When determining what entity type is best for your organization, you need to consider several factors, and working with an outside adviser can help avoid trouble down the road, says Steven H. Gross, CPA, a partner with Skoda Minotti.
“A limited liability company (LLC) often makes the most sense, as it provides the most flexibility, but there are other options to consider,” says Gross. “Even with an LLC, you need to determine the best way to be taxed.”
Smart Business spoke with Gross about how to make the best choice to lessen your tax burden and avoid common tax traps.
What types of entity structures can businesses choose from?
The most common options are a C corporation, an S corporation, partnerships and, as mentioned above, an LLC.
A corporation (S or C) is a separate legal entity. C corporations are tax paying entities, that is, they pay taxes on their taxable income just as individuals pay taxes on their taxable income. A C corporation can make a distribution to its shareholders, which may be taxed as a dividend. These dividends are not deductible to the corporation, but taxed, at least until 2013, at a favorable tax rate to the recipient. Depending on the tax situation of the individual and the corporation, paying some dividends may result in less taxes paid by the corporation and individual combined.
An S corporation is also a separate legal entity but generally is not a tax-paying entity for federal tax purposes. An advantage of an S corp. is that its profits are taxed to the shareholders, not the corporation itself; therefore the double taxation that exists in a C corp. is eliminated. Another advantage is that the amount of profits taxed to the shareholders is subject to self-employment tax. Since S corp. profits are not subject to self-employment tax, you can manage your self-employment taxes better than in a C corp. In an S corp., profits and losses have to be allocated to the shareholders in the same percentages, as ownership and distributions cannot be disproportionate.
Another entity structure option is an LLC. Generally, a multi-member LLC will be taxed as a partnership. An LLC filing a partnership return is not a tax-paying entity and the profits and losses flow through to the members in a similar manner to an S corp. Members of an LLC can elect to have the entity taxed as an S corp. or a C corp.
What are some benefits of an LLC?
An LLC that is treated as a partnership allows its members to avoid the double taxation and higher income tax of a corporation while, at the same time, retaining limited liability and other favorable attributes of a corporation.
An LLC, unlike an S corp., has the ability to specially allocate items of income, loss, deduction or credit, so long as the allocations have substantial economic effect.
Note that, even if an LLC is treated as a partnership for federal income tax purposes, an LLC may also be treated as a corporation and be subject to franchise taxes under state law.
What are some benefits of an S corporation?
As stated before, shareholders of an S corp. do not pay self-employment tax on the flow-through profits.
An S corp. with only one shareholder still files a separate return, unlike a single member LLC. A single member LLC is a disregarded entity for federal tax purposes and all of the business income and expenses are reported on Schedule C of the individual’s income tax return.
Disposition of an ownership interest in an S corp. at a loss may yield an ordinary loss under I.R.C. Sec. 1244, while disposition of an LLC ownership interest generally yields a capital loss.
What are some common tax traps businesses fall into?
When you have flow-through entities, you have basis issues when it comes to losses. If you meet certain criteria, those losses can be deducted on your tax return. However, individuals often think that if they are incurring losses in their pass-through entity, they can deduct those losses on their individual income tax returns when, in fact, they do not have basis to take the losses.
Another trap in the C corp. arena is charitable contributions. Contributions made in a C corp. are only deductible to the extent that they don’t exceed modified net income by 10 percent. Any excess contributions can be carried forward for up to five years. If a C corp. is running at a loss, the shareholder may want to consider making the donation personally.
How do you determine the right choice for your business?
Business owners need to seek advice on what would be the best choice in their particular situation. Sit down with an adviser, determine the pros and cons and weigh the options.
The issues can be very confusing and difficult to get your arms around. These are intricate tax issues and you would be best served by sorting through your options with an experienced professional.
Steven H. Gross, CPA, is a partner with Skoda Minotti. Reach him at (440) 449-6800 or firstname.lastname@example.org.