Choice of Entity: Tax Issues
When forming a business, the first step is to choose the correct structure for the business (for example, a corporation, partnership or limited liability company (LLC)). The best entity type for a business depends on structure, liability, management and tax considerations.
Overview of Tax Classification of Business Entities
Businesses are generally formed under state law as:
- Partnerships (as general partnerships, limited partnerships, limited liability partnerships, or limited liability limited partnerships).
For tax purposes, a business entity is treated as one of the following:
- Disregarded entity.
The state law classification of a business entity is not always the same as the tax classification of a business entity (for example, a state law partnership can often elect partnership or corporation tax status).
The tax classification of a business entity is important because the tax rules that apply to a disregarded entity, C-corporation, S-corporation and partnership are quite different.
A business entity treated as a disregarded entity for tax purposes is an entity with a single owner that is generally ignored for tax purposes even though it is a separate legal entity for state law purposes. The disregarded entity owner is considered to own the assets (and is subject to the liabilities) of the disregarded entity for tax purposes and reports the entity's income and expenses on its own income tax return. In other words, a disregarded entity is treated like a sole proprietorship, branch, or division of the owner.
For example, a single-member LLC treated as a disregarded entity for tax purposes does not file a US federal income tax return. Instead, the LLC's sole member reports the LLC's income and expenses directly on its own income tax return.
LLCs Do Not Have Their Tax Regime
Even though an LLC is a recognized type of business entity formed under state corporate law, LLCs do not have their own US 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.
All corporations other than S-corporations are C-corporations. C-corporations generally are subject to two levels of tax on their income:
- At the entity level when earned.
- At the stockholder level when distributed.
The two taxation levels' relative inefficiency is somewhat reduced by the 21% corporate income tax rate that applies beginning in 2018.
An eligible C-corporation generally can avoid double taxation by electing on the formation to be treated as an S-corporation if it meets the Internal Revenue Code (IRC) requirements for an S-corporation election (such as the requirements regarding the number, type, and residency of stockholders discussed below). If a C-corporation makes an S-corporation election after formation, there are potential adverse tax consequences.
An S-corporation is a "pass-through" entity for tax purposes, which means it generally does not pay an entity-level tax. Instead, the S-corporation's profits and losses generally pass-through to its stockholders, who include their respective share of those items on their income tax returns (whether or not distributed).
However, there are significant limitations on the availability of the S-corporation election. For example, an S-corporation can have only one class of stock, no more than 100 stockholders, and with certain limited exceptions, only US individuals (citizens or residents) can be stockholders. In addition, only an eligible US entity can make the election (generally a US C-corporation or other US business entity eligible to elect 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 is to take effect.
Like an S-corporation, a business entity taxed as a partnership is a pass-through entity for tax purposes, which means it does not pay an entity-level tax. Instead, the partnership's profits and losses are computed and allocated annually and pass-through to the partners who include their respective share of those items on their income tax returns (whether or not distributed).
Unlike an S-corporation, a partnership does not have restrictions on its owners' number, type, or residency. Therefore, a business entity that desires pass-through taxation often chooses partnership tax status.
Although both S-corporations and partnerships are pass-through entities for tax purposes, the tax rules that apply to S-corporations and partnerships are somewhat different.
Differences in the Tax Rules that Apply 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 partnership for tax purposes generally can divide earnings in any way it chooses.
- All trade or business income of a partnership generally is considered self-employment income to the partners and is subject to self-employment tax. For S-corporations, typically, only the compensation income paid to the stockholder-employee is subject to employment tax. Any other income is not subject to employment tax. This often results in substantial employment tax savings for the owners of an S-corporation.
- Partnerships do not qualify for certain statutory benefits available only to C- 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 partnership's existing value) to achieve the same or better tax result (than an incentive stock option) for its holders.
Choice of Tax Classification by Business Entities
The state law classification of a business entity is not always the same as an entity's tax classification. Under the "check the box" treasury regulations, a business entity is classified either 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 the check the box treasury regulations, certain entities are automatically classified as per se 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 per se C-corporation that meets the S-corporation election requirements (such as the requirements regarding the number, type, and residency of stockholders) can elect S-corporation status on formation. If a C-corporation makes an S-corporation election after formation, there are potential adverse tax consequences.
An eligible entity (meaning, a business entity not treated as a per se C-corporation) generally chooses its tax purposes classification. Partnerships and LLCs organized under state law are eligible entities under the check the box treasury regulations.
An eligible entity only needs to formalize the box election on IRS Form 8832 if it desires 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. Suppose an eligible entity elects C-corporation tax status after formation. In that case, it generally cannot make an election to change its tax classification to partnership or disregarded entity tax status for five years unless there is a significant ownership change (more than 50%) and the Internal Revenue Service (IRS) permits the change. This limitation on changing elective tax classification does not apply if the election to be taxed as a C-corporation is made by a newly formed eligible entity, and the election is effective on the date of formation.
An eligible entity electing C-corporation tax status can later elect S-corporation tax status, but there are potential adverse tax consequences.
Single-Member LLC: C-Corporation or S-Corporation for Tax
Under the default 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 meeting the requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status).
If 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 may have tax consequences (gain or loss recognition) for the original member.
Multiple-Member LLC: Partnership, C-Corporation or S-Corporation for Tax
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 generally has tax consequences (gain or loss recognition) for the original members.
Converting from a C-Corporation to an S-Corporation after Formation
An eligible C-corporation can convert to an S-corporation after formation, but the conversion has potential adverse tax consequences. For example, the converted S-corporation pays an entity-level tax, at the corporate rate (21%), on any built-in gains (BIG Tax) if recognized during a specified recognition period after the S-corporation election takes effect.
The specified recognition is the first five years after converting. Asset appreciation occurring after the S-corporation election is not subject to the BIG tax. If there is a chance of an acquisition in this recognition period, a C-corporation may not want to convert to an S-corporation. This is because the S-corporation may have to pay a BIG tax if it is acquired by an asset purchase (or by a stock purchase treated as an asset purchase for tax purposes) during the recognition period.