By: Carlos Nazario CPA, JD, Tax Director at Millan and Co, PC, Austin, TX. February 2019. email@example.com
Usually a business is organized using an entity, which has legal capacity independent form its organizers, and can own property, raise capital, enter into contracts, incur debt, among other things.
The most well-known form of organizing a business is the “C” Corporation, which can have unlimited number of shareholders, which are shielded from the entity liabilities. Companies traded in the stock market like Apple, IBM, Facebook are organized that way. The corporation pays taxes on its earnings at a rate of 21%. The corporation distributes earnings to the stockholders by issuing dividends which are reported as taxable income by the stockholders and pay taxes again. This process of paying taxes twice on the same earnings is called double taxation. A “C” Corporation files IRS Form 1120.
Companies which are not publicly traded have used other types of entity that allows them to minimize their liability risk and eliminate the double taxation. Each owner reports its share of earnings in the company on his tax return. These entities are commonly referred to as pass-through, flow-through or fiscally-transparent entities. Some of the most commonly known pass-through entity forms are: General Partnership, Limited Partnership, Limited Liability Partnership, “S” Corporation and Limited Liability Company.
A General Partnership requires at least two partners. A general partner is personally liable for all partnership debts. Limited partner’s liability is generally limited to amount invested. Its income is usually subject to self-employment tax. Partners do not get paid wages, but they receive guaranteed payments. General partners treat their share of business income and guaranteed payments for services or use of capital as income subject to self-employment tax. A partnership files IRS Form 1065.
A limited partnership must have at least one general partner and one or more limited partners. A certificate of limited partnership must be filed on the State. General partners have unlimited personal liability. Limited partners have no liability beyond investment, but they have no right to manage or control. General partners treat their share of business income and guaranteed payments for services or use of capital as income subject to self-employment tax. Limited partners only report guaranteed payments for services as self-employment income.
Limited Liability Company – LLC
A Limited Liability Company – LLC has the limited liability characteristic of a corporation and have the pass-through characteristic of a partnership. It must have at least one member. There are no restrictions on the makeup of those members. Therefore, an individual, corporation, partnership, thrust or other entity may be a member of an LLC. It can elect to be treated as a partnership or an “S” Corporation when it has two or more members. An LLC operating agreement must be filed with State. Members have no liability beyond investment. LLC are managed by Managers which can be but do not have to be members. Members generally treat their share of business income and guaranteed payments for services or use of capital as income subject to self-employment tax. Members treated as limited partners only report guaranteed payments for services as self-employment income. Generally, an LLC can elect to be treated as a sole proprietor, partnership, S corporation or C corporation.
Limited Liability Partnership
In general, partners in a limited liability partnership are protected from liabilities resulting from the negligent acts, wrongful acts, and omissions of their fellow partners and most employees. LLP partners are not relieved of liabilities resulting from their wrongful acts, negligent acts, and omissions. In addition, LLP partners are liable for the wrongful acts, negligent acts, and omissions of employees that were under their supervision when they committed these acts or made those omissions. LLP partners are personally liable for any commercial obligations incurred by their form in the ordinary course of its business.
An “S” Corporation is a small business and closely held corporation with up to 100 shareholders with one class of stock which has made the election to be taxed as an “S” Corporation. In general, all shareholders must be individuals who are US citizens or residents. The shareholders are not liable for the debts incurred by the corporation, their liability is generally limited to the amount invested. They are managed by the board of directors who appoint the corporate officers. An “S” Corporation files IRS Form 1120S.
Entity choice is state specific. It doesn’t happen at the federal level. You incorporate or organize at the state level. The laws of the individual state matter: not all entity choices are respected or treated the same in every state.
Your choice of corporate entity may be different from your tax entity. Incorporation or organization with the Department of State in your state does not constitute a tax election with the Internal Revenue Service (IRS). For example, you can incorporate as a C corporation but elect with IRS to be taxed as an S corporation. You could also organize as an LLC but opt to be taxed as a partnership, S corporation, C corporation or disregarded altogether.
In the process of selecting a business entity, the benefits related to the form of business entity vary based on the business ownership, operations, and long-term goals; however, when evaluating the most appropriate legal structure for a particular business, a business owner’s three main considerations are risk management, income tax efficiency, and long-term capital requirements.
Each entity type has a different risk involved and should be carefully analyzed in order to protect the personal assets of the investor.
As for income tax efficiency, an LLC is unique in that it can be taxed as a disregarded entity, partnership, “C” Corporation or an “S” Corporation. Unfortunately, there is no one business entity structure that will always produce the lowest overall tax impact for a business and its owners. Business income taxes varies depending on a number of factors, including the expected business net profit, the owner’s personal income tax situations and the constantly changing tax laws; however, most small businesses are formed as pass-through entities (sole proprietorship, partnership, “S” Corporation and similarly taxed LLCs).
Pass-through entities are not taxed on their net income but instead pass their net income or loss directly through to the business owners. Owners of pass-through entities pay income tax on their share of the business net profits regardless of whether they ever take profit distributions from the business.
One significant difference between the “S” Corporation structure and the sole proprietorship and partnership structures occurs with respect to the Self-Employment Tax (SE Tax). Owners of sole proprietorships, partnerships and similarly taxed LLCs pay SE Tax on their share of the business net profit, whereas owners of “S” Corporation and similarly taxed LLCs do not. Therefore, the “S” Corporation structure can offer the advantage of less SE Tax compared to a sole proprietorship, partnership or similarly taxed LLC in situations where it is reasonable to pay a salary amount that is less than the Social Security limit while distributing the remainder as profits to the owners.
While owner-employees of an “S” Corporation or similarly taxed LLC can avoid the SE Tax, they generally cannot avoid paying employment taxes altogether. Owner-employees of C and S corps or similarly taxed LLCs who hold executive officer position(s) and manage the day-to-day business of the enterprise, generally need to take a W-2 salary in order to comply with the IRS “reasonable compensation” doctrine for corporate officers. This reasonable compensation requirement tends to mitigate the SE Tax advantages because W-2 salary is subject to Social Security and Medicare tax withholding and also subject to federal and state unemployment taxes.
In terms of insurance and other fringe benefits, the “C” Corporation structure offers a greater variety of fringe benefit plans than any other type of business entity. While sole proprietors, partners, shareholder-employees owning more than 2% of an “S” Corporation and members of LLCs taxed as sole proprietorships, partnerships or “S” Corporations must pay taxes on fringe benefits (such as group-term life insurance, medical reimbursement plans and medical insurance premiums), shareholder-employees of C corps generally do not have to pay taxes on these benefits. However, provided all of the IRS qualifications for claiming the self-employed health insurance deduction are met, sole proprietors, partners, shareholder-employees of “S” Corporations, and LLC members can generally deduct 100% of the cost of their medical insurance premiums, including coverage for their spouse and dependents, as an adjustment to gross income on their personal tax return, Form 1040, which tends to mitigate some of the “C” Corporations insurance benefits advantage.
The Tax Cuts and Jobs Act of 2017 (TCJA) created a new 20 percent deduction for qualified business income from sole proprietorships, passthrough entities like S corporations, partnerships, and limited liability companies taxed as partnerships. This new 20% qualified business income deduction (QBID) is subject to some complicated restrictions and limitations.
We urge you to evaluate which entity may represent better the level of liability and ownership composition that your business needs along with the most efficient tax structure possible.
Please contact our senior tax advisor, Carlos Nazario firstname.lastname@example.org to discuss how to minimize your 2018 taxes. At Millan and Co. we are business consulting CPAs who can help you in your business tax preparation and overall tax compliance.