Choosing a Business Entity: Part II

January 10, 2023  | By David Lowe

Part II: Tax Considerations and Entity Selection Case Studies

Entrepreneurial spirit, customer service, innovation and grit are some of the keys to running a successful business. Perhaps just as important, though – at least from a financial perspective – is the entity type that a company adopts.

Part I on this topic outlined the legal requirements for creating different entity types, and it provided a basic overview of liability issues. Now, let’s consider how various business entities are taxed and how entrepreneurs weigh the multitude of factors when picking the best business form for their specific situations.

TAX CONSIDERATIONS

Sole proprietorships

Business income or losses from a sole proprietorship go on Schedule C. The net profit or loss then carries over to the business owner’s personal Form 1040.

Sole proprietors pay self-employment tax (up to 15.3 percent) on their earnings and pay half of their employees’ Social Security taxes.

Although sole proprietors do not pay unemployment taxes for themselves, they pay Federal Unemployment Tax (FUTA) for their employees. The IRS requires FUTA payment if either of the following is true:

• the employer paid wages of $1,500 or more in any calendar quarter
• one or more employees worked at least part of a day in any 20 different weeks of the calendar year

Sole proprietorships, partnerships and S corporations can receive a 20 percent qualified business income (QBI) deduction, subject to a number of specific conditions.

Partnerships

As the Nolo legal encyclopedia explains, partnerships themselves do not pay federal income taxes, and the entity files Form 1065 for informational purposes only. Because partnerships are pass-through entities, the actual tax levy flows through to the partners. Each partner receives a Schedule K-1, which shows the partner’s proportional share of the profits or losses from the business. The information from the K-1 flows through to Schedule E on the partner’s Form 1040.

The partnership agreement explains how profits and losses are allocated – i.e. in what percentages – to each partner. Although special allocations may be allowed (potentially subject to increased IRS scrutiny), allocations typically are based on each partner’s percentage of ownership.

For example, if a partner has a 10 percent interest and the business reports net income of $1 million, the partner would report $100,000 of income.

It is important to note that partners still owe taxes on their share of profits even if the business does not actually make payments to the partners. This can happen when the partners decide to reinvest in the business.

Because partners can face a large tax bill without receiving enough money from the business to cover it, personal cash flow management is essential. This could mean purposely keeping a larger emergency fund than if one were a W-2 employee (whose employer withholds taxes from each paycheck). Or, to help with mental accounting, some people find it useful to maintain an extra bank account – separate from their regular checking, savings and/or emergency accounts. The additional account can serve specifically to accumulate and disburse funds for estimated tax payments, which the IRS requires each quarter.

Maintaining multiple personal bank accounts and assigning a specific purpose to each one can help one avoid accidentally overspending and then coming up short at tax time. For example, if funds for estimated taxes sit in the same savings account that also holds money for vacations, it could be easy to splurge on travel, leaving too little money to cover the quarterly IRS payment. On the other hand, maintaining a special account just for taxes can provide spending “guardrails.” As long as that account balance equals the estimated tax payment amount by the IRS deadline, all is good.

“Basis” is another important tax concept for partnerships. The reason? Partners may take cash distributions out of the business, and the taxation (or lack thereof) depends on the partner’s basis.

Partners contribute money, property or services to the enterprise, and each partner’s total contributions determine the basis for that partner.

For example, if a partner invests $50,000 of cash into the business, contributes property with a tax basis of $50,000 and provides $100,000 of services, that partner’s basis would be $200,000. Note that partners must report ordinary compensation income for the value of the services they provide.

Basis increases as income flows through to the partner, and it decreases based on the partner’s share of partnership losses. Basis also decreases because of nondeductible expenses and distributions.

For example, if the partner mentioned above started with a basis of $200,000 and then reported $50,000 as his or her share of the business income, the basis would increase to $250,000. If the business suffered the next year and the partner’s share of losses equated to $50,000, the partner’s basis would drop back to the original $200,000.

Distributions are treated as a non-taxable return of capital until the basis falls to $0. For example, if a partner has a basis of $200,000, it would be possible to take a tax-free distribution of up to $200,000. If, on the other hand, the partner took a distribution of $220,000, the first $200,000 would be non-taxable, and then the remaining $20,000 would be taxed as a capital gain.

Self-employment taxes apply to partners, although the rules differ for general partners versus limited partners. According to the IRS, general partners (who participate in day-to-day management of the business) have self-employment income both from guaranteed payments and from their distributive share of the business’ income or loss. Limited partners (who contribute capital to the enterprise but don’t participate in management) don’t pay self-employment tax on their share of the business income. If limited partners receive guaranteed payments, however, they do pay self-employment tax.

C corporations

Unlike sole proprietorships and partnerships, corporations do pay federal income taxes at the entity level. Corporations may elect S corporation status (more on that later), which has different tax implications than those for C corporations. For now, let’s look at C corporations, which file their taxes on Form 1120.

C corporations pay a federal income tax rate of 21 percent – reduced by the Tax Cuts and Jobs Act from the former maximum rate of 35 percent. This may seem like a benefit when compared to pass-through entity taxation, as the 21 percent corporate rate is significantly lower than the top individual tax rate (currently 37 percent).

However, because of the way the IRS treats dividends paid to shareholders, C corporations are subject to double taxation. The Tax Foundation notes how the total tax bill grows. After a corporation pays the regular corporate tax rate on its income, if the company pays dividends, those can be taxed at up to 20 percent if they are classified as “qualified” and 37 percent if they are “ordinary.” (Here’s a helpful comparison of the criteria for qualified versus ordinary dividends.) Along with the tax on dividends, some high-income shareholders may be subject to the 3.8 percent net investment income tax.

As the IRS notes, corporations do not get tax deductions for dividend payments, and shareholders may not deduct corporate losses.

Because of double taxation, C corporation owners may be tempted to maximize their salaries – either to reduce corporate profits or to avoid paying (taxable) dividends. This can be risky, though, as the IRS requires compensation to be “reasonable” and not what the agency classifies as dividends in disguise.

Another consideration relates to payroll taxes. An owner/employee of a C corporation pays half of the Social Security and Medicare taxes (7.65 percent total), and the company pays the other 7.65 percent. This is more favorable than the self-employment tax levied on sole proprietors and partners.

Also, C corporations can give many tax-free fringe benefits, such as health insurance, group term life insurance and travel. Those benefits not only benefit employees and owners, but also are tax-deductible to the business. Pass-through entities, in contrast, typically cannot deduct the cost of such fringe benefits.

C corporations have flexibility to retain a certain amount of earnings without facing additional taxes. Many C corporations may retain as much as $250,000 in earnings without having to document the reason. For “personal service corporations” – those in fields such as health, accounting, law or engineering – the limit is $150,000. Beyond those credit amounts, corporations must document what the IRS deems a “reasonable business needs” – such as expanding operations, paying off debt or acquiring another company. If corporations retain more earnings than the $250,000/$150,000 credit amount and cannot prove a reasonable business need to hold on to the funds, they will be subject to a tax of 20 percent on the retained amount above $250,000/$150,000. The accumulated earnings tax is in addition to, not a replacement for, the regular 21 percent corporate tax rate.

S corporations

An S corporation is a corporation that has elected to be taxed with pass-through treatment. To become an S corporation, all shareholders must sign Form 2553. If the S corporation election is to take effect in the next tax year, the company may file Form 2553 at any time during the preceding tax year. For the election to take effect in the current tax year, the filing deadline is two months and 15 days after the beginning of the tax year. IRS instructions outline those deadlines and provide examples of how they apply in various situations.

S corporations file Form 1120S for information purposes, although the entity is not subject to the 21 percent corporate tax levied on C corporations. However, the IRS states that S corporations do pay tax on certain built-in gains and passive income.

In a manner similar to partnership taxation, S corporation shareholders receive K-1s and report their allocable income or loss from the business. As with partnerships, basis is an important concept. The IRS has provided a detailed explanation of basis calculations, but in many ways, basis and non-taxable distributions work the same way for S corporations as for partnerships.

There are a few key differences, though. For one thing, S corporations must allocate income and losses based on each shareholder’s percentage of stock ownership. Unlike partnerships and LLCs, S corporations may not use special allocations. Also, S corporation shareholders may increase their basis due to business debt only if they personally loaned money to the corporation. Partners, on the other hand, may increase their basis by their allocable percentage of money that the partnership borrows.

As with C corporations, the owner/employees of S corporations pay payroll taxes rather than self-employment taxes.

Limited liability companies (LLCs)

LLCs have several taxation options. These depend somewhat on how many owners – also called “members” – the LLC has. One-member LLCs are taxed as sole proprietorships (although these and other LLCs offer the liability protection that sole proprietorships lack).

Multi-member LLCs generally are taxed as partnerships, although LLCs may opt instead for C corporation or S corporation tax structures.

Self-employment taxes generally apply to LLC members. However, Nolo notes that if an owner is merely a silent investor (without service or management responsibilities), the owner may receive an exemption from self-employment taxation.

CASE STUDIES

Let’s consider a few hypothetical scenarios to see how an entrepreneur might choose the most beneficial business entity type. Keep in mind that these are just examples, and they should not be construed as legal advice. For guidance on your specific situation, please consult an attorney who specializes in business law.

Scenario 1:

Maria Gonzales and two friends plan to invest in a business. Their schedules are quite busy, so they wish to participate in ownership without assuming operational responsibilities. They have found an experienced professional to handle day-to-day management.

One of the friends has less cash to invest than the others do, but she developed an innovative technological process specifically for the enterprise. That process is expected to drive the bulk of the company’s initial growth. As a result, Maria and her friends have discussed allocating ownership other than strictly based on monetary contributions to the business.

Maria and her friends are concerned about liability.

They expect the business to generate a loss in its first tax year and then become profitable by the second year. Maria and her friends all earn high incomes and are in the 37 percent federal tax bracket. Maria’s friends plan to retire at the end of this year and then draw much lower income from part-time consulting. Maria enjoys her role as a corporate executive, but she is confident that she would find nonprofit work even more fulfilling. She has prepared for the significant income reduction and plans to start her new career next year.

Based on the many factors involved, Maria and her fellow investors may want to establish an LLC taxed as a partnership. That could fulfill several of their objectives:

• Ability to invest as “silent partners” who aren’t involved in day-to-day management
• Liability protection
• Potential for special allocations of income and loss.
  • If this were not a concern, an S corporation might be a good option. S corporations, however, may not make special allocations. For that reason, based on the objectives Maria and her friends have listed, an S corporation might not be the best entity type. 
• Flow-through taxation
  • Flow-through losses could benefit Maria and her friends this year – when their personal income is high. 
  • Business profits should not pose a personal tax problem in future years, when Maria and her friends will be in much lower marginal brackets.
  • The friend who has less cash than the others may need to focus on building reserves to pay estimated taxes. 

Scenario 2:

Dr. Henry Jones, a surgeon, plans to start a medical device company. He wants to attract as many investors as possible and eventually take the company public. In addition, Dr. Jones expects the company ultimately may benefit by offering multiple classes of stock.

Dr. Jones expects to invest heavily in machines and other capital expenditures. He expects that once equipment acquisition and initial business expansion plans are complete, the company will record high profits. 

Dr. Jones earns $900,000 per year and is in the highest tax federal income tax bracket. Dr. Jones has amassed a net worth of $15 million, and he wants to protect his family’s assets from business-related lawsuits and/or debts.

Dr. Jones could fulfill several of his objectives by establishing a C corporation. Advantages in his situation could include:

• Good access to capital, with an unlimited number of potential investors
• The potential for common and preferred stock
• Liability protection
• Corporate tax rate much lower than Dr. Jones’ personal tax rate. Double taxation is a concern, but careful tax planning can help mitigate it. The company may pay high (but reasonable) salaries to key team members who have specialized expertise. It also may retain earnings for legitimate business expansion needs. Through those and other proactive strategies, the corporation can limit dividend payments – thereby reducing total taxes.

As these hypothetical case studies illustrate, selecting an appropriate business entity type requires careful consideration of many factors. It is essential to consult experienced professionals – such as financial planners, business-focused attorneys and proactive CPAs – for advice about specific situations. With the right legal form in place, you will have the right foundation to focus on what you really love: wowing your clients and building a thriving, rewarding business.