Business Entities (Part II)

In the last post, BUSINESS ENTITIES (PART I) we described the different types of entities available to conduct a business. We concluded that in choosing a business entity, an entrepreneur would most likely choose the entity that would keep taxes to a minimum while providing the maximum personal liability protection. This post will examine the taxation issues in more detail.

There are six potential areas in which one entity can be taxed differently than another entity. In these six areas, we will compare a regular or C Corporation (which includes an LLC that elects to be taxed as a C Corporation), an S Corporation (which is a regular Corporation for all purposes except that the entity and it’s owners elect to pay tax personally on the Corporate income) with other pass through entities (which includes a Sole Proprietorship, Partnership and LLC which does not elect to be taxed as a Corporation.

1. Multiple Taxes On Income From Operations. The ordinary business income of a C Corp is taxed to the Corporation at corporate tax rates. If and when this income is distributed to shareholders, it is taxed again to the shareholders as a dividend. The income from the business operations of an S Corp or other pass through entity is taxed only on the owner’s personal income tax return.

2. Multiple Taxes Upon Sale Or Liquidation. Income from the sale or liquidation of the business assets will result in corporate income to a C Corp as well as personal income to its shareholders when ultimately distributed to them. It should be noted that while multiple taxation of the income from operations of a closely held C Corp can often be avoided by distributing the cash to shareholders in the form of deductible compensation rather than dividends, this technique will not usually work with income from the sale or liquidation of the business assets. The income from the sale or liquidation of an S Corp’s assets will generally not result in multiple levels of taxation except to the extent it is attributable to gain from the assets existing when the Corp elected S Corp status and the election was made by a C Corp within ten years of the disposition of the corporate assets(the Built-In-Gains Tax). A Corporation that either has always been an S Corp or was a C Corp but made the S election more than ten years prior to the sale or liquidation would not be subject to the Built-In-Gains Tax. The income from the sale or liquidation of the assets of other pass through entities (Sole Proprietorship, Partnership or LLC) is never subject to multiple taxes.

3. Penalty Taxes. The earnings of certain Corporations can also be subject to penalty taxes in addition to the Corp’s regular income tax. The Accumulated Earnings Tax is imposed (although rarely) on certain C Corps that are formed or used to accumulate rather than distribute its earnings as taxable dividends to its shareholders. The Personal Holding Company Tax is imposed on closely held C Corps (5 or fewer shareholders) with at least 60% of its income from passive sources (dividends, interest, royalties and certain rents) that also fail to distribute earnings to shareholders. The corporate Alternative Minimum Tax is a tax designed to ensure that high income C Corps utilizing certain tax benefits pay a minimum amount of tax. S Corps are not subject to any of these taxes although there is an Excess Passive Income Tax on former C Corps with income from passive sources greater than 25% of the S Corp’s total income. There are no penalty taxes imposed on other pass through entities.

4. Pass Through of Business Tax Losses. If the business suffers a tax loss, which is common for start-up businesses, S Corps, Partnerships, Sole Proprietorships and LLC’s can pass this loss to their owners, potentially reducing such owners’ personal taxes. C Corps cannot pass through losses to their shareholders.

5. Basis in Retained Earnings. Basis is a very important tax concept. To the extent an owner of a business entity has tax basis, distribution of previously taxed income is tax free, losses are deductible and gain upon sale of the ownership interest in the entity is tax free. C Corp shareholders can not increase basis in their stock by the Corp’s retained earnings. S Corp shareholders and owners of other pass through entities increase their tax basis in their respective ownership interests by their share of the entity’s undistributed earnings.

6. Basis for Entity Level Debt. C Corp and S Corp shareholders cannot increase tax basis in their stock by their proportionate share of money borrowed by the Corporation, even if as is usually the case in closely held businesses, the shareholders personally guarantee the debt. The tax basis of Partners and LLC members in their respective entities is usually increased by their proportionate share of the entity’s borrowings.

It should be obvious that Sole Proprietorships, Partnerships and LLC s enjoy an advantage over C and S Corps with respect to the goal of paying the least amount of tax. The next post, BUSINESS ENTITIES ( PART III), will examine the choice of entity decision with respect to the goal of protecting the business owner’s personal assets from business liabilities.