Choice of Entity
The Tax Cuts and Jobs Act signed in December of 2017 reduced the income tax rate on corporations and pass through entities. The Act, coupled with an increase in business activity in Arizona, has created a lot of questions about the appropriate choice of entity, i.e., what is the best type of legal entity to use and which income tax classification to use. Like tools in a tool box, each type of entity and tax classification has its own purpose. There are generally three types of legal business entities in the U.S. that are commonly used today to hold assets – Corporations, Limited Liability Companies and Partnerships. Each entity has its own distinct characteristics. Each entity also has several alternatives as to how the income generated from that entity is taxed. Unfortunately, there is no magic rule of thumb that dictates which type of entity or tax classification to use. Several questions must be addressed, such as the purpose of the entity, how it is capitalized, how it is managed and the long-term exit strategy. Too often, business owners jump online and quickly form the entity without giving adequate thought to these issues and wind up costing themselves time and money later on. In addition, many advisors get stuck on one tool and use it as their go-to solution for all circumstances. Just like each tool has its own purpose, each entity and income tax classification are suited to address a particular situation. Have questions on your choice of entity and tax classification that is most appropriate for your purpose? Give us a call and we will work through the alternatives with you. To help get you started, here is some general background information on entities, how they are formed and how they are used.
Corporations have been around for a while and offer strong liability protection to the owners. With a few notable exceptions for piercing the corporate veil and failing to adhere to the corporate formalities, the owners of a corporation will not be subject to the liabilities of the entity. Corporations are formed by filing Articles of Incorporation with the Arizona Corporation Commission and have bylaws and shareholders agreements defining the relationships between the owners, called shareholders. The entity is overseen by a board of directors and the officers of the corporation run the day to day activities. A corporation is taxed by the IRS as a C-Corporation by default, but the owners can elect to treat the entity as an S-Corporation. While the legal benefits are similar, the treatment of the income for each tax classification is very different.
For corporations taxed as C-Corporations, the entity’s income is reported at the entity level and the owners are not taxed individually on that income until dividends are declared and paid. C-Corporations are popular for businesses where the objective is to obtain capital for investment, accumulate and reinvest income in the business and the exit strategy is to sell to, or merge with, a third party. Coupling the lower corporate income tax rates during operation with the capital gains tax rate upon sale minimizes the overall income tax burden on the owners. The problem with this structure is that if the shares are not sold, the income is potentially taxed twice – once when it is earned by the entity and a second time when the income is distributed to the owner. In certain circumstances, this planning tool has been diminished by the 199A pass-through deduction enacted by the Tax Cut and Jobs Act of 2017. For a discussion of 199A see http://www.deangelislegal.com/199a-pass-through-deduction/. Most publicly traded and widely held entities are corporations taxed as C-Corporations. Some professional service businesses still use this structure, choosing to zero out income each year to avoid the double taxation issue. Most real estate owners do not place real estate in a C-Corporation structure because the real estate may not be sold or distributed out of the entity without adverse income tax consequences; they generally utilize an entity taxed as a partnership for greater flexibility.
S-Corporations are not a type of entity, but are simply corporations who have made an election to be treated under the small business provisions of the Internal Revenue Code. S-Corporations file information returns only. All income is passed through the entity to the owners, who must be a U.S. citizen or resident alien. In some instances, this is a disadvantage because of the tax obligation imposed on the owner caused by the reporting of the income. In other words, the income from the entity will be taxed at the owner’s potentially higher marginal personal income tax rate. For entities expecting to earn less than the income threshold under 199A, a single member LLC may be a more cost effective approach. For a discussion of the income thresholds under 199A see the post here: http://www.deangelislegal.com/199a-pass-through-deduction/. S-Corporations are used often when the entity is going to generate significant income for the foreseeable future and the owner is providing services to the entity. This classification allows the owner to distinguish what income is attributable to personal services and subject to employment taxes and what are distributions. As in the C-Corporation, real estate owners do not use the S-Corporation structure because of the potential for adverse income tax consequences on the sale or distribution of the property.
Limited Liabilty Companies (LLCs)
LLCs became popular in the early 90’s as kind of a hybrid with the liability protection of a corporation, but taxed as a partnership. LLCs are created by filing Articles of Organization with the Arizona Corporation Commission and have operating agreements which govern the relationships between the owners, called members. The entity is managed by either the manager or the member. An LLC is a good alternative when there is not time or resources to evalulate choice of entity decisions. Depending on the number of owners and the elections they make, an LLC can be treated as a sole proprietorship, partnership, C-Corporation or S-Corporation. For discussion purposes, we will divide LLCs into two groups – single member LLCs and multi-member LLCs.
Single Member LLCs
LLCs with only one owner, or a husband and wife in a community property state electing to be treated as one owner, are disregarded for income tax purposes. This means that the income is not a separate entity for income tax reporting purposes and all income is reported on the owner’s personal income tax return as sole proprietorships. The ease of not having to file a separate tax return makes this a cost-effective option in certain circumstances. This structure works great for small start up businesses under the 199A income thresholds, real estate holding companies and subsidiary businesses. For a discussion of the 199A income thresholds see http://www.deangelislegal.com/199a-pass-through-deduction/.
LLCs with two or more owners who are not married to each other are treated as partnerships by default. Thus, the profits and losses of the entity pass through to the owners. However, the owners may elect to treat the entity as a C-Corporation or an S-Corporation by filing certain forms. Regardless of how the income is taxed, a separate tax return will be required each year and penalties are assessed if the return is not filed. The partnership tax classification is commonly used for real estate and oil and gas investments. It is also used for operating businesses where the owners are not providing services to the entity. If one of the owners is providing services to the business, an election can be filed to treat the entity as an association taxed as a C-Corporation or S-Corporation as discussed above.
General Partnerships and joint ventures have become obsolete with the rise of LLCs. Their decline in popularity is due to the fact that each owner is joint and severally liable for the debts and obligations of the partnership, thus making it less desirable to the LLC taxed as a partnership. General Partnerships are created when at least two owners agree to share the profits of a business. There are no filing requirements, unless the owners want to have some liability protection. In that case, a Certificate of Registered or Limited Liability Partnership must be filed with the Arizona Secretary of State, not the Arizona Corporation Commission. The rights and obligations of the partners are found in the partnership agreement. The General Partner is responsible for the management of the entity. While the entity files an information return each year, any income derived from the entity passes through to the owners and is taxed at their personal income tax rates. While Registered or Limited Liability Limited Partnerships are still used in certain industries such as real estate and oil and gas investments, the trend is to use LLCs for their tax attributes, simplicity and flexibility. Therefore, General Partnerships, if still around, should be converted to an entity offering greater liability protection.