Preface: Selecting the right entity car for optimized taxes is complex. Appropriately choosing an entity for your business, that will support a lower tax burden often requires collaboration with your tax advisor. Flipping a coin is not advised.
Flagstone Crossings To Lower Taxes: What Entity is Right (Segment III)
Credit: Donald J. Sauder, CPA | CVA
Partnership entities are an association of two or persons taxed on a Form 1065 for Federal purposes. They can be general partnerships, limited partnerships, or multi-member LLC’s. The organization is a pass-through entity that does not pay income tax at the entity level but instead passes the profit and losses through to the company’s “partners” on a Form K-1 that is filed with the individual 1040s.
Partnerships vehicles provide flexibility to the allocate income, ownership, voting rights, and provide multi-owner features without the tax incorporation features. Partners received guaranteed payments for services instead of a W-2 as from a corporation. Ordinary income from the partnership is often subject to FICA taxes on the individual partner’s 1040 if they are active in the company. For tax purposes, this is a significant tax characteristic and decision maker between an S-Corporations and multi-member LLCs.
General partnerships are easy to setup, but often not advised since there is easier affordable liability protection with a multi-member LLC. General partnerships, however, permit an increased ability to raise capital, but because both debts and liabilities are attached to partners, hold certain risks.
Multi-member LLC’s are often considered a hybrid of a partnership and corporation. Since the profits pass through to members on a Form K-1, the tax benefits are often appreciated. Also, members have limited risk with liability on debts and the investment; they can also participate in management, permit corporations and partnerships to be members, and do not have restrictions on the number of active or inactive members.
Partnership tax flexibility and conventional attributes are a commonly debated tax topic among advisors. One such feature is treating partners as employees.
Quoting from Noel Brock’s 2014 article: Treating partners as employees: Risks to consider
This error can have many tax consequences, not the least of which is the mistaken tax treatment of the partner’s income as wages subject to Federal Insurance Contributions Act (FICA) taxes under Sec. 3101, Federal Unemployment Tax Act (FUTA) taxes under Sec. 3301, and income tax withholding under Sec. 3402 (called employment taxes in this article), instead of self-employment income subject to self-employment tax under Sec. 1401 (Self-Employment Contributions Act (SECA)), which is not subject to wage withholding.
When Congress enacted the 1954 Code, it provided that a partnership could be an aggregate of its partners or a separate entity. Where no view of partnership taxation was adopted by a given Code provision, the view that was “more in keeping with the provision” should prevail. One Code provision that treats a partnership as a separate entity from its partners that was adopted in the 1954 Code is Sec. 707(a). It provides that, if a partner engages in a transaction with his or her partnership in other than his or her capacity as a member of the partnership, the transaction will, except as otherwise provided in Sec. 707, be treated as a transaction occurring between the partnership and one who is not a partner. Sec. 707(a) introduced the possibility that, given the right circumstances, a partner may hold the dual status of partner and employee in a single partnership.
Of note, is the numerous state Departments of Revenue that are now also looking at this tax perspective of employees as partners with increased scrutiny. The risks are substantial for established partnerships. Appropriate tax counsel and awareness of any tax risk are advised.
Selecting the right entity for your business startup is a tax decision that could include unknown long-term ramifications for any business owner. Say, partnerships, LLC, Corporation or sole proprietor? Agreed, Saint John Paul the Great said it well “The future starts today, not tomorrow.”
This blog is only a summary of the pertinent features to tax planning for entity selection. Getting it right is not as easy as it seems because tax laws are complicated. Making the best decision for your business, that will support a lower tax burden requires collaboration with your tax advisor. Flipping a coin is not advised.