Choice of Entity: Tax Issues
When forming a company, the first step is to choose a suitable structure, be it a corporation, partnership or limited liability company (LLC). Choosing a suitable entity depends on many factors, including liability, management and tax considerations.
Tax Classification of Business Entities
The following are available entity types under state law:
- Corporations,
- Partnerships (general partnerships, limited partnerships, limited liability partnerships, or limited liability limited partnerships), and
- LLCs.
A company is treated as one of the following for tax purposes:
- A "Disregarded entity,"
- C-corporation,
- S-corporation, and
- Partnership.
An entity's state law classification is not necessarily the same as the tax classification. For example, an LLC can elect partnership or corporation tax treatment. A company's tax classification is critical, since the taxation of the various entity types are vastly different.
Disregarded Entity
A company treated as a disregarded entity is essentially ignored for tax purposes, even though it is a separate legal entity under state law. A disregarded owner is considered to own the assets (and to be subject to the liabilities) for tax purposes, and reports the company's income and expenses on his own tax return. In other words, a disregarded entity is treated as the sole proprietorship of the owner.
For example, a single-member LLC treated as disregarded does not file a separate tax return. Instead, the LLC's sole member reports income and expenses on his or her personal tax return.
LLCs Do Not Have Their Tax Regime
Although an LLC is a recognized type of entity, LLCs do not have their own federal income tax regime. 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.
C-Corporation
All corporations not considered S-corporations are C-corporations. C-corporations are subject to two levels of tax on their income:
- At the entity level when earned, and
- At the shareholder level when distributed.
The relative inefficiency of the two levels of taxation is reduced by the 21% corporate income tax rate applicable from 2018.
An eligible C-corporation can avoid double taxation by electing S corporation tax treatment. If a C-corporation makes an S-corporation election, there may be negative tax consequences.
S-Corporation
An S-corporation is a "pass-through" entity, meaning it does not pay tax at the entity level. Instead, the profits and losses pass to shareholders, who include their respective share of the pass-through items in their tax returns.
However, there are significant restrictions on the availability of the S-corporation election. For example, an S-corporation can only have one class of shares, no more than 100 shareholders, and with certain limited exceptions, only US citizens (citizens or residents) can be shareholders.
Furthermore, only an eligible US entity can make the election (a US C-corporation or other US business entity entitled to elect the C-corporation tax status). An eligible US entity makes a timely S-corporation election on IRS Form 2553, no more than two months and 15 days after the beginning of the tax year the election takes effect.
Furthermore, only an eligible US entity can make the election (a US C-corporation or other US business entity entitled to elect the C-corporation tax status). An eligible US entity makes a timely S-corporation election on IRS Form 2553, no more than two months and 15 days after the beginning of the tax year the election takes effect.
Partnership
Similar to an S-corporation, a company taxed as a partnership is a pass-through entity, which means it does not pay a tax at the company level. Instead, the profits and losses of the partnership are calculated and allocated annually, and passed on to the partners, who include their respective share of these items in their income tax returns.
Unlike an S-corporation, a partnership does not have restrictions on the number, type or residence of its owners. Therefore, a company that wishes to pass on taxation often chooses the partnership tax status.
Although both S-corporations and partnerships are pass-through entities, the tax rules applicable to S-corporations and partnerships are very different.
Differences in the tax rules applicable to S-Corporations and Partnerships
Some examples of the differences include:
An S-corporation must divide profits according to share ownership. By contrast, a business entity that is a tax-based partnership can divide profits in any way it chooses.
All trade or business income of a partnership is considered self-employment income for the partners and is subject to self-employment tax. For S-corporations, only the compensation income paid to the shareholder-employee is usually subject to employment tax. No other income is subject to employment tax. This often leads to significant employment tax savings for owners of an S-corporation.
Partnerships do not qualify for certain legal benefits that are available only to C- and S-corporations. For example, a partnership cannot offer incentive stock options. However, a partnership can often use a profit interest (i.e. a share of future profits and appreciation, but none of the existing value of the partnership) to achieve the same or better tax result.
Choice of tax classification by business entities
The classification of a company by state law is not always the same as the tax classification of a company. Under the "check the box" rules, a company is classified as a "per se" C-corporation or as an entity eligible to choose its tax classification (referred to as an eligible entity).
Per Se Corporations
Under check the box, certain companies are automatically classified as C-corporations and cannot make an election to be treated as a disregarded entity or partnership for tax purposes. A corporation incorporated under state law is a per se C-corporation for tax purposes.
A C-corporation per se that meets the election requirements for S-corporation (such as the requirements for number, type and residence of shareholders) can elect S-corporation status at the time of formation. If a C-corporation makes an S-corporation election after its formation, there are potential negative tax consequences.
Eligible Entities
An eligible entity (i.e. a company not treated as a C-corporation per se) chooses its tax classification. Partnerships and LLCs organized under state law are eligible entities under the check the box Treasury regulations.
An eligible entity must formalize the box election on IRS Form 8832 only if it wants C-corporation tax status instead of its default tax status.
An eligible entity should file a check the box election within 75 days of its formation to avoid potential adverse tax consequences. Let's say an eligible entity elects C-corporation tax status after its formation. In this case, it cannot make an election to change its tax classification to a partnership or disregarded tax status for five years unless a significant ownership change (more than 50%) is permitted and the Internal Revenue Service (IRS) permits the change.
This limitation on the change of elective tax classification does not apply if the election is to be taxed, as a newly formed eligible entity makes a C-corporation and the election is effective on the day of the election.
An eligible entity that elects C-corporation tax status can later elect S-corporation tax status, but there are potential negative tax consequences.
Single-Member LLC: C-Corporation or S-Corporation
Under the standard classification rules, a single-member LLC is treated as a disregarded entity for tax purposes, unless it elects C-corporation tax status.
A single-member LLC that meets the requirements for the S-corporation election can elect the S-corporation tax status on the basis of the formation (or after the formation if it elects the C-corporation tax status).
When a single-member LLC (treated as a disregarded entity for tax purposes) adds another member, the LLC automatically converts to a partnership for tax purposes. This conversion can have tax consequences (gain or loss recognition) for the original member.
Multiple-Member LLC: Partnership, C-Corporation or S-Corporation
A multiple-member LLC meeting the S-corporation election requirements can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status).
If a multiple-member LLC (treated as a partnership for tax purposes) reduces its membership to a single member, the LLC automatically converts to a disregarded entity for tax purposes. This conversion has tax consequences (gain or loss recognition) for the original members.
Copyright © 2024
Created with
