When launching a new business venture, you must decide what form of
business entity will provide the greatest tax savings and the best return to
owners and investors.
An initial public offering (IPO) is often
regarded as the coveted prize at the end of
the rainbow for many entrepreneurs, so
the firm is structured as a C corporation.
But upon reaching success, many businesses are sold before going public.
Structuring as a C corporation might eliminate some of the tax advantages that could
be realized in the short term as an S corporation or a partnership, and it may result in
double taxation when the business is sold,
says Brad Graves, partner-in-charge of the
Tax Group at Haskell & White LLP.
“Many entrepreneurs are leaving benefits
on the table when they assume that an IPO
is the endgame they seek, when a partnership structure might provide the best tax
benefits today without diminishing the end
result tomorrow,” says Graves.
Smart Business spoke with Graves about
the tax advantages of the various business
entities.
How do C corporations, S corporations and
partnerships differ in flexibility?
For C corporations, income and losses
are reported and taxed at the corporate
level and profit distributions are generally
characterized as dividends. There’s no
deduction for profit distributions at the
corporate level, because dividend income
is allocated to the shareholder who recognizes the dividend at fair market value
when reporting it for individual income tax
purposes. Any noncash distributions trigger a gain at the corporate level.
As S corporations, a business’s income
and losses are passed through to the shareholder level and allocation is equal for all
shares. Noncash distributions trigger a gain
at the corporate level that is then passed
through to the shareholders. However, this
increases the shareholder’s stock basis,
which will eventually offset future income
or generate a loss when the stock is sold.
As a partnership, a business’s income
may be allocated among the partners with various preferences, guarantees and
tranches in order to reflect the agreed
upon economic sharing of the partners, as
long as certain safe harbor provisions are
met. In addition, noncash distributions do
not generally trigger a gain.
What are the differences in taxation of operating income between the three?
C corporations are taxed on operating
income at the corporate level, which can
climb up to the maximum federal rate of 35
percent, and the lower capital gains tax
rate does not apply for corporations.
Capital losses are allowed up to the level of
capital gains and can be carried forward
five years or backward three years.
In S corporations and partnerships, all
income is passed through and reported and
taxed at the shareholder or partner level.
Capital gains and losses are taxed at the
shareholder’s or partner’s capital gain rates
and subject only to the limitations at the
shareholder or partner level.
What is the difference in how business losses are treated?
If you think that the business will be generating losses, at least for a while, it’s important to consider how they will be
treated for tax purposes. For C corporations, losses may only be carried over at the
corporate level. While S corporations pass
losses through to the shareholders to the
extent of stock basis, plus basis in shareholder loans to the corporation. However, if
the firm will be heavily leveraged, a partnership may be preferable. Partnerships
can utilize losses in much the same way as
S corporations. Losses pass through to the
extent of basis in partnership interest (capital account plus allocable share of debt,
including debt from banks and other third
parties) with one caveat that ‘at-risk’ limitations will limit losses funded by nonre-course debt unless it is ‘qualified.’
How do the three entities differ in the tax
implications resulting from the sale or liquidation of the business?
A sale or liquidation of the assets by a C
corporation results in double taxation. The
corporation realizes gain or loss from the
sales of the assets, pays corporate income
taxes and distributes the remaining assets
to the shareholders, who will be taxed on
the proceeds they receive.
The S corporation is regarded as a ‘single-taxation’ entity when the business is sold,
so gains or losses resulting from the sale
are passed through to the shareholders,
who report the income and losses and pay
the taxes. Stock basis is increased, thereby
reducing gain on stock redemption.
In the event of a liquidation of a partnership by distribution of the assets to the
partners, no gain or loss is generally recognized — so there’s no tax. In the event of a
sale of the partnership’s assets, gains and
losses at the partnership’s level are passed
through to the partners, who report the
income and losses and pay the taxes. The
partners’ bases in their partnership interest
receive a corresponding increase or
decrease, thus ensuring only a single level
of taxation.
BRAD GRAVES is partner-in-charge of the Tax Group at Haskell
& White LLP. Reach him at [email protected] or (949) 450-6200.
