By Kenneth H. Bridges, CPA, PFS March 2019
One of the significant decisions you face when starting a company is deciding through which type of legal entity you will operate the business; and for existing businesses, an evaluation should be made periodically as to whether the type of entity you are using is still the best choice for you.
Prior to the Tax Reform Act of 1986, the C-corp rate was lower than the individual rate, and also it was possible to let earnings accumulate inside a C-corp and bail the earnings out at a later date without a second level of tax by way of a liquidation of the entity. TRA’86, however, reduced the individual rate below the corporate rate and eliminated the ability to bail accumulated C-corp earnings out tax-free via a liquidation. Accordingly, in the years following TRA’86 it became almost a no-brainer that if you could qualify your business for flow-through entity treatment (mostly S-corps at that time), you would do so. In the years since TRA’86, however, the potential substantial penalty associated with operating as a C-corp (double taxation) has steadily decreased. The C-corp rate has continued to fall, while the individual rate on ordinary income has (mostly) increased, the individual rate on C-corp dividends has been reduced to the capital gains rate, and an exclusion for gain on the sale of certain C-corp stock has been enhanced to the point that some gains on C-corp stock completely escape tax. The Tax Cuts and Jobs Act (TCJA) enacted in late 2017 reduced the C-corp rate from 35% to 21%, further increasing the potential appeal of operating as a C-corp. However, while at first blush a 21% Federal C-corp rate versus a 37% top Federal rate on ordinary income for individuals might make it seem a no-brainer to structure as a C-corp, the analysis (as discussed below) is much more complex than that, and most privately-held companies will likely find that they are better served to continue as flow-through entities.
What are your choices? If the business will have only one owner, then your choices are unincorporated sole proprietorship, single member limited liability company (SMLLC), S-corp or C-corp. If the business 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 any business with one individual owner who has not formed a legal entity to own the business. The advantage of such is simplicity. This does not require the formation of a legal entity, opening a separate bank account, or filing a separate income tax return. However, because this format offers you no legal liability protection, it is generally not the best choice (and there can also be perception issues). Any business income of a sole proprietorship (or single member LLC taxed as such) will be subject to not only income tax, but also self-employment tax.
What is a general partnership? A general partnership is essentially the same as an unincorporated sole proprietorship, except that it involves more than one owner, and is required to file an annual partnership income tax return reporting its revenue and expenses and then provide to each partner a Schedule K-1 reflecting their share of the taxable income to be reported on their own returns. A general partnership provides no liability protection, and so this format should rarely be used. Also, as with the sole proprietorship, any business income is subject to self-employment tax. Finally, it should be noted that anytime two or more parties agree to split profits from a venture and they do not form another type of entity, for income tax purposes they are deemed to have formed a general partnership and are required to file a partnership income tax return for such.
What is an LLP? “LLP” stands for limited liability partnership. This is essentially a general partnership of licensed professionals (typically attorneys or CPAs) who have made a special election to enjoy some measure of liability protection (typically from unsecured creditors or from tort claims against the entity or claims of malpractice involving other professionals in the partnership). For income and self-employment tax purposes, the LLP is treated like a general partnership.
What is a limited partnership? A limited partnership consists of two types of partner: (1) at least one 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 the entity but are not involved in day-to-day management. The GP has unlimited liability for claims against the partnership, and so a separate legal entity (LLC, S-corp or C-corp) is typically formed to serve this purpose; unless the limited partnership conducts no business activities directly and only holds passive investments. The LPs enjoy legal liability protection. In some states (but not Georgia), if an LP becomes too involved in the business they risk losing their limited liability status. In some situations, the limited partnership format can potentially be used as a way to minimize the self-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 the profit or loss directly on their own returns. The ability of a partner to deduct the loss is limited to his or her “basis” and “at-risk” amounts, but partners can generally count the liabilities of the partnership in computing their “basis” and, in some cases, in computing their “at-risk” amount. This is an advantage which partnerships have over S-corps. Also, with partnerships you have almost complete flexibility over the number and types of partners you can have, and you can allocate the taxable income or loss and make distributions in any manner upon which the partners agree, so long as the allocations have “substantial economic effect”. Further, partnerships can generally distribute appreciated property (e.g. real estate) to one or more partners without triggering any unrealized gain for income tax purposes, and partner equity compensation can generally be structured tax free as a “future profits interest”.
What are the disadvantages of partnership status? While the beauty of partnerships is their flexibility, one of the downsides is their attendant complexity. Anyone who has ever attempted to read a typical partnership agreement or LLC operating agreement (replete with references to the regulations under IRC 704(b)) knows that, absent having a masters in tax law, you likely will have a difficult time determining what you are entitled to under the agreement. Also, partnership interests are not eligible for the gain exclusion under IRC 1202 (discussed further below), a portion of gain on sale of units may be treated as ordinary income (e.g. if the partnership holds cash basis receivables), partner compensation may attract the tax of any state within which the partnership conducts business, income from the business may have greater exposure to self-employment tax, and partnerships generally cannot merge tax-free with a corporation.
What is an LLC? “LLC” stands for limited liability company. It is essentially the same as a limited partnership, except that all partners (or “members”) enjoy liability protection. Also, an LLC can have a single owner, in which case (as discussed below) the default answer is that it is treated as a disregarded entity.
How is an LLC taxed? If an LLC has only one owner, then the default rule is that it is treated as a “disregarded entity”. If an LLC has more than one owner, then the default rule is that it is treated as a partnership. In either case, the LLC can instead make an election 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 an election otherwise, it is treated for income tax purposes as a “disregarded entity”. This means you enjoy whatever legal liability protection LLC status provides (and also possibly some perception value versus being a sole proprietorship), but for income tax purposes you can ignore the legal entity and simply report all of its revenue and expenses on the owner’s income tax return. This simplicity can be very advantageous for a small business (e.g. a one-person consulting firm with no employees other than the owner, which means you could avoid filing separate income tax returns or dealing with payroll tax returns). Also, real estate is frequently held in a single member LLC because you are then positioned to possibly sell the LLC units and have such qualify as a sale of real estate for purposes of the IRC 1031 like-kind exchange rules. Note that even though the SMLLC is disregarded for income tax purposes, you still need to maintain separate books and records and bank account and observe the formalities of the separate legal entity.
What is an S-corp? An S-corp is a corporation or LLC which has made a special election under Subchapter S of the Internal Revenue Code to avoid corporate income tax and have its profit or loss reported on the returns of its owner(s). In this regard, an S-corp is treated for income tax purposes like sole proprietorships and the various types of partnerships discussed above.
What are the advantages of S-corp status? The principal advantage of being a flow-through entity is that you avoid the risk of double taxation that comes with C-corp status (either upon distribution of operating profits or upon a sale of the business), with a (usually) secondary advantage of being able to pass tax losses through to the owners for use on their own income tax returns. Also, owners who materially participate in the business of a flow-through entity can generally avoid the 3.8% Medicare tax on net investment income of profits from operation of or sale of the business which generally applies to C-corp dividends or sale gain. When compared to partnerships, the principal advantages of S-corp status are simplicity of allocations, better ability to manage FICA/self-employment tax, 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 principal disadvantages of S status are limitation on number and type of owners, single-class of stock restriction, disqualification from the potential IRC 1202 exclusion, the currently higher marginal rate on individuals (up to 37%) than corporations (21%), and complexity it causes in the owners’ tax situation (flow-through of income or loss versus it being contained at the corporate level). When compared to other types of flow-through entities, the principal disadvantages are limitation on number and type of owners, single-class of stock restriction, inability to include liabilities of the entity in owner’s stock basis, and inability to remove appreciated assets from the entity without triggering tax.
What is a C-corp? An incorporated entity is automatically a Subchapter C corporation unless it elects Subchapter S status. A C-corp is a separate taxable entity, subject to income tax on its net profit. Any profits distributed to shareholders as dividends are subjected to a second level of tax at the shareholder level. Unlike with flow-through entities, the owner of a C-corp incurs the 3.8% Medicare tax on distributions or gain from sale of the stock, regardless of level of participation 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 double taxation. While the potential magnitude of such has decreased significantly over the past 32 years due to tax law changes favorable to C-corp status, the reality is that the combined corporate and 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 on S-corp profit distributed to a shareholder who is active in a business which qualifies for the QBI 20% deduction. Tack on potential state income taxes, and the differential is even greater (e.g. 48% C-corp vs 35% S-corp, if you assume a 6% state rate). Also, you cannot pass losses from a C-corp through to its shareholders for use on their personal returns, appreciated property generally cannot be removed from the corporation without triggering the tax gain, and use of the cash method is generally prohibited once 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-through entities 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 not a “specified service business” and has sufficient W-2 wages paid. This deduction effectively reduces the top individual Federal rate on qualifying income to 29.6%. In many cases, this is enough 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 business income from Schedule C or a general partnership is subject to this, as is arguably income from an LLC taxed as a partnership. S-corp income and C-corp income, however, is not; so long as the shareholder/employee receives a reasonable level of salary.
What are some situations likely favoring flow-through entity status? Real estate owning entities will typically be partnerships (or LLCs treated as such), and professional service firms will typically be partnerships or S-corps. Other factors tending to favor flow-through entity status are (1) the company will 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) the company will qualify for the QBI deduction; (4) the stock will not likely qualify for the IRC 1202 100% gain exclusion (or the amount of gain will be 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 on K-1 income or gain.
What are some situations likely favoring C-corp status? Early-stage tech companies planning to raise venture capital and exit in 5 – 7 years, companies that will have significant foreign or institutional ownership, companies for which the stock would likely qualify as IRC 1202 stock, companies that will not qualify for the QBI deduction, and companies that need to accumulate capital (e.g. to build inventories) and for which the owner may hold the stock until death are all good 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 purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.