax on wages in excess of the FICA limit ($90,000 in 2005) for doing so.
If your company qualifies as a manufacturer as defined under the American Jobs Creation Act of 2004, beginning in 2005, taking additional salary also will reduce the amount of the new manufacturer’s deduction. The deduction is equal to 3% of net income from manufacturing activities for taxable years beginning in 2005 or 2006. The percentage will ultimately increase to 9% in future years.
The Medicare tax applies to all compensation paid to a shareholder-employee, but not to S corporation income passed through to shareholders. To reduce this tax, shareholders in some S corporations may want to keep their salaries reasonably low and offset this with increased distributions, not subject to FICA tax.