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How to choose the best entity
This document provides an overview of different business entities including sole proprietorships, partnerships, limited liability companies, S corporations, and C corporations. It discusses the key characteristics, tax treatment, formation, and other considerations for each entity. The document aims to help readers choose the best business entity for their needs based on factors like liability, taxes, capital raising ability, and transferring ownership. It provides detailed information on tax filing, income allocation, losses, distributions, sales, and estate planning for each entity type.
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How to choose the best entity
- 1. How to Choosethe Best Business Entity by Alan D. Campbell Ph.D., CPA, CMA, CFP® alancampbell@elmore.rr.com Author of the forthcoming book Tax Savings Prescriptions
- 2. 2 Objectives • Explain howto choose the best business entity: – Sole proprietorship – Partnership – Limited liability company – S Corporation – C Corporation
- 3.
- 4. 4 Characteristics • Easy toform and operate • The owner has unlimited liability • The owner has limited ability to raise capital
- 5. 5 Formation • The ownermay operate under a fictitious name (a d/b/a) • The owner may have to file a fictitious name registration with the county or parish
- 6. 6 Formation • The individualowner owns the assets • No owner recognizes any gain or loss on the transfer of personal use assets to the business
- 7. 7 Income Tax Treatment •Only one level of income tax • Income and expenses retain their character • The net income is taxed at the owner’s marginal tax rate
- 8. 8 Income Tax Treatment •The owner reports income and expenses on Form 1040, Schedule C • Losses (except passive losses) are deductible against the owner’s other income
- 9. 9 More Than OneBusiness • Income and expenses from each different business are reported on separate Schedules C • A net loss from one active business may offset net income from other businesses
- 10. 10 Self-Employment Tax • Reportedon Form 1040, Schedule SE • The net income is multiplied by 92.35% • The resulting amount is multiplied by the SE tax rate of 15.3% • Half of the SE tax is deductible for AGI
- 11. 11 Passive Losses • Apassive loss may be deducted only against passive income for both income tax and self-employment tax purposes • Unused passive losses are carried forward
- 12. 12 Employing One’s Children •Can reduce income taxes and the self- employment tax • Wages paid to one’s children under age 18 are exempt from employment taxes
- 13. 13 Employing One’s Spouse •Salaries are subject to income taxes and employment taxes • Can be useful in saving self-employment tax on health insurance premiums and income tax and SE tax on medical expense reimbursement plans
- 14. 14 Employing One’s Spouse •Can make business travel costs for the accompanying spouse deductible • Can provide the spouse with earnings that can be tax sheltered with pension plans such as a SIMPLE plan
- 15. 15 Section 179 Deduction •The Section 179 deduction reduces income tax and the self-employment tax • Wages count as business income for purpose of the income limitation
- 16. 16 Net Operating Losses •May generally be carried back two years and forward for up to 20 years for income tax purposes • Are not deductible for self-employment tax purposes
- 17. 17 Transferring the Business Theowner cannot transfer a part of the equity in the business without first changing it to another type of entity
- 18. 18 Sale of theBusiness • A sale of a sole proprietorship is treated as a sale of its assets • Part of any gain will be ordinary income
- 19. 19 Transferring the Business toReduce Estate Taxes • Bequeath the business to the surviving spouse • Sell the business outright and make annual gifts from the proceeds
- 20. 20 Transferring the Business toReduce Estate Taxes • Sell the business for a private annuity • Sell the business for a self-canceling installment note
- 21.
- 22. 22 Characteristics • General partnershave unlimited liability • Partnerships have a greater ability to raise capital than do sole proprietorships
- 23. 23 Characteristics • Partnerships have relativelysimple administration and filing requirements compared to corporations • Partnerships are often much more complex for tax purposes than are other entities
- 24. 24 Formation • Transfers ofproperty to a partnership in exchange for an interest in the partnership are generally tax deferred • The receipt of a partnership interest for services is taxable as determined under Section 83
- 25. 25 Tax Year • Thepartnership must use the same tax year as used by partners that own more than 50% of the interest in the partnership • If not possible, use the tax year of all the principal partners
- 26. 26 Tax Year • Ifnot possible, use the tax year with the least amount of income deferral • The IRS may approve a different tax year if a business purpose exists
- 27. 27 Tax Year The partnershipmay elect a different tax year if the partnership makes the required payment and the deferral period is three months or less
- 28. 28 Income Tax Treatment •Partnerships have a great deal of flexibility in allocating income between or among the partners • Single level of taxation • Partners, not the partnership, pay taxes
- 29. 29 Income Tax Treatment Incomeis taxed to the partners even if the partnership makes no distributions of cash or other assets
- 30. 30 Employment Tax Treatment Forgeneral partners, the distributive share of ordinary income and any guaranteed payments are subject to the self- employment tax
- 31. 31 Reporting Partnership Income •The partnership must file Form 1065 • Income is reported to each partner on Schedule K-1 • Ordinary income or (loss)
- 32. 32 Reporting Partnership Income •Separately reported items include portfolio income, capital gain/loss, and the Section 179 deduction • Net earnings from self-employment
- 33. 33 Losses • Losses flowthrough to the partners to the extent of each partner’s – Amount at risk – Adjusted basis in the partnership interest, which includes the partner’s share of the partnership’s debts
- 34. 34 Losses • Passive lossesare deductible only to the extent of passive income • Losses from a limited partnership interest are generally passive losses
- 35. 35 Distributions from the Partnership •Distributions include distributions of cash and other assets • A net decrease in a partner’s share of the liabilities is treated as a cash distribution
- 36. 36 Distributions from the Partnership •Distributions are deemed to occur at the end of the year • All other items that affect basis are taken into account before distributions
- 37. 37 Distributions from the Partnership Distributionsof property reduce the basis in the partnership interest by the adjusted basis of the property to the partnership
- 38. 38 Distributions from the Partnership •Distributions of cash are a reduction in the basis of the partner’s interest in the partnership • Distributions of cash in excess of basis result in a recognized gain
- 39. 39 Sale of aPartnership Interest A sale of a partnership interest is treated as a sale of a capital asset except to the extent of “hot assets”
- 40. 40 Optional Basis Adjustment •The partnership may elect to adjust a partner’s outside basis when – A partner acquires the interest of another partner or – The partnership distributes property to a partner
- 41. 41 Sale of the Assetsof the Business • The partnership can sell the assets of the business • The gain or loss on each asset must be calculated and characterized
- 42. 42 Termination of aPartnership A partnership terminates for legal purposes on the death, withdrawal, or bankruptcy of any partner
- 43. 43 Termination of aPartnership • A partnership terminates for tax purposes – When at least 50% of the interest in the partnership is transferred in any 12- month period or – When no business activity is carried on by any partner
- 44. 44 Transferring the Business toReduce Estate Taxes • Form a family limited partnership • Make a lifetime gift of the general partnership interest or sell it • A corporation or LLC could be formed to be the general partner
- 45. 45 Transferring the Business toReduce Estate Taxes• Retain a limited partnership interest • The value of the retained interest will receive discounts for – Lack of marketability and – Lack of control
- 46. 46 Four Types ofEntities May Be Taxed as Partnerships • General partnership • Limited liability partnership (LLP) • Limited partnership • Limited liability company (LLC)
- 47. 47 General Partnership • Allpartners have unlimited liability • Each partner is taxed on the partner’s distributive share of – The partnership’s ordinary income – The separately stated items
- 48. 48 Limited Liability Partnership •Used by professional services firms • All partners have unlimited liability for the normal business debts of the partnership
- 49. 49 Limited Liability Partnership Partnersare not liable for the professional negligence of another partner unless the other partner is under their direct supervision
- 50. 50 Limited Partnership • Limitedpartners have limited liability • Limited partners cannot take part in management • Limited partners are often a source of a large amount of capital
- 51. 51 Limited Partnership • Musthave at least one general partner • The general partner is often a corporation or LLC • Limited partners pay self-employment tax on guaranteed payments only
- 52.
- 53. 53 Characteristics • None ofthe members is personally liable for the debts of the LLC • All members have the legal right to participate in management
- 54. 54 Characteristics • LLCs mayhave an unlimited number of members • Any taxpayer can be a member of an LLC (corporations, non-resident aliens, trusts, partnerships)
- 55. 55 State Law • Littleestablished case law exists to interpret the various state statutes • Uncertainty exists for LLCs that operate in more than one state as to which state’s law will prevail
- 56. 56 Formation • Transfer ofproperty to an LLC in exchange for an ownership interest is – Generally governed by the partnership tax provisions (Subchapter K) – Generally tax deferred
- 57. 57 Income Tax Treatment •One member LLC is taxed as – A disregarded entity (sole proprietorship) – A corporation if the LLC so elects
- 58. 58 Income Tax Treatment •LLC in the USA with two or more members is taxed as – A partnership – A corporation if the LLC so elects
- 59. 59 Employment Tax Treatment Ifthe LLC elects to be taxed as a corporation, the salaries of the members who work for the LLC will be subject to FICA tax and income tax withholding
- 60. 60 Employment Tax Treatment Ifthe LLC elects to be taxed as a corporation, the LLC will be subject to FICA tax and unemployment taxes
- 61. 61 Employment Tax Treatment Ifan LLC owned by one individual is taxed as a disregarded entity, all of the net income will be subject to self- employment tax
- 62. 62 Employment Tax Treatment Ifan LLC is taxed as a partnership, the members who are equivalent to general partners will be subject to self-employment tax on their distributive share and on any guaranteed payments
- 63. 63 Employment Tax Treatment Memberswho are equivalent to limited partners will be subject to self-employment tax only on their guaranteed payments
- 64. 64 LLCs Taxed asPartnerships • The flexibility of a partnership • The limited liability of a corporation
- 65. 65 LLCs vs. SCorporations • LLCs are NOT subject to the taxes on built-in gains and excessive passive income • LLCs are NOT limited as to the number of members
- 66. 66 Selling the Assetsof the Business and Liquidating the LLC • The gain or loss on each asset must be calculated and characterized • The treatment of liquidating distributions depends on how the LLC is taxed
- 67. 67 Sale of aMembership in the LLC • If the LLC is taxed as a partnership, the interest in the LLC is a capital asset • Capital gain or loss results, except to the extent of the sale of “hot assets”
- 68. 68 Sale of aMembership in the LLC A loss on the sale of a membership in an LLC taxed as a partnership or disregarded entity cannot qualify for ordinary loss treatment under Section 1244
- 69. 69 Sale of aMembership in the LLC • If the LLC is taxed as a corporation, the sale of the LLC membership should result in capital gain or loss • Possible limited ordinary loss treatment under Section 1244
- 70.
- 71. 71 Eligibility Requirements • Mustbe a domestic (USA) corporation • Must be eligible to elect S status (not an insurance company or non-qualifying bank)
- 72. 72 Eligibility Requirements • Shareholdersare only – Individuals – Estates – Tax-exempt organizations, and – Seven kinds of trusts • No more than 100 shareholders
- 73. Eligibility Requirements • Ahusband and wife count as one shareholder • Certain family members may elect to be treated as one shareholder, up to six generations 73
- 74. 74 Eligibility Requirements • Onlyone class of stock • Stock with different voting rights is allowed • Disproportionate distributions can be deemed to indicate that the corporation has more than one class of stock
- 75. 75 Eligibility Requirements • Generally,nonresident alien shareholders are NOT allowed • An exception applies if the nonresident alien is married to a U.S. citizen or resident alien and elects to be taxed as a resident alien
- 76. 76 Trusts That Can OwnS Corporation Stock • Grantor trusts • Voting trusts • Testamentary trusts • Qualified Subchapter S trusts • Qualified retirement plan trusts • Small business trusts • Beneficiary-controlled trusts
- 77. 77 Characteristics • Limited liability •Unlimited life • Centralized management • Limited transferability of interests without losing the S election • Subject to more government regulation
- 78. 78 Formation • The transferof assets in exchange for the corporation’s stock is tax deferred if the persons who transfer property own 80% or more of the stock immediately after the transfer • The transfer of assets for the debt of the corporation is taxable
- 79. 79 Formation • The receiptof stock in exchange for services is taxable as determined under Section 83 • Service provider may make election under Section 83(b) if stock is restricted
- 80. 80 Making the SElection • File Form 2553 with the IRS • All shareholders must consent • The election must be timely and properly filed
- 81. 81 Deadline for theS Election • The corporation may make the S election at any time in the year before it is to become effective • The corporation may make the S election on or before the 15th day of the third month of the tax year of the year it is to be effective
- 82. 82 Deadline for theS Election • A new corporation may make the S election on or before the 15th day of the third month of its first tax year • The first tax year begins on the day the corporation has assets, shareholders, or begins business
- 83. 83 Deadline for theS Election If the corporation makes the S election late, the IRS may treat the election as timely if the corporation had reasonable cause
- 84. 84 Deadline for theS Election • The election is faulty if the corporation failed to qualify or did not obtain shareholder consents • However, the IRS may honor the election if the corporation corrects the problem within a reasonable time
- 85. 85 Tax Year • AnS corporation generally must use the calendar year • A fiscal year is allowed if it has a business purpose • The corporation may also use the same year as used by shareholders who own more than 50% of its stock
- 86. 86 Tax Year • TheS corporation may also elect to use a different tax year • The maximum deferral of income is three months • Requires payments to the IRS to compensate for the deferral
- 87. 87 Ownership of CCorporations • A C corporation may NOT own stock in an S corporation • However, an S corporation may own stock in a C corporation • No consolidated return allowed with a C corporation
- 88. 88 QSubs • An Scorporation may have qualified S corporation subsidiaries (QSubs) • The QSubs are disregarded for tax purposes
- 89. 89 QSub Criteria • Mustqualify as an S corporation • The S corporation parent must own all of its stock • The parent elects to treat it as a QSub
- 90. 90 Income Tax Treatment •No corporate income tax except for – Built-in gains – Excessive net passive income – LIFO recapture tax – Recapture of investment tax credit
- 91. 91 Penalty Taxes • AnS corporation Is NOT subject to – The accumulated earnings tax or – The personal holding company tax
- 92. 92 Income Tax Treatment •The S corporation must file Form 1120S by March 15th • Income is allocated to the shareholders on Schedule K-1
- 93. 93 Income Tax Treatment •Income is taxed to the shareholders at their marginal tax rates • Capital gains, tax- exempt income, and other separately stated items retain their character
- 94. 94 Income Tax Treatment •Income is taxed to the shareholders on a per share per day basis • Therefore, S corporations are not as flexible as partnerships
- 95. 95 Splitting Income • Scorporation stock can be given to family members to split income among the family members • However, the S corporation must pay reasonable compensation to family members who provide services or capital to the corporation
- 96. 96 Splitting Income The IRSmay ignore gifts of stock to family members if the IRS determines that the donor retains the economic benefits and control of the stock
- 97. 97 Dividends Received Deduction Unlikea C corporation, an S corporation is NOT entitled to the dividends received deduction
- 98. 98 Treatment of Certain FringeBenefits • Statutory fringe benefits are included in the gross income of more than 2% shareholders • The S corporation may deduct the fringe benefits as business expenses
- 99. 99 Employment Tax Treatment •Shareholders who work for the corporation are employees • Salaries are subject to FICA tax and income tax withholding • The corporation Is subject to FICA tax and unemployment taxes
- 100. 100 Reducing Employment Taxes TheS corporation can reduce employment taxes by paying the lowest amount of a range of reasonable salaries to shareholder- employees
- 101. 101 Treatment of Losses •Losses flow through to the shareholders to extent of each shareholder’s: – Basis in stock – Basis in loans to the S corporation
- 102. 102 Tax Planning for LossDeductibility The shareholder can loan money to the S corporation or make a contribution to capital before the end of the year if necessary to deduct the loss currently
- 103. 103 Treatment of Losses •The treatment of losses is favorable for new businesses that are likely to incur losses • When the corporation becomes very profitable, the shareholders can revoke the S election
- 104. 104 Treatment of Losses •Losses subject to – Amount at risk rules – Passive activity loss rules – Hobby loss rules
- 105. 105 Treatment of Losses •Losses of an S corporation are often more limited than are losses of a partnership • The basis in a partnership interest includes the partner’s share of the debts of the partnership
- 106. 106 Treatment of Distributions •Distributions are a tax free recovery of basis to the extent of the shareholder’s basis in the stock • The basis in debt does NOT absorb distributions
- 107. 107 Treatment of Distributions Distributionsin excess of the basis of a shareholder’s stock result in gain recognition to the shareholder
- 108. 108 Treatment of Distributions ofProperty • Distributions of appreciated property result in gain recognition by the corporation • However, no losses may be recognized
- 109. 109 Treatment of Distributions ofProperty • The amount of the distribution of property is its – Fair market value – Minus any debts assumed or taken subject to by the shareholder
- 110. 110 Former C Corporations •Former C corporations with accumulated earnings and profits (E&P) keep an accumulated adjustments account (AAA) • AAA is the total of income and loss from the S period (except tax-exempt income and related expenses)
- 111. 111 Former C Corporations •Distributions come first from the AAA and reduce the basis in the shareholder’s stock • Distributions come next from E&P and are taxable
- 112. 112 S Election Remains UntilRevoked or Lost • Voluntary revocation is easy and requires the approval of a majority of the shareholders • Involuntary revocation occurs when – A new shareholder with over one half of the stock refuses to consent to the election – The corporation no longer qualifies as a small business corporation – The corporation does not meet the passive investment income limitation
- 113. 113 Termination of theS Election for Excessive Passive Income • Passive income greater than 25% of its gross receipts for three consecutive years and • C corporation earnings and profits exist for each of the three years
- 114. 114 Preserving the SElection • Management and shareholders should know the factors that affect S status • Avoid passive investment income limitation violations • Restrict transfer of stock to avoid loss of S status
- 115. 115 Inadvertent Terminations • TheIRS may continue to allow the S election if – The termination is inadvertent and – The corporation takes the necessary steps to meet the eligibility criteria within a reasonable time
- 116. 116 New Election • Ifthe S election is terminated, the corporation must – Wait five years to make a new election or – Obtain the consent of the IRS
- 117. 117 Sale of theBusiness • You can structure the sale of the business as – A sale of stock or – A sale of assets followed by a corporate liquidation
- 118. 118 Sale of theBusiness • A sale of the stock should result in capital gain or loss • Possible limited ordinary loss treatment under Section 1244
- 119. 119 Liquidation • Liquidation ofan S corporation is governed by the provisions of Subchapter C • No double tax occurs except to the extent of built-in gains
- 120.
- 121. 121 Characteristics • Limited liability •Unlimited life • Centralized management • Free transferability of interests • Subject to more government regulation
- 122. 122 Characteristics • Unlimited number ofshareholders allowed • Often used for a growing business that is reinvesting its profits in the business
- 123. 123 Formation The transfer ofassets to the corporation in exchange for its stock is tax deferred if the persons who transfer property own 80% or more of the stock immediately after the transfer
- 124. 124 Formation • The transferof services to the corporation in exchange for its stock is taxable as determined under Section 83 • The transfer of property in exchange for the corporation’s debt is taxable
- 125. 125 Fringe Benefits • Manyfringe benefits are deductible by the corporation • They are often tax free or tax deferred to the shareholders- employees
- 126. 126 Passive Activity LossRules • Apply only to – Personal service corporations – Closely held corporations
- 127. 127 Net Operating Losses •Do NOT flow through to the shareholders • Can generally be carried back two years and then forward for up to 20 years
- 128. 128 Capital Losses • Aredeductible only to the extent of capital gains • Are carried back three years and then carried forward for up to five years
- 129. 129 Special Deductions • Organizationcosts • Dividends received deduction • Charitable contributions
- 130. 130 Sale of theBusiness • Sale of stock – No corporate tax – Shareholder realizes capital gain or capital loss – Possible limited ordinary loss treatment under Section 1244
- 131. 131 Sale of theBusiness • Sale of assets – Corporation recognizes gain or loss on sale of each asset – Distributions are taxed to the shareholders as capital gain or capital loss
- 132. 132 Double Taxation • Incomeis taxed at the corporate level • Dividends are taxed to shareholders when distributed
- 133. 133 Reducing Double Taxation •Avoid distributing dividends • Make cash payments to the shareholders that are deductible by the corporation
- 134. 134 Reducing Double Taxation •Make cash payments to the shareholder that are a tax free recovery of basis • Make the S election
- 135. 135 Deductible Cash Payments •Lease payments • Reasonable compensation • Interest
- 136. 136 Cash Payments ThatAre a Tax Free Recovery of Basis • Principal payments on debt • Stock redemptions treated as a sale • Liquidating distributions
- 137. 137 Penalty Taxes • Accumulated earningstax • Personal holding company tax
- 138. 138 Double Tax onthe Sale of the Assets of the Business • The corporation recognizes gain or loss on the sale of the assets • The shareholders recognize capital gain on the distribution of the proceeds
- 139. 139 Conclusion • The bestentity for a your business depends on many factors, including state income tax rules • You should make the decision with guidance from your attorney and tax professional
- 140. Bonus Material 11 ReasonsYou May NOT Want to Incorporate
- 141. 1. Banks RequireCosigners • Banks will usually require major shareholder(s) to consign any corporate loans • Thus, there would be no limited liability for bank loans 141
- 142. 2. Piercing theCorporate Veil • Most corporations keep poor records such as minutes and resolutions • Many stockholders of small corporations commingle personal and corporate assets 142
- 143. Shareholders Become Liable •A plaintiff’s attorney may be able to pierce the corporate veil • If so, the shareholders could be personally liable for any corporate debt 143
- 144. 3. Defending a LawsuitIs Expensive • Even if a corporation keeps good records and does not commingle assets • The corporation would have to pay to defend a lawsuit, except to the extent that an insurance company will pay 144
- 145. 4. Breach ofFiduciary Duty • Even if the corporation keeps good records and does not commingle assets • You can be sued individually for breach of fiduciary duty as a director or officer of the corporation • You can insure such risk, but it can be expensive 145
- 146. 5. Foreign CorporationFees • A corporation is an artificial person that has received a charter from a particular state • To do business in another state, the corporation must register with that state and pay a fee as a “foreign corporation” 146
- 147. 6. Few AdditionalDeductions • Section 162 authorizes deductions for business expenses • It applies to all types of businesses • There are few deductions a corporation may claim that are not allowed to other types of business entities 147
- 148. 7. Employment Taxesfor Children Under Age 18 • If your children are under age 18 and they work for your sole proprietorship, their wages are not subject to employment taxes • If your children work for your corporation, their wages are subject to employment taxes 148
- 149. 8. More Government Formsto File • If you operate as a corporation, you have to file more forms and pay more fees to federal and state governments • Complying with all the rules takes additional time and money away from your business 149
- 150. 9. Can LoseStock to Personal Judgments • A court may not force a creditor to be a partner with someone • If someone gets a judgment against an LLC member or partner, usually all the creditor gets is a charging order 150
- 151. Judgment Creditor Can SeizeStock to Satisfy Judgment • A personal judgment creditor of a shareholder may be able to take the stock to satisfy the judgment • You can buy personal umbrella liability insurance to hedge against this risk 151
- 152. 10. Payroll Tax Penaltieson Your Own Salary • If your corporation pays you a salary and does not deposit the payroll taxes timely, the corporation could be subject to large penalties • And you as an individual could be subject to the trust fund recovery penalty 152
- 153. 11. Possible Taxon Transfer of Appreciated Assets • If you transfer appreciated assets to a corporation that you control and if you do not comply with Section 351 • You could owe income tax just for placing the assets in a corporation 153
- 154. Conclusion • Think carefullyand get excellent advice before you form a corporation • Corporations do have some benefits • But many of the alleged benefits are myths and half truths 154
- 155. Credits This presentation wascreated using PowerPoint® presentation graphics program, a Microsoft® software. PowerPoint® is a Windows®-based and Mac®-based application. All clip art is used with permission from Microsoft®. Microsoft®, Windows®, and PowerPoint® are either registered trademarks or trademarks of Microsoft Corporation in the United States and/or other countries. 155
- 156. Disclaimers Alan D. Campbell(d/b/a Campbell Education) is an independent entity and is not affiliated with, nor has he been authorized, sponsored, or otherwise approved by Microsoft Corporation. 156