By Kenneth H. Bridges, CPA, PFS March 2019
One of the significant decisions you face when starting a company isdeciding through which type of legal entity you will operate the business; andfor existing businesses, an evaluation should be made periodically as towhether the type of entity you are using is still the best choice for you.
Prior to the Tax Reform Act of1986, the C-corp rate was lower than the individual rate, and also it waspossible to let earnings accumulate inside a C-corp and bail the earnings outat a later date without a second level of tax by way of a liquidation of theentity. TRA’86, however, reduced the individual rate below the corporate rateand eliminated the ability to bail accumulated C-corp earnings out tax-free viaa liquidation. Accordingly, in the yearsfollowing TRA’86 it became almost a no-brainer that if you could qualify yourbusiness for flow-through entity treatment (mostly S-corps at that time), youwould do so. In the years since TRA’86,however, the potential substantial penalty associated with operating as aC-corp (double taxation) has steadily decreased. The C-corp rate has continued to fall, whilethe individual rate on ordinary income has (mostly) increased, the individualrate on C-corp dividends has been reduced to the capital gains rate, and anexclusion for gain on the sale of certain C-corp stock has been enhanced to thepoint that some gains on C-corp stock completely escape tax. The TaxCuts and Jobs Act (TCJA) enacted in late 2017 reduced the C-corp rate from35% to 21%, further increasing the potential appeal of operating as aC-corp. However, while at first blush a21% Federal C-corp rate versus a 37% top Federal rate on ordinary income forindividuals might make it seem a no-brainer to structure as a C-corp, theanalysis (as discussed below) is much more complex than that, and mostprivately-held companies will likely find that they are better served tocontinue as flow-through entities.
What are your choices? If the business will have only one owner, then your choices areunincorporated sole proprietorship, single member limited liability company(SMLLC), S-corp or C-corp. If thebusiness will have multiple owners, then your choices are general partnership,limited partnership (LP), LLC, S-corp or C-corp.
What is an unincorporated sole proprietorship? An unincorporated sole proprietorship is anybusiness with one individual owner who has not formed a legal entity to own thebusiness. The advantage of such is simplicity. This does not requirethe formation of a legal entity, opening a separate bank account, or filing aseparate income tax return. However, because this format offers you no legalliability protection, it is generally not the best choice (and there can alsobe perception issues). Any business income of a sole proprietorship (orsingle member LLC taxed as such) will be subject to not only income tax, butalso self-employment tax.
What is a general partnership? A general partnership is essentially the same as an unincorporated soleproprietorship, except that it involves more than one owner, and is required tofile an annual partnership income tax return reporting its revenue and expensesand then provide to each partner a Schedule K-1 reflecting their share of thetaxable income to be reported on their own returns. A general partnership provides no liabilityprotection, and so this format should rarely be used. Also, as with the soleproprietorship, any business income is subject to self-employment tax. Finally, it should be noted that anytime twoor more parties agree to split profits from a venture and they do not formanother type of entity, for income tax purposes they are deemed to have formeda general partnership and are required to file a partnership income tax returnfor such.
What is an LLP? “LLP” stands for limited liabilitypartnership. This is essentially ageneral partnership of licensed professionals (typically attorneys or CPAs) whohave made a special election to enjoy some measure of liability protection(typically from unsecured creditors or from tort claims against the entity orclaims of malpractice involving other professionals in the partnership). Forincome and self-employment tax purposes, the LLP is treated like a generalpartnership.
What is a limited partnership? A limited partnership consists of two types of partner: (1) at leastone general partner (GP) who controls the day-to-day activity of the entity;and (2) one or more limited partners (LP) who typically have invested in theentity but are not involved in day-to-day management. The GP has unlimited liability for claimsagainst the partnership, and so a separate legal entity (LLC, S-corp or C-corp)is typically formed to serve this purpose; unless the limited partnershipconducts no business activities directly and only holds passiveinvestments. The LPs enjoy legalliability protection. In some states(but not Georgia), if an LP becomes too involved in the business they risklosing their limited liability status. In some situations, the limitedpartnership format can potentially be used as a way to minimize theself-employment tax exposure associated with ownership of a business.
What are the income tax advantages of partnerships? A partnership is a “flow-through” entity,meaning that it generally does not pay income tax, and its partners report theprofit or loss directly on their own returns. The ability of a partner todeduct the loss is limited to his or her “basis” and “at-risk” amounts, butpartners can generally count the liabilities of the partnership in computingtheir “basis” and, in some cases, in computing their “at-risk” amount. This is an advantage which partnerships haveover S-corps. Also, with partnershipsyou have almost complete flexibility over the number and types of partners youcan have, and you can allocate the taxable income or loss and makedistributions in any manner upon which the partners agree, so long as theallocations have “substantial economic effect”.Further, partnerships can generally distribute appreciated property(e.g. real estate) to one or more partners without triggering any unrealizedgain for income tax purposes, and partner equity compensation can generally bestructured tax free as a “future profits interest”.
What are the disadvantages of partnership status? While the beauty of partnerships is theirflexibility, one of the downsides is their attendant complexity. Anyone who hasever attempted to read a typical partnership agreement or LLC operatingagreement (replete with references to the regulations under IRC 704(b)) knowsthat, absent having a masters in tax law, you likely will have a difficult timedetermining what you are entitled to under the agreement. Also, partnership interests are not eligiblefor the gain exclusion under IRC 1202 (discussed further below), a portion ofgain on sale of units may be treated as ordinary income (e.g. if thepartnership holds cash basis receivables), partner compensation may attract thetax of any state within which the partnership conducts business, income fromthe business may have greater exposure to self-employment tax, and partnershipsgenerally cannot merge tax-free with a corporation.
What is an LLC? “LLC” stands for limited liability company. It is essentially the same as a limitedpartnership, except that all partners (or “members”) enjoy liability protection. Also, an LLC can have a single owner, inwhich case (as discussed below) the default answer is that it is treated as adisregarded entity.
How is an LLC taxed? If an LLC has only one owner, then thedefault rule is that it is treated as a “disregarded entity”. If an LLC has more than one owner, then thedefault rule is that it is treated as a partnership. In either case, the LLC can instead make anelection to be treated for income tax purposes as a C-corp or an S-corp.
What is a “disregarded entity”? If an LLC has only one owner, absent anelection otherwise, it is treated for income tax purposes as a “disregardedentity”. This means you enjoy whateverlegal liability protection LLC status provides (and also possibly someperception value versus being a sole proprietorship), but for income taxpurposes you can ignore the legal entity and simply report all of its revenueand expenses on the owner’s income tax return. This simplicity can be veryadvantageous for a small business (e.g. a one-person consulting firm with noemployees other than the owner, which means you could avoid filing separateincome tax returns or dealing with payroll tax returns). Also, real estate is frequently held in asingle member LLC because you are then positioned to possibly sell the LLCunits and have such qualify as a sale of real estate for purposes of the IRC1031 like-kind exchange rules. Note thateven though the SMLLC is disregarded for income tax purposes, you still need tomaintain separate books and records and bank account and observe the formalitiesof the separate legal entity.
What is an S-corp? An S-corp is a corporation or LLC which hasmade a special election under Subchapter S of the Internal Revenue Code toavoid corporate income tax and have its profit or loss reported on the returnsof its owner(s). In this regard, an S-corp is treated for income tax purposeslike sole proprietorships and the various types of partnerships discussedabove.
What are the advantages of S-corp status? The principal advantage of being a flow-through entity is that youavoid the risk of double taxation that comes with C-corp status (either upondistribution of operating profits or upon a sale of the business), with a(usually) secondary advantage of being able to pass tax losses through to theowners for use on their own income tax returns.Also, owners who materially participate in the business of aflow-through entity can generally avoid the 3.8% Medicare tax on net investmentincome of profits from operation of or sale of the business which generallyapplies to C-corp dividends or sale gain.When compared to partnerships, the principal advantages of S-corp statusare simplicity of allocations, better ability to manage FICA/self-employmenttax, and the ability to merge tax-free with a corporation.
What are the disadvantages of S-corp status? When compared to C-corp status, the principaldisadvantages of S status are limitation on number and type of owners,single-class of stock restriction, disqualification from the potential IRC 1202exclusion, the currently higher marginal rate on individuals (up to 37%) thancorporations (21%), and complexity it causes in the owners’ tax situation(flow-through of income or loss versus it being contained at the corporatelevel). When compared to other types offlow-through entities, the principal disadvantages are limitation on number andtype of owners, single-class of stock restriction, inability to includeliabilities of the entity in owner’s stock basis, and inability to removeappreciated assets from the entity without triggering tax.
What is a C-corp? An incorporated entity is automatically a Subchapter C corporationunless it elects Subchapter S status. A C-corp is a separate taxable entity,subject to income tax on its net profit. Any profits distributed toshareholders as dividends are subjected to a second level of tax at theshareholder level. Unlike withflow-through entities, the owner of a C-corp incurs the 3.8% Medicare tax ondistributions or gain from sale of the stock, regardless of level ofparticipation in the business.
What are the advantages of C-corp status? TCJA reduced the Federal rate on C-corp income to 21%, so the C-corp rate is now well below the top individual rate of 37%. Stock in qualifying C-corps held at least 5 years can be eligible for a special gain exclusion under IRC 1202 of up to $10,000,000 per shareholder or 10 times the amount invested in the stock, if more. C-corps are not subject to any restrictions on number or types of owner nor classes of stock, they do not complicate the tax filings of their shareholders, they can generally adopt whatever fiscal year-end they choose, and foreign and institutional investors generally prefer to invest in C-corp stock.
What are the disadvantages of C-corp status? The primary disadvantage of C-corp status is the risk of doubletaxation. While the potential magnitudeof such has decreased significantly over the past 32 years due to tax lawchanges favorable to C-corp status, the reality is that the combined corporateand personal Federal tax on profit distributed from a C-corp can be 39.8%(including the 3.8% Medicare tax) versus a 29.6% effective maximum rate onS-corp profit distributed to a shareholder who is active in a business whichqualifies for the QBI 20% deduction. Tack on potential state income taxes, andthe differential is even greater (e.g. 48% C-corp vs 35% S-corp, if you assumea 6% state rate). Also, you cannot passlosses from a C-corp through to its shareholders for use on their personalreturns, appreciated property generally cannot be removed from the corporationwithout triggering the tax gain, and use of the cash method is generally prohibitedonce average annual revenue exceeds $25,000,000.
How do the new QBI rules impact choice of entity? Along with cutting the C-corp rate to 21%, Congress threw flow-throughentities a bone by including in TCJA a 20% “qualified business income” (QBI)deduction for most flow-through business income, so long as the business is nota “specified service business” and has sufficient W-2 wages paid. Thisdeduction effectively reduces the top individual Federal rate on qualifyingincome to 29.6%. In many cases, this isenough to swing the equation in favor of flow-through entity status.
How do FICA and SECA tax impact the decision? The combined employer/employee FICA or SECA tax is 15.3% on the first$132,900 of each employee’s salary, 2.9% on the next $67,100, and then 3.8%thereafter. The full amount of businessincome from Schedule C or a general partnership is subject to this, as isarguably income from an LLC taxed as a partnership. S-corp income and C-corp income, however, isnot; so long as the shareholder/employee receives a reasonable level of salary.
What are some situations likelyfavoring flow-through entity status? Real estate owningentities will typically be partnerships (or LLCs treated as such), andprofessional service firms will typically be partnerships or S-corps. Other factors tending to favor flow-throughentity status are (1) the companywill be highly profitable and desires to distribute the profits to the owner(s);(2) the owner does not anticipate holding the stock until death; (3) thecompany will qualify for the QBI deduction; (4) the stock will notlikely qualify for the IRC 1202 100% gain exclusion (or the amount of gain willbe substantially in excess of the $10M limit on gain exclusion); and (5) the owner(s)have sufficient participation in the business to avoid the 3.8% Medicare tax onK-1 income or gain.
What are some situations likely favoring C-corpstatus? Early-stage tech companies planning to raiseventure capital and exit in 5 – 7 years, companies that will have significantforeign or institutional ownership, companies for which the stock would likelyqualify as IRC 1202 stock, companies that will not qualify for the QBIdeduction, and companies that need to accumulate capital (e.g. to buildinventories) and for which the owner may hold the stock until death are allgood potential candidates for C-corp status.
Can you convert from one entity type to another? As a general rule (with some exceptions such as a tax-basis deficit capital account in a partnership), you can go from flow-through entity status to C-corp tax-free, but you cannot convert from C-corp status to LLC/partnership status without triggering taxable gain. Assuming the company qualifies, you can elect S-corp status for a C-corp, which will enable the company to avoid double taxation on future profits and appreciation, but any unrealized gain that exists at the date of the S election will be subject to corporate-level tax if the business is sold in an asset deal within 5 years of the S election.
Spreadsheeting it all out – If you have a good crystal ball and can forecast your revenue, expenses, profit, distributions, capital retention needs, timing of exit, exit price, type of acquisition structure likely desired by (or acceptable to) potential buyer, and any tax law changes in the interim, then we can spreadsheet it all out and quantify precisely the benefit or detriment of each entity type. In the absence of a perfect crystal ball, some judgment and guessing are involved; but spreadsheeting out the alternatives can certainly help with the decision.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges &Dunn-Rankin, LLP, an Atlanta-based CPA firm.
This article is presented for educational and informational purposesonly, and is not intended to constitute legal, tax or accounting advice. The article provides only a very generalsummary of complex rules. For advice onhow these rules may apply to your specific situation, contact a professionaltax advisor.
