Preface: Tax practitioners are often requested to provide advice for entrepreneurs starting a new business. Although non-tax angles are an important degree and should not to be discounted even slightly, often entrepreneurs are more concerned with the central tax considerations of a new venture. This blog is written to help entrepreneurs navigate business entity decisions from a tax perspective.
Taxing Decisions – Business Entity Taxation
Credit: Donald J. Sauder, CPA
The three main business entities often considered with entrepreneurial ventures are 1.) partnerships 2.) corporations 3.) limited liability company (LLC).
A partnership is pass-through entity with all business revenues and expenses attributable to profit motivated activities transferring from the business tax filing, e.g. Federal Form 1065, to the owners via a Form K-1. The K-1 encompasses the tax attributes applicable to the holder(s) of the partnership interests, i.e. an individual or say another partnership.
For example, let’s say a partnership has $5,000 of net income for the year with three owners at 33.3% interests would pass through $1,665 of income on each K-1 to the individuals to report as revenue on their individual 1040 tax filing. The revenue would be taxed at the applicable tax filing status and rate, differing for each owner’s specific taxable position. Typically, personal tax rates are lower for married filing jointly tax payers, under current tax laws vs. single. Partnerships can be either general or limited liability. Talk with your trusted counsel with regards to applicable legal risks on partnership structures.
Limited Liability Companies
Limited liability companies (LLC) can be taxed as either a partnership, corporation or sole proprietorships. LLC’s are here to stay and have a practical place in entity selection in today’s business marketplace. An LLC taxed as a partnership files the same Federal Form 1065 as a partnership, but provides owner with limited liability protection, e.g. a veiling of state legislated legal protection only afforded corporations in prior decades. LLC’s taxed as partnerships can be either member managed, or manager managed. Management is determined by the operating agreement. Talk with your trusted counsel with regards to applicable legal risks on LLC structure relevant to your state. LLC’s also have the option to be taxed as C-Corporations or S-Corporations in the State of Pennsylvania.
C-Corporation taxation assesses a tax on income of a business at a tax rate separate from the individual shareholder. For discussion purposes, net income more than $50,000 is taxed a higher rate exclusive the shareholders individual tax position. Losses in C-Corporations are suspended inside the business, and cannot offset income from other sources for active owners. After paying the tax in a C-Corporation, the dividends distributed to ownership are again taxed at qualifying dividend rates, i.e. 15%. The distribution of the net taxed earnings, taxed again, resulting in double taxation. For this reason, there are few reasons for small businesses to use the C-Corporation tax structures. In addition, C-Corporations in Pennsylvania pay taxes at a rate of 9.99% vs. individual rates of 3.07%. Therefore every $25,000 of earnings in a C-Corporation costs $1,730 more than pass-through earnings on a K-1, say in a partnership just on the state tax. A C-Corporation in Pennsylvania earning $100,000 could easily pay in-excess of $50,000 in taxes per year, on net distributed income, or greater than a 50% tax rate. Current laws plan to reduce Federal tax rates only to 20%. State rates and dividend rates would remain at similar current 2017 percentages.
Corporations can elect S-Status with a Form 2553 filing, if they meet certain requirements, e.g. one class of stock, fewer than 100 shareholders, qualifying stockholders, i.e. individuals say. S-Corporations provide veiling protections, as does an LLC, but under the stated corporation umbrella. Earnings and losses pass-through to owners on a K-1, like the partnership taxation.
Entity selection for your business is both a taxing tax and legal question. Compensation of ownership, methods of accounting, ownership tax rates, social security tax implications on business and wage earnings, and projected future revenues are all pertinent factors in decided on a business entity that is optimal.
There are often ambiguous answers and no bold lines to the entity selection decisions in many entrepreneurial situations. Appropriate counsel is advised. However, in Pennsylvania the LLC is an increasingly common entity vehicle, providing permissible tax flexibility for a “belt or suspenders” option with regards to partnership or corporate taxation, when multiple owners are involved; or with one owner, sole proprietor or corporate taxation. Opinions vary. You are now advised to make an informed decision.
This blog is written for education and informational purposes only and is not to be construed as tax, legal or accounting advice. Consultation with your accredited advisors are imperative and advised before making any business decision, especially entity selection in this context.