Business Entities and Tax Choices

By: Paul G. Christensen, Esq.

While the selection of taxation is vital, the choice of entity may or may not have an impact on this choice. Professional guidance is necessary. Act with due caution in selecting the type of entity that matches your tax objectives. For-profit entities are taxed under three basic schemes:

• Income earned by a “disregarded” entity is recognized and the tax is paid by the owner. Examples: sole proprietorships and single-member LLCs.
• Income earned and reported by a “flow-through” entity is recognized and the tax is paid by the owners. Examples: partnerships and S-corporations.
• Income earned and reported by a corporate entity is recognized and the tax is paid by the entity. Example: C-corporations.

Partnerships

Partnership earnings and the tax attributes of these earnings “flow-through” to the owners, maintaining the same nature for the owner as for the partnership. For example: capital gains generated by the partnership are treated as capital gains on the individual’s tax return.

Corporations

C-corporations pay their own taxes at corporate, not personal rates, and the owners pay tax on any dividends received; this is called double taxation. If an S-election is made, then its earnings and the tax attributes of those earnings “flow-through” to the owners by way of a Form K-1 tax statement and are reported on the owner’s personal income tax return. While it may appear that an S-corporation’s owners treat the tax losses and gains similar to those of a partnership, they differ with respect to payroll taxes and transactions between the owner and the entity.

Limited Liability Companies

Limited liability companies (LLCs) are treated as partnerships for tax purposes. However, in rare circumstances, an LLC may elect to be treated as a corporation, a taxable entity, and as a corporation it may further elect to be treated as an S-corporation, a “flow-through” entity.

In general:

C-corporations are most often used for larger, mature companies with larger numbers of shareholders. C-corporations also are preferred for public companies because public shareholders do not wish to expose themselves to pass through taxation without ever receiving a distribution.

S-corporations are often used for start-up and smaller companies. S-corporations typically have fewer shareholders than C-corporations and hold non-appreciating assets.

Partnerships, both general and limited liability, have largely been replaced in usage by limited liability companies. Limited liability companies may be operating or holding companies and often own appreciating assets—such as real property or valuable equipment—taking advantage of taxation flexibility and asset protection attributes.

Determining the appropriate legal entity and the appropriate tax treatment are matters of judgment based upon the specific circumstances of each entity and its owners. The consequences of these decisions are significant and long-lasting and justify considerable effort on the part of the owners, accountants and attorneys to develop the most beneficial legal and tax structures for a given situation