Choice of entity: Tax considerations for business owners
When setting up a business, many factors come into play, but the most important considerations include the choice of entity. In this article, learn about the tax factors to make the best choice for your business.
When setting up a new business, owners often find themselves struggling with how they should set up the business. The first article in this series covered non-tax factors for entity choice including owner liabilities and ease of formation. This article discusses tax factors for owners to consider before making a choice of entity.
Business entities available for federal tax purposes
The type of business entity a business can be classified as depends on the number of owners. Single-owner companies can be sole proprietorships or corporations, while companies with more than one owner can only be classified as either corporations or partnerships. For federal tax purposes, corporations can be further classified as a C corporation or an S corporation, if certain qualifications are met.
Limited liability companies (LLCs) are hybrid entities that exist on the state level, but federal tax law does not recognize them as an entity type; instead the federal tax classification is based on the number of owners and the factors discussed below. A single-owner LLC will be treated as a sole proprietorship for federal tax purposes unless the LLC elects to be treated as a corporation. LLCs with two or more owners are automatically classified as partnerships unless they elect to treat the business as a corporation.
Choice of entity tax consideration #1: Level of taxation
When determining which type of entity to choose, prospective business owners should consider who will be responsible for paying income taxes for the entity. Will the entity be taxed or do the profits and losses from the business get reported on the owners’ individual returns?
When the profits and losses are reported on the owners’ return, the entity is referred to as a pass-through or flow-through entity. Partnerships and sole proprietorships are the traditional pass-through entities because the business is not treated as separate or distinct from its owners. There are many complex rules involved in this process such as income allocations, expense allocations, but the main takeaway is that pass-through entities have no entity-level tax. As a sole proprietor, business income and expenses are reported directly on the sole proprietor’s individual return. Most sole proprietors report this income on Schedule C of their Form 1040. Partners will receive a Schedule K-1 (Form 1065) from the partnership, and this schedule provides information on how to report any income, expenses, credits, etc. allocable to the partner on their individual returns.
In contrast, C corporations are treated as a completely separate entity from the owners— the IRC makes it clear that as an entity separate from its owner, a C corporation has its own tax responsibilities. Therefore, C corporations are taxed on the profits and losses of the business and the owners are not responsible for paying these taxes. Unlike pass-through entities, C corporations are subject to an entity-level tax.
On the other hand, S corporations are more akin to sole proprietorships and partnerships: they are treated as pass-through entities. The shareholders of the S corporation receive a Schedule K-1 (Form 1120-S) that reports their share of the items that must be reported on their individual tax returns.
LLCs are subject to the check-the-box regulations; this means LLCs have the option in their first tax year to choose if they will be treated as a pass-through entity or not. The members of an LLC must file Form 8832 in the first tax year of operations to designate whether the business will be taxed as a partnership, S corporation, C corporation, or disregarded entity (akin to a sole proprietorship). For more information on the complex rules regarding this choice see Form 8832. This option to select how the business is taxed is one of many features that explains why LLCs have become popular since their inception 40 years ago by the state of Wyoming.
Owner consideration: Do the owners want to report the business income and expenses on their own returns or would they rather the company report these items and pay taxes on its own return?
Choice of entity tax consideration #2: “Double taxation” applies to C corporations and LLCs taxed as C corporations
“Double taxation” refers to the concept of profits taxed first at the entity level and then again at the individual level when earnings are distributed to the shareholders or members. This concept intertwines with the level of taxation because only C corporations and LLCs that choose to be taxed as C corporations are subject to entity-level tax and possible double taxation.
The profits of the business are first reported on the corporation’s (or electing corporation’s) return (Form 1120) and then again reported when the earnings are distributed in the form of dividends the shareholders/members must report on their returns. Pass-through entities only pay tax once--when the income is reported on the owners’ returns because the pass-through entity pays no tax. This is less of an issue at the beginning of a business’s life cycle because the likelihood is low that there will be significant profits at the entity level and dividends paid out to shareholders.
Owners should also keep in mind that lower corporate tax and dividend tax rate could be more beneficial to an owner than paying individual, marginal tax rates on flow-through income. In some cases, it could be a savings for owners to be "double taxed” as a corporate shareholder.
Owner consideration: Will the company see significant profits and dividends paid to its shareholders?
Choice of entity tax consideration #3: Contribution of property can cause gain recognition
Upon formation, owners typically contribute property to the business in exchange for their ownership interest. This contribution can be cash or its equivalents, tangible property, or intangible property. Typically, when a taxpayer exchanges property (other than cash) for other property such as stock, gain could be recognized if the taxpayer’s adjusted basis in the property exchanged is less than the fair market value of the property received. Partnerships and corporations (the rules are the same for C or S corporations here) have special provisions related to this situation. Sole proprietorships do not have special rules for this because the property never changes hands: the entity and proprietor are treated as the same.
Special rules for forming partnerships, corporations, and LLCs by contributing appreciated property
The focus of the special rules discussed here is for contributions of appreciated property (property that has a fair market value in excess of the owner’s adjusted basis). Typically, the adjusted basis is what the property owner paid for the property with certain adjustments.
When a taxpayer contributes appreciated property to a partnership in exchange for their interest, IRC § 721 allows the taxpayer to defer the property’s built-in gain until the partnership sells the property. When the partnership sells the property IRC § 704 requires the partnership to allocate that deferred gain to the partner that contributed the property, and any gain above that is split among the partners. See page 5 of IRS Publication 541 for more on these rules.
This can be extremely beneficial if the new partnership requires a lot of capital upfront and one of the potential partners already owns the potential property. Absent this section, the taxpayer would treat the exchange as a sale of the property for its fair market value which, in turn, requires them to report the gain on their individual return that year.
For more information on what to do if a partner wishes to contribute services in exchange for their interest, see the Insights article, “Partnerships, Part I: Carried interest and the loophole”
Corporations and built-in gains
Corporations have a similar provision that allows shareholders to contribute property to a corporation in exchange for shares in the company. IRC § 351 provides that built-in gain on the property is usually deferred if:
- an individual or group of individuals contribute money or property in exchange for stock, and
- they have control of the corporation immediately after the exchange.
In this situation, “control” is defined as the group or individual contributing property own at least 80% of total voting power of all stock and at least 80% of all outstanding stock of the corporation. For this to work, the individual/contributor can only receive stock; any money or property received is called boot and some of the gain will have to be recognized. Note that services are not property and exchange of services for stock is taxable.
See page 3 of IRS Publication 542 for more information on nonrecognition treatment.
Owner considerations: What property can the owners contribute to the entity? Does it have any built-in gain? Can the owners meet the nonrecognition rules for either type of entity?
Choice of entity tax consideration #4: For partnerships, liabilities and built-in gains can affect basis and sales of interests
There are two areas where basis adjustments can really influence a prospective owner’s decision: liabilities and sales of an owner’s interest. When it comes to liabilities, partnerships have a benefit--when a partner’s share of liabilities increases, it is treated as a contribution of cash by the partner which allows them to increase their outside basis. When their share of liabilities decreases it is treated as a distribution of cash and they reduce their outside basis. If that adjustment would make the outside basis negative, the amount exceeding the partner’s outside basis will have to be recognized as gain. This gets more complicated when a partner contributes property that is subject to a liability that the partnership assumes. In that case, the assumption of the liability by the partnership is treated as a distribution of cash which results in a negative basis adjustment that could trigger gain. But the partner can offset a portion of this adjustment by increasing their outside basis by their share of the liability assumed.
For more information and examples of this see page 10 of IRS Publication 541.
Remember that a partner contributing property with built-in gain will recognize the amount of the built-in gain if the partnership later sells the property for a gain. But what happens when the contributing partner sells their interest prior to the sale of the gain property? The partnership will have the option to make adjustments to the partners’ inside basis in the partnership assets using a § 754 election.
This election allows the partnership to allocate the built-in gain to the continuing partners and the new partner will not be responsible for the built-in gain portion when the property is later sold. It is appropriate where the new partner paid fair market value for the interest, and doesn’t require the new partner to recognize gain as if they only paid an amount equal to the leaving partner’s outside basis in the partnership. This is not an automatic rule, and the partners should have a provision in their partnership agreement regarding § 754 election. For more on this topic see IRC § 754 and § 743.
These provisions only apply to partnerships, and corporations do not have a similar rule allowing basis adjustments for liabilities.
Owner considerations: What property do the partners want to contribute and what liabilities will be taken on by the partnership?
Choice of entity tax consideration #5: Cash distributions can trigger double taxation
When businesses start to receive cash from their operations, double taxation comes back into play. As discussed above, when C corporation shareholders receive cash payments from the business they are typically treated as dividends and taxed at 15%. Pass-through entities on the other hand are exempt from double taxation because the individual owner pays tax on their share of the company’s income.
Partnerships have a unique rule that states distributions of cash are not taxable as long as they do not exceed the partner’s outside basis in the partnership. There are some situations where payments of cash are not distributions, but rather something else like a guaranteed payment, that is taxable. Note for those partners that do not already keep detailed records of their basis should do so in order to avoid gain recognition.
Distributions to S corporation shareholders are a little more complicated in that they can be taxed as a dividend, tax free or gain from the sale of stock. S corporation shareholders can find more information on page 17 of IRS Publication 542.
Owner considerations: Will the company distribute cash to the S corporation shareholders or partners?
Choice of entity tax consideration #6: Property distributions can trigger gain or loss
When an entity distributes property to one of its owners it is treated in a similar manner as a cash distribution for sole proprietorships. The entity does not recognize gain or loss on the property upon distribution since the distribution is not treated as an exchange. There are a few exceptions to this rule for partnerships involving disguised sales, marketable securities, and hot assets.
Disguised sales occur when one partner contributes property to the partnership, and another contributes money, or money and property. Then, within seven years, the partner that contributed the property receives the money or other property as a distribution, while the other partner gets what was originally the first partner’s property distributed to them. In this case, any pre-contribution gain on the property must be recognized by the contributing partner.
Marketable securities are treated as a cash equivalent which means a distribution of marketable securities in excess of the partner’s outside basis will result in gain recognition just like cash distributions. The rules for hot assets are too complex for this introductory article but see page 5 of IRS Publication 541, for more information on the topic, and the other exceptions referenced above.
Corporations, whether C or S, do not benefit from nonrecognition treatment when they distribute property to their shareholders. If the property distributed has a fair market value in excess of its adjusted basis, the corporation will have to treat the distribution as if it sold the property to the shareholder for fair market value. This can be a problem if the corporation holds property that the shareholders expect to receive later as a distribution. In this scenario a pass-through entity might be the more beneficial choice. For more information on property distributions by corporations see page 17 of IRS Publication 542.
Owner consideration: Do owners expect to receive distributions of property?
Choice of entity tax final consideration: Get help from an advisor
The factors above should be addressed by written agreement in the form of an operating agreement, partnership agreement, or bylaws in order to avoid confusion when they arise.
These factors represent only a small portion what owners should consider, but it is beneficial to take the time to consider these before consulting an attorney. The best practice before setting up any business is to consult a business lawyer who can help owners understand all of the issues impacting choice of entity and give personalized advice about how the business entity affects owners. They can also help a prospective business owner make an informed decision and draft agreements and documents.
Need more business tax help? Check out the small business specialty services available through Block Advisors today.