By Howard J. Kass, CPA
Partner, Zinner & Co. LLP
When forming a small business, the choice of business entity is one of the most important decisions to be made. The business entity one chooses will determine how profits from the business will be taxed and to what extent the business owner(s) will either be protected from or exposed to personal liability from their business operations. The available choices of business entities are Sole Proprietorships, Partnerships (both General and Limited), Corporations (both C and S) and Limited Liability Companies (LLC).
As mentioned above, the choice of which business entity to use should be based on a number of factors, including the degree to which the owner(s) wish to be protected from personal liability and the tax treatment afforded to the owner(s) of that entity. Let’s examine the tax treatments of the different entity choices first.
We can classify business entities into two broad types; entities that pay tax on their own income, and entities that pass the tax obligation on to their owners. In looking at the above list of entities, only one, the C Corporation, pays tax on its own income. C corporations are subject to tax on their own income based on the following tax table:
Corporate Income Tax Rates
Taxable income over Not over Tax rate
$ 0 $50,000 15%
50,000 75,000 25%
75,000 100,000 34%
100,000 335,000 39%
335,000 10,000,000 34%
10,000,000 15,000,000 35%
15,000,000 18,333,333 38%
18,333,333 ………. 35%
In addition, the withdrawal of profits from the corporation by its shareholders will entail the assessment of a second level of tax on the shareholder. This is often referred to as the double taxation of C corporations.
All the other entities pass their tax obligations along to their owners, frequently with differing results, depending on the type of income being passed through and the specific entity being used. While sole proprietorships constitute direct ownership of a business by an individual, the other forms of ownership, partnerships, limited liability companies, and S corporations, are all referred to as pass-through entities because they all pass their income on to their owners. The ultimate income tax paid depends upon who the owners are, which, except for S corporations, can be any type of entity. S corporations may only be owned by individuals and a small number of specialized trusts.
Self Employment Tax
There are usually two broad types of income generated by a business entity; net operating income from a trade or business and net rental income. While both sources of income are subject to income tax at the same rates, net operating income from a trade or business will usually be classified as net income from self employment and will be subject to an additional tax, called self employment tax, at a rate of up to 15.3%. This is the means by which self employed individuals contribute to the Social Security system. In addition to the nature of the income (trade or business), the classification of income as self employment income is based upon the type of entity being used. Those entities that can generate self employment income are Sole Proprietorships, General Partnerships, and Limited Liability Companies. S Corporations, while being pass through entities, do not currently pass self employment income on to their owners, although this is an area that Congress considers to be ripe for abuse and, therefore, subject to reform.
In addition, and equally important to the tax issues, one must consider the exposure to personal liability, both for the business they operate and the type of entity they utilize. All businesses entail some degree of risk, but, undoubtedly, certain businesses carry much higher degrees of risk than others. It is difficult to regard the ownership and operation of any small business as a low risk venture.
For that reason, it is important to take every reasonable safeguard one can to protect oneself from the risks inherent to small business ownership. There are several ways to protect oneself, including the use of prudent business practices, carrying adequate liability insurance, and utilizing limited liability entities for the ownership and operation of all businesses owned. While common sense should dictate prudent business practices, and a competent insurance professional should prove valuable in providing the proper insurance coverage, it is important to examine how the choice of entity can help or hurt you in your quest to avoid personal liability. Keep in mind that I am providing general information here. If you require more specific information on the asset protection aspects of any of these entities, consult your legal advisor.
The two forms of ownership that offer no protection from personal liability are also the two simplest forms of ownership; the sole proprietorship and the general partnership. A sole proprietorship is the default entity in use when an individual operates a small business in his or her own name, without the use of any other legal entity. Such ownership opens the owner up to any and all possible risks associated with the operation of that business ranging from a potential default on business financing to potential risks related to product liability or failing to meet a deadline. These risks put all personal assets owned by the individual vulnerable to attack in any legal proceeding, including their home, personal bank accounts, autos and other personal assets . Ownership of the same business within a general partnership doesn’t afford any more protection. It simply exposes all of the partners in the partnership to those same risks.
The remaining forms of ownership, corporations (both S and C), limited partnerships, and limited liability companies, do provide protection from personal liability with some important caveats.
In most cases, limited partnerships provide protection from personal liability for their limited partners. However, every limited partnership must have a general partner and that general partner is exposed to unlimited liability. Frequently, the general partner will, in turn, be a limited liability entity, such as a corporation, so as not to expose any individual to unlimited personal liability. It is also important that limited partners do not assume roles of management or otherwise actively participate in the management of the business of the limited partnership, to preserve their limited liability.
Corporations have a long, well documented, history of protecting their owners from personal liability. To preserve that protection and prevent potential creditors from piercing the corporate veil, it is important to observe all the corporate formalities and be certain that there is no commingling of personal and corporate assets.
That notwithstanding, there is an option that allows small corporations to dispense with most of the corporate formalities; the close corporation agreement. By adopting a close corporation agreement, most of the corporate formalities are relaxed, making it easier for small corporations to operate, while continuing to preserve the corporate veil. Keep in mind, however, that it is still essential to avoid the commingling of personal and corporate assets. The availability of protection from personal liability through the use of a corporation is not affected by the choice of whether to operate as an S or C corporation. Those are merely tax elections having no effect on the degree of asset protection available.
Limited liability companies are the newest business entities offering protection from personal liability to their owners. While there is not as large a body of case law attesting to their asset protection characteristics, as there is for corporations, LLC’s have become generally accepted as a viable means of protecting their owners from personal liability. Further, they do not carry the same burden of formalities as corporations and offer significant flexibility in their tax treatment, at the Federal level. Indeed, through the proper use of available tax elections, LLC members can even choose to be taxed as partnerships, S corporations or C corporations. Tax treatment of these entities varies from state to state and it is recommended that you consult your tax advisor to discuss the state tax issues associated with LLC’s.
Determination of Basis
When forming a business, it is not unusual for that business to generate losses in the first year or two. In order for a business owner to deduct those losses, they must have something called basis in that business. The rules for determining one’s basis (tax cost) in their ownership interest differs for the various entities in question. Following is a brief summary by entity type:
Generally, the amount paid for one’s stock will be their basis.
- Items increasing basis:
- Purchase of stock
- Recognition of income
- Items decreasing basis:
- Distributions to shareholders
- Recognition of losses
Sole Proprietorships, Partnerships & LLC’s
- Items increasing basis:
- Contributions of capital
- Recognition of income
- Items decreasing basis:
- Distributions to partners or members
- Recognition of losses
How Do You Get Money To The Owners?
It seems that finding ways to get money to the business owners is often one of the biggest challenges we face. In reality, it doesn’t need to be, as long as one is aware of the methods and limitations.
Sole proprietorships and partnerships provide money to their owners simply by making distributions of capital. One must be careful that there is sufficient basis in the entity to take that distribution, or there could be negative tax consequences as a result. It is, therefore, important to consult your tax advisor before making such a distribution.
C corporations provide money to their owners in several ways. If the owners work in the business, the corporation should pay them a reasonable salary. If the business occupies a building that the shareholder owns, it should pay them rent, and if the corporation has retained earnings, it may pay dividends. The down side of paying dividends is that they are not deductible by the corporation. This is the element of double tax mentioned earlier. The up side, however, is that, under current tax law, C corporation dividends are generally taxed at a preferential rate of fifteen percent.
Similar to C corporations, S corporations may also provide money to their owners in several ways. Here, too, if the owners work in the business, the corporation should pay them a salary, if the business occupies a building that the shareholder owns, it should pay them rent and, if the corporation has accumulated S corporation earnings (Accumulated Adjustments Account), it may make distributions to its shareholders. The difference here is that distributions to S corporation shareholders from accumulated earnings are tax free to those shareholders, since they have already recognized the income previously passed through to them. With both forms of corporations, there are issues that should be considered with regard to reasonable compensation, but those fall outside the scope of this discussion.
As you may expect, eventual liquidation of the business is treated differently, depending on the type of entity used. Generally, there will be no tax effect to closing a sole proprietorship, assuming that the business owner pays all liabilities and has cash remaining in the business checking account at the end. If there are unpaid liabilities that are ultimately forgiven, there will be income to recognize and tax to pay as a result of the forgiveness of the unpaid liabilities. This applies across all entity types.
When a partnership or LLC distributes cash in liquidation of the entity, the partner or member, must compare the cash received with their basis in the entity to determine gain or loss, if any. If a partner or member receives property, rather than cash, then, generally, they will recognize no gain or loss on the distribution of that property.
When a corporation liquidates, we must also be concerned whether it distributed cash or property. When the corporation is liquidated with a cash distribution, the shareholder must compare the cash received with their basis in the stock and will generally recognize gain or loss on that liquidation. When a corporation distributes property it becomes a little more complicated. Under such circumstances, the corporation is deemed to have sold the property at its fair market value followed by a distribution of the cash, net of any tax paid. This deemed distribution is then the basis for determining the gain or loss on liquidation.
Acquisition of a Building – Who Should the Owner Be?
In the course of your business operations, you may decide to acquire your own building, rather than renting. If real estate is acquired to be used in a trade or business, that building should be owned by an entity separate from the business. Why? There are several reasons; some tax related as well as non-tax reasons.
First, some of the non-tax reasons:
- If the building and the operating business are held in separate limited liability entities and one of the entities is subject to a legal claim, the other entity’s assets should be protected from that claim.
- If the business owner is ready to retire, having the building in a separate entity may facilitate their retaining the building and collecting rent from the new business owners.
Some of the tax reasons:
- Certain entities are more conducive to owning and operating rental property than others. This, too, is beyond the scope of this article.
- In addition, upon the sale of the building, there are definite tax disadvantages to corporate ownership, as opposed to other forms of ownership.
The bottom line here, as well as throughout this discussion, is that one needs to give due consideration to all the relevant issues in choosing a business entity, and avail themselves to competent legal and tax counsel before engaging in any significant business transaction. For answers to your questions on this, or any other, tax issue, please contact me at email@example.com.