Tax Advantages and Disadvantages for Different Entities
Tax Advantages & Disadvantages
The advantages and disadvantages of each entity should be discussed with the business owners, both to determine their input on the issue as well as to inform and educate them about the implications. Although it is important for the accountant to be familiar with the nontax factors involved in choosing an entity, an experienced attorney should be directly involved in providing advice on liability issues. The accountant must be fully versed in the tax advantages and disadvantages of the various entities prior to advising a client in their selection. The following text outlines the key tax advantages and disadvantages of each entity.
Key Tax Advantages:
Wages Paid to Children A unique advantage of a proprietorship is the ability to pay wages to children of the owner without incurring any FICA or FUTA payroll tax liability. Children of the owner under age 18 are exempt from FICA and those under age 21 are exempt from FUTA. In addition, the child does not owe the employee portion of the FICA tax. This tax break allows the proprietor to reduce taxable business income for both income tax and self-employment tax purposes without incurring the FICA and FUTA taxes that apply to wages paid to other employees. Because the child’s wage income is earned income, some of it can usually be sheltered by the child’s standard deduction. The wages paid to the child must be reasonable in relation to the actual work performed.
At-risk Rules A taxpayer’s deductible business loss is limited to the amount that the taxpayer has at risk with respect to an activity. The at-risk rules limit loss deductions to the amount of the taxpayer’s cash contribution and the adjusted basis of other property contributed to the activity, plus any amounts borrowed for use in the activity if the taxpayer has personal liability for the borrowed amounts or has pledged assets not used in the activity as security for the borrowed amounts. Nonrecourse loans are not considered at risk. The owner of a proprietorship generally receives basis from all debt for loss deduction purposes. Generally, this allows a proprietor to fully deduct any losses without an at-risk limitation.
Fringe Benefits via Spousal Employment A proprietorship can offer tax-advantaged accident and health benefits to the owner, spouse, and dependents by employing the spouse and setting up an accident and health plan that covers the employee, the employee’s spouse (the owner), and the employee’s dependents (the owner’s children). As long as the spouse is a bona fide employee, the IRS concedes that the cost of the plan can be deducted, while the employee (the owner’s spouse) can exclude the benefit from taxable income.
If an employer provides health benefits under an insurance plan, no discrimination requirements exist. Thus, a sole proprietor can provide health insurance to his employed spouse, regardless of how many other employees were covered by health insurance. A proprietor’s ability to employ a spouse and provide fully deductible health insurance as a fringe benefit represents an opportunity to increase the self-employed health insurance deduction to 100% deductibility, and also to achieve full deductibility of this expense against business self-employment income.
No Double Taxation A proprietorship is not subject to the potential double taxation faced by a C corporation. Upon distribution of a dividend or at liquidation, income retained by a C corporation will be taxed again to the shareholders. Thus, retained income will be subject to double taxation in most cases (once when earned at the corporate level and again when paid out as a dividend or liquidation proceeds at the shareholder level). A proprietorship is not subject to this double taxation because all of the income is taxed at one level. Also, a proprietorship does not face the gain recognition that occurs at the entity level when a corporation (C or S) distributes an appreciated asset to its owners.
Key Tax Disadvantages:
Self-employment Tax Owners of a proprietorship are considered self-employed persons subject to Self-employment tax (SE tax). SE tax rates consist of two separate components—a social security component and a Medicare component. The social security tax ceiling applies to the taxpayer’s combined wage and SE incomes. For 2002, the social security tax of 12.4% applies to a maximum of $84,900 of self-employment income, while the Medicare tax of 2.9% has no ceiling.
All Income Taxed at Individual Level In the proprietorship format, the net trade or business income is combined with the taxpayer’s other income to calculate taxable income. If the proprietorship reports a loss, this combining can reduce the taxpayer’s tax liability. As a C corporation, the loss is trapped inside the corporation and is not available to reduce the shareholder’s personal taxable income. Conversely, the net income of a proprietorship is combined with the taxpayer’s other income to arrive at taxable income. If the proprietorship is quite profitable, the trade or business income combined with the taxpayer’s other income can bring the taxpayer into the highest individual tax bracket. As a C corporation, the business income is taxed at the corporate level, at a rate lower than the top individual rates.
Lack of Fringe Benefits In general, a sole proprietorship is unable to provide tax-free fringe benefits (other than qualified retirement plans) to the owner/proprietor and the family members of the proprietor. In some cases, however, it may be possible for the proprietor to employ his or her spouse, and thereby accomplish tax-advantaged fringe benefits.
Key Tax Advantages
Tax Basis from Partnership Debt A partner obtains additional basis from partnership debt because the partner’s share of debt is treated as a cash contribution for basis purposes. As a result of the partnership basis-from-debt rule, general partners can potentially deduct losses in excess of their investments (to the extent of the additional basis from their shares of partnership debt). This can be a big advantage if the start-up business expects relatively large tax losses in early years.
In comparison, the deductibility of losses by S corporation shareholders is less liberal. S corporation shareholders only receive basis for debt if it is a direct loan from the shareholder to the corporation.
Basis Adjustments When Partnership Interests Are Acquired A unique aspect of partnership taxation is that someone acquiring a partnership interest can step up the tax basis of a pro rata share of the partnership’s assets to reflect the purchase price. This option is available if the partnership makes or has in effect a so-called Section 754 optional basis adjustment election. If such an election is in place, the deductions related to partnership assets (for example, depreciation) allocated to the purchasing partner are based on the higher purchase price basis rather than on the partnership’s historical tax basis. Also, if the partnership sells the depreciated property, the purchasing partner’s allocation of gain is smaller because of the higher basis the partner has in the property. No such election is available to purchasers of C or S corporation shares.
Tax-free Contributions and Distributions of Property Partners generally can make contributions of appreciated property, that is, property with a fair market value in excess of basis, to a partnership at any time without recognition of taxable gain. Also, partnerships can generally distribute appreciated property to the partners without recognition of taxable gain. These rules often give partnerships and partners the freedom to make necessary transfers of property without immediate adverse tax consequences.
Ability to Make Special Tax Allocations A special tax allocation is an allocation of income, gain, loss, deduction, or credit among the owners that is not in proportion with their ownership interest. For example, the allocation of 90% of tax losses to a 50% owner is a special tax allocation. In a partnership such a special allocation is possible.
No Entity-level Taxes Partnerships are free from the regular corporate income tax, the personal holding company tax, the accumulated earnings tax, and the entity-level alternative minimum tax that apply to C corporations. In addition, the C corporation issue of unreasonable compensation does not apply to partnerships, as all income is taxed at the partner’s level.
Deductibility of Partner-level Interest Expense Partners may incur interest on debt used to acquire a partnership interest or make a capital contribution to a partnership. The rules for deducting such interest are the same as the rules that apply to S corporations. The partner can deduct the interest expense on page two of Schedule E in the same location as the income or loss pass-through from the partnership. This tax treatment is much more favorable than the tax treatment of interest incurred to acquire C corporation stock. Such interest is treated as investment interest, with the deductible amount limited to the taxpayer’s investment income.
Elimination of Self-employment Tax of a Limited Partner By statute, a limited partner (including a member of a LLC) does not include his or her share of partnership income as self-employment income, with the exception of guaranteed payments for services actually rendered. There are, however, exceptions in proposed regulations under which a limited partner may be subjected to self-employment tax.
Key Tax Disadvantages:
Inability to Reduce Payroll Taxes All partnership ordinary income from business activities allocable to general partners and all guaranteed payments to partners for services are subject to the self-employment (SE) tax at the individual partner level. Consequently, partnerships do not have the opportunity to reduce SE tax by limiting the amount paid in the form of wages to general partners and increasing the amount treated as nontaxable distributions. Exceptions exist, however, for income not related to the partnership’s trade or business, such as real estate rental activity. In general, a limited partner is not subject to self-employment tax on partnership income, with the exception of guaranteed payments to the limited partner for services actually rendered.
Unfavorable Tax Treatment of Fringe Benefits for Partners A fringe benefit, such as accident and health insurance, paid by the partnership for the benefit of partners and their spouses and dependents is deductible by the partnership as a guaranteed payment to the partner. However, the partner must include the amount in taxable income. Self-employed health insurance premiums are partially deductible by the partner at the individual level as an above-the-line deduction. A partnership can employ a spouse of the partner to allow for the deductibility of the fringe benefits in computing the ordinary income of the partnership. The employment relationship must be legitimate (i.e., actual services must be rendered in exchange for reasonable compensation).
Lack of Flexibility to Select a Tax Year-end A partnership is generally required to use the same year-end as that of its principal partners, usually December 31, unless it is willing to make tax deposits. These tax deposits approximate the tax deferral gained at the partner level from the use of the alternative year-end. Unfortunately, the tax deposit computation is based on the highest individual tax rate plus 1% applied to an approximation of the amount of deferred taxable income. Thus, many partnerships find using an alternative year-end to be prohibitively expensive. In limited circumstances, if a newly formed start-up partnership can prove a business purpose for using an alternative year-end, tax deposit payments are not required.
Treatment of Losses on Partnership Interests Losses from the disposition of partnership interests are generally capital in nature. In contrast, shareholders of C and S corporations may be able to claim ordinary loss treatment for up to $100,000 of annual losses from the sale or worthlessness of shares that qualify as IRC Sec. 1244 stock.
Potential Ordinary Treatment for Gains on Sales of Partnership Interests To the extent a partnership has so-called hot assets, IRC Sec. 751 mandates that some or all of the selling partner’s gain on sale be treated as ordinary income rather than capital gain. Hot assets include substantially appreciated inventory, unrealized receivables, and potential ordinary income recapture on the sale of most depreciable assets. This is essentially the same result as a proprietorship sale of assets, but less favorable than the capital gain that can occur on the sale of stock of a corporation.
Single Section 179 Deduction Limit An individual operating under a separate proprietorship form may potentially claim a Section 179 deduction for qualifying property placed in service during the tax year. But if several individual proprietors together form a partnership, only a single Section 179 deduction would be permitted for the partnership, which would be shared by each partner.
Key Tax Advantages:
Tax Rates Since corporations are separate legal entities, their net income is taxed at corporate rates. The individual tax brackets tend to move to higher rates at lower income levels. By maintaining a C corporation, the corporation and its shareholders can, in some cases, pay significantly less total overall tax than the shareholders alone would pay if all corporate income was passed through to them.
Self-employment Tax Savings The use of a corporation can reduce the self-employment tax that would be incurred if the business was operated in proprietorship or partnership form. When a business is conducted in corporate form, only the portion of the business earnings that are withdrawn from the corporation as salaries are exposed to FICA and FUTA payroll taxes. In some businesses, particularly smaller entities or those in their formative years, lower levels of earnings withdrawals by the owner-employees are the norm. If the business is conducted as a proprietorship or partnership, however, all earnings, even those retained within the business for growth, will trigger the self-employment tax.
Fringe Benefits for Employee-owners Employees must include the value of fringe benefits in their taxable income unless another provision of the Code specifically excludes it. Fortunately, C corporations can offer a number of tax-advantaged fringe benefits to their employees (who in closely held businesses are frequently also the owners). The corporation can deduct the benefits, and the employees can exclude them from taxable income.
Flexibility to Select a Fiscal Year-end C corporations, other than personal service corporations (PSCs), are one of the few entities allowed to report on a fiscal year for income tax purposes. Because most businesses tend to have fluctuations in taxable income from year to year, the use of a C corporation operating on a fiscal year can provide a leveling effect by shifting income between tax years. Salary payments from the fiscal year corporation to the calendar year Form 1040 of employee-shareholders may be postponed or accelerated to offset the natural fluctuations in business income from year to year. Also, the use of a fiscal year can result in deferral of the taxation of earnings to the extent deductible payments (compensation, rent, interest) are issued from the corporation to individual stockholders after December 31.
Treatment of Passive Losses C corporations, other than PSCs and closely held corporations, can deduct passive losses in full. PSCs are subject to the same rules as individuals, estates and trusts, which means they can generally deduct passive losses only against passive income. A closely held corporation (defined as a corporation in which more than 50% of the stock’s value is held by five or fewer individuals at any time during the last half of the year) can use passive losses to offset net active business income, but not portfolio income. Closely held corporations involved in real property trades or businesses are not subject to limitations on the deductibility of passive losses from rental real estate.
Dividends Received Deduction Qualified dividends received from domestic corporations are partially deductible by C corporations. The deduction is generally 70% of the dividends received, but increases to 80% if the investor corporation owns 20% or more of the stock in the distributing corporation, and to 100% in the case of dividends paid to a member of the same affiliated group. The deduction is not available on dividends passed through to the owners of an S corporation.
Section 1244 Ordinary Stock Loss Shareholders may be able to claim ordinary loss treatment from the sale or worthlessness of C corporation shares that qualify as IRC Sec. 1244 stock. In contrast, losses from partnership interests (including interests in LLCs treated as partnerships for tax purposes) are generally capital in nature. An ordinary loss on Section 1244 stock can be claimed only by an individual to whom the stock was originally issued. Thus, shareholders who have acquired their stock by gift or inheritance or by purchase from the original holder are not eligible for Section 1244 treatment.
Key Tax Disadvantages:
Double Taxation of Corporate Earnings The tax treatment of income and losses of a C corporation may result in double taxation. Income retained by a C corporation will eventually be taxed to the shareholders if it is distributed as a dividend or if the corporation is liquidated. Even if the shareholder sells stock, presumably the retained after-tax income has been reflected in added stock sale proceeds. Thus, retained income will eventually be subject to double taxation in most cases—once when earned at the corporate level, and again when paid out as dividends or liquidation proceeds, or received as stock sale proceeds at the shareholder level.
Double taxation, however, is not always detrimental if the income within the C corporation can be controlled so as to remain at the bottom federal corporate tax rates.
Double Taxation of “Inside Gains” If a corporation distributes appreciated property (including goodwill) to its shareholders, the corporation is treated as if it sold the property to the shareholders for its fair market value. Gain or loss is recognized by the corporation as a result of the distribution. It’s wise to be cautious about forming or using C corporations containing assets that have inside gain potential. For example, there are very few situations where a depreciable building (which often also has potential appreciation) would be placed within a C corporation. The only cure to the risk of double taxation of inside gains occurs if the shareholder can sell the stock of the corporation, which results in capital gain. Many buyers, however, are reluctant to purchase stock.
Excessive Compensation from C Corporations Compensation payments to an employee-shareholder from a corporation may be challenged by the IRS as unreasonably high. In such situations the IRS may assert that the excessive amount of salary is a nondeductible constructive dividend, which leads to the assessment of additional corporate income tax. Generally, compensation will be considered reasonable if it is an amount that “would ordinarily be paid for like services by like enterprises under like circumstances”. A determination of the reasonableness of compensation is dependent on the facts and circumstances of each case.
Personal Service Corporation (PSC) Limitations In general, a PSC is a C corporation whose owner-employees render personal services. PSCs are subject to a significant number of special tax limitations that do not apply to other corporations. To add further complexity, a corporation may meet the definition of a PSC for purposes of one rule but not be considered a PSC for purposes of others.
The most significant of the special tax rules that apply to PSCs are as follows:
PSCs are limited in their ability to use a tax year different from the calendar year.
The 35% flat tax rate that applies to PSC taxable income. Defeating the 35% flat corporate tax rate (when using the cash method of accounting) requires that year-end bonuses be used to reduce corporate income to near zero.
The passive loss rules apply to PSCs in essentially the same manner as to individuals.
Personal Holding Company (PHC) Tax A PHC is a C corporation that has more than 50% in value of its outstanding stock owned by five or fewer individuals and has at least 60% of its adjusted ordinary gross income from passive sources. The PHC tax is levied on the corporation at a flat rate tied to the maximum individual tax rate. In general, PHC income consists of dividends, interest, royalties, rents, and income from personal service contracts.
While the PHC tax is only imposed on a C corporation, election of S status may not be an effective solution. An S corporation that has prior C corporation earnings and profits, and more than 25% of its gross receipts from PHC income sources is also exposed to a corporate-level tax of 35% on the net passive income.
Accumulated Earnings Tax (AET) Penalty Taxes The AET is imposed when a C corporation’s accumulated earnings and profits exceed the greater of $250,000 or the amount required for the reasonable needs of the business. The $250,000 exemption is reduced to $150,000 in the case of a corporation whose principal function is performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. The AET is levied at a flat rate equal to the highest individual rates. A corporation subjected to the accumulated earnings tax will often remove or reduce this tax by reporting a deemed dividend distribution to shareholders.
Investment Interest Expense Limitations When an individual shareholder purchases C corporation stock or borrows funds to contribute to the capital of a C corporation, the interest expense on the related debt is considered investment interest. Investment interest expense is only deductible to the extent of the investment income of the individual. Although excess investment interest expense carries forward to future years, a cash flow hardship can result. This occurs because the source of repayment of the stock acquisition loan is usually salaries and wages from the C corporation. Election of S status can be an effective solution because interest expense to acquire or contribute to the capital of an S corporation is deductible in arriving at AGI.
Limitations Caused by Corporate Ownership Changes The ability to use a corporation’s net operating losses, built-in losses, unused tax credits, and capital loss carryovers is severely restricted if that corporation experiences an ownership change (generally a 50% change of stock ownership within a three-year period).
These rules reflect a potential disadvantage of the corporate form compared with businesses organized as S corporations, sole proprietorships, and partnerships. These other entities pass through tax losses and credits to their owners, who use these losses and credits to shelter income from other sources.
Key Tax Advantages
No Double Taxation Probably the most significant tax advantage of an S corporation is the lack of double taxation as is evident with a C corporation. However, S corporations that formerly were C corporations may be subject to built-in gains tax, which is intended to mirror the double tax applied to C corporations.
Pass-through to Shareholders S corporations are pass-through entities that allow long-term capital gains, tax-exempt income, and corporate losses to be passed through to shareholders to report on their personal tax returns. If tax losses are expected to be incurred in the early years of a start-up business, they can be passed through to S corporation shareholders (subject to the basis, at-risk, and passive loss rules) instead of remaining trapped in the corporation where they are of no benefit until taxable income is earned.
No Personal Holding Company or Accumulated Earnings Taxes Unlike C corporations, S corporations are not exposed to the risk of the personal holding company tax or the accumulated earnings tax. These penalty taxes are levied on C corporations only.
No Excessive Compensation Issues Because S corporation income is taxed only once at the shareholder level, there is no issue of excessive compensation of employee-shareholders. However, an S corporation can be questioned for unreasonably low wages paid to an employee-shareholder if draws by employee-shareholders in lieu of wages in an attempt to mitigate payroll taxes.
Ability to Reduce Payroll Taxes S corporations and their employees must pay federal FICA and FUTA on employee wage income, including the wages of employee-owners. However, cash distributions from S corporations to employee-owners are not subject to payroll taxes or self-employment tax, provided the distributions are not disguised wages. The IRS and the courts have made it clear in recent years that amounts treated as distributions to S corporation employee-owners will be recharacterized as wages subject to federal payroll taxes if they are actually disguised compensation for services as an employee. Also, payments on inadequately documented loans have been recharacterized as compensation to a controlling S shareholder. Thus, to realize any payroll tax savings, the amounts treated as wages must not be so understated the IRS can successfully assert that some or all of the cash distributions should be recharacterized as wage compensation.
No Corporate Alternative Minimum Tax S corporations are not subject to the corporate alternative minimum tax (AMT). However, they must make certain computations such as depreciation adjustments to report the information necessary for shareholders to make their AMT calculations.
No Personal Service Corporation Rules The unfavorable rules applicable to personal service corporations do not apply to S corporations.
Deductibility of Shareholder Interest Expense Shareholders may incur interest on debt used to acquire S corporation stock or make a capital contribution to the S corporation. The rules for deducting such interest are the same as the rules that apply to partnerships. The shareholder can deduct the interest expense on page two of Schedule E in the same location as the income or loss pass-through from the partnership. This tax treatment is much more favorable than the tax treatment of interest incurred to acquire C corporation stock. Such interest is treated as investment interest, with the deductible amount limited to the taxpayer’s investment income.
Tax-free Withdrawals of Equity Unlike C corporation shareholders, S corporation shareholders can generally withdraw (in the form of cash) their equity in a tax-free manner, to the extent of basis in their stock. The ability to do so is enhanced by the fact that S corporation stock basis is increased by the owners’ shares of passed-through taxable income. In contrast, when a C corporation has earnings and profits, distributions to the shareholder are treated as dividends to the extent of current or accumulated earnings and profits.
Possible Ordinary Loss Treatment for Stock Losses S corporation shareholders may be able to claim ordinary loss treatment for up to $100,000 of annual losses from the sale or worthlessness of shares that qualify as IRC Sec. 1244 stock. Section 1244 allows certain shareholders to treat losses incurred from the sale, exchange, or worthlessness of qualified corporate stock as ordinary losses and not as losses from the disposition of a capital asset. In contrast, losses from a partnership interest, including LLCs treated as partnerships for tax purposes, are generally capital in nature.
Increases in stock basis for contributions to capital and increases due to pass-through of S corporation income do not qualify for Section 1244 treatment.
Capital Gain Rates on Stock Disposition When a proprietor or partner disposes of an interest in a business, a portion of the gain is generally ordinary income rather than capital gain (i.e., ordinary income treatment is attributable to the portion of the gain arising from accounts receivable, inventory, and Section 1245 depreciation recapture). Furthermore, the ordinary income elements are not eligible for installment sale treatment. On the other hand, when the business is within an S corporation, a shareholder can sell stock and generally report the entire disposition under capital gain rates and with the availability of the installment method.
Key Tax Advantages/Disadvantages:
The advantages and disadvantages of an LLC will depend on the entity’s classification for tax filing purposes. LLC will be classified as a partnership due to the default rules of the check-the-box regulations. A single-member LLC will be taxed as a sole proprietorship unless an election is made to be taxed as a corporation. Corporations can subsequently elect S status. Please refer to the sections above for the key tax advantages and disadvantages for these types of entities.