After deciding to start a business or invest in one, the next critical step is to determine the type of entity to hold the investment or operations. This will have quite the legal and tax ramifications for any business. [At Leo Berwick we’re here to help you choose the entity that best fits you.]
These are a few ways in which the choice of entity can impact a business:
- Tax impact to the owners and the business
- Ability to shield liabilities from its owners
- Ability to scale
- Role and ownership definition
This article will briefly discuss the most common types of entities that are used in the U.S.: corporations (either C corporations or S corporations), partnerships, and limited liability companies.
A corporation is the most basic form of entity used to operate a business. It is a legal entity independent of its shareholders. When correctly structured, this legal separation protects the shareholders from the debts and liabilities of the business while allowing the shareholders to continue to control daily operations, redemptions, acquisitions and more.
From a U.S. tax perspective, corporations can be either C corporations or S corporations.
A C corporation structure creates two layers of federal taxes: a tax at the federal level and an individual shareholder-level tax for any distributions made to shareholders. [To learn about the tax consequences of distributions on corporations, read our article on The Impact of Distributions on Corporations.]
In 2017, the federal corporate tax rate was cut from 35% to 21%. The current lower tax rate has encouraged corporations to reinvest profits rather than distributing to shareholders. Not only does reinvestment reduce shareholders’ tax liabilities, it also provides an opportunity for corporations to scale the business. However, the tax rate is subject to future changes and the tax impact of a potential increase of the corporate tax rate should be carefully considered when deciding between a C corporation and another choice of entity.
Another important consideration is the ability of buyers of C corporations to receive a tax basis step up of the assets within the corporations when such acquisitions are via the purchase of shares.
To avoid the double layer of tax, a corporation that meets certain requirements can file an election with the U.S. IRS to gain a special tax status as an S Corporation. For federal income tax purposes, this means that that the earnings of the corporation may bypass federal taxation at the corporate level and are instead only taxed in the hands of the shareholders at their respective income tax rates. Note, however, that a single level of tax may not be true in all states as some states do impose a corporate-level tax even on S corporations.
Another potential benefit of structuring as an S corporation (or a partnership or limited liability company as discussed below) is the shareholders’ ability to deduct up to 20% of their qualified business income from the S corporation.
While an S corporation has tax benefits not available to a C corporation, to so qualify and receive such benefits, the corporation is subject to a host of restrictions, including limitations on who can own the S corporation. For example, C corporations and partnerships may not be S corporation shareholders. [To learn more about the requirements needed to choose this entity structure, read our article, S-Corporations: Advantages and Disadvantages.]
In the process of a deal, an purchaser may prefer to buy assets as opposed to shares of a corporation because it provides a step-up in the assets’ tax basis which allows more depreciation and amortization of such assets and thereby lowering the tax bill. In the S corporation situation, a purchase of the corporation’s share may nonetheless allow a step-up in asset basis provided that a specific election is made with the IRS. The election may result in higher tax cost to the sellers and so it may impact the purchase price. As a result, buyers often go through tax modelling to ascertain the desirability of such an election and how much extra to pay for the company.
For tax purposes, partnerships are generally also flow through entities. They include general partnerships, limited partnerships, professional partnerships (LLPs) etc. Like an S corporation, partnerships are not taxed at the entity level, and therefore there is only a single layer of federal taxation. In accordance with the terms of the partnership agreement, the partners will be allocated income, expenses and other tax items based on their respective interests in the partnership. Therefore, a well drafted partnership agreement is not only important in clearly defining roles from a managerial standpoint, it will also delineate how tax items are allocated between the partners. While partners may decide to designate income and deductions to the partners who can obtain the most after-tax benefits, the partners do not have unfettered discretion as the U.S. tax code imposes a set of complex rules to ensure that the tax allocations have “substantial economic effect.”
As mentioned above, like the shareholders of an S corporation, partners may deduct up to 20% of their qualified business income from the partnership.
It is important to note that not all partnerships are tax flow-through entities. For example, certain publicly traded partnerships are treated as C corporations. Furthermore, partnerships and limited liability companies may make tax elections with the IRS to be treated as a corporation and will be taxed as such.
The U.S. limited Liability company (LLC) is a type of entity that allows a choice of tax treatment depending on whether an entity classification tax election has been made. In this “best of both worlds”, the LLC extends the same liability protection to its investors as a C corporation while maintaining the flow through capabilities of a partnership or S corporation. Without the tax election, an LLC with two or more members is usually treated as a partnership for tax purposes. Where the LLC only has one owner, in the absence of the tax election, it will be considered a “disregarded entity” (DRE). The legal entity exists independently, but for tax purposes the entity ceases to exist. It is important to note that the treatment of an LLC in taxing regimes outside of the U.S. may be quite different. For example, Canada treats U.S. LLCs as corporations, regardless as to whether the U.S. tax election has been made or how many owners the LLC has.
While the tax election form (U.S. IRS Form 8832) is about as simple as a U.S. tax form can be, many issues have to be considered when deciding whether such an election is appropriate, and the analysis can be quite complex. For example, as mentioned above, many countries would treat an LLC as a corporation. If the LLC is considered a partnership for U.S. tax purposes, its hybrid nature may adversely impact the entity’s eligibility for tax treaty benefits.
Do the Triangles and Circles Mean on an Organizational Chart?
An organizational chart is a common tool used by accountants and lawyers to explain the often-complex processes of mergers and acquisitions. This organizational chart is meant to break down legalese or tax language into a form of communication readily understood by everyone: symbols, or, in other words, abstractions.
Here are a few of the symbols commonly used on organizational charts:
The choice of entity should align with the objectives of an entity’s owners. Whether it’s a C corporation, S corporation, partnership, or LLC, there are many considerations that should be taken into account when choosing an entity, some of which were discussed in this article. This choice would impact not only the tax consequences resulting from the business’ daily operations, but also when the business is being sold. With the increasingly international nature of the corporate business landscape, the choice of entity brings about even more complex tax considerations because not all jurisdictions would impose the same tax treatment as the U.S. For instance, an LLC is usually considered a corporate entity under the tax laws of most countries; by contrast, as discussed earlier, it can be a corporation, a partnership or even a DRE depending on how many owners the LLC has and whether a tax election has been made. [At Leo Berwick, we’re here to help you with that choice.]
[Other articles mentioned in this article include: “The Impact of Distributions on Corporations,” “S-corporations,” “Disregarded Entities,” and “Check the Box Forms.”]