Choosing the Right Business Entity for Tax Purposes in the USA: When starting a business in the USA, one of the most important decisions you’ll need to make is selecting the right legal entity for tax purposes. The main question to ask your client is “What is your goal and objective for choosing an entity?” Most of the time, the choice is made for tax-saving purposes, but there are other considerations to think about when selecting what legal vehicle to operate your business in.
Choosing the Right Business Entity for Tax Purposes in the USA
In this article, we will give you a quick overview of the various tax implications you should be aware of when deciding on an entity for your business. So let’s jump in and get started!
When it comes to choosing a legal entity for your business, there are several options to consider, including Followings,
- C Corporations,
- S Corporations,
- Partnership , and
- Single Member Limited Liability Companies (SMLLC), Also Known As Sole Proprietorships.
Each entity has its own unique tax implications, advantages and disadvantages, so it’s important to understand what each option entails before making a decision. we’ll give you a brief overview of each entity type to help you make an informed decision about what’s right for your business.
C corporations, commonly known as “C corps,” are required to file Form 1120, U.S. Income Tax Return for a corporation. However, they are notoriously known for their double taxation policy.
The taxability of income is first taxed at the C corp level, and when dividends are distributed to the shareholders, they are also taxed at the individual level as dividend income. Because of double taxation, many companies prefer to structure as pass-through entities such as an S corporation or partnership.
All items of income, credit, loss, and deductions are computed at the entity level in arriving at corporate taxable income or loss. The Tax Cuts and Jobs Act of 2017 reduced the corporate income tax rate to a flat rate of 21%, which is lower than the highest non-corporate tax rate. When there are losses at the C corp level, they become Net Operating Losses (NOL) that must be carried forward indefinitely for the 2021 tax year and beyond.
C corporations can have multiple classes of stock and can have preferred returns/dividends to their shareholders. In addition, there are no restrictions as to who can own C corporate stock.
The drawback of being a C corporation is that the losses are trapped at the entity level and cannot be deducted at the owner’s level. Additionally, the earnings can be subject to double taxation both at the entity level and the individual level when shareholders receive dividends.
S corporations file Form 1120S, U.S. Income Tax Return for an S corporation. Unlike the C corp that has double taxation, the S corp income is reported for informational purposes only and taxed to the shareholder on their individual return. This is also known as a “flow-through entity” since S corps do not normally pay taxes at the entity level.
The character of the business income that flows through to the shareholder is “ordinary income” not subject to self-employment taxes. While one can think they can get away with shielding themselves from having to pay Social Security and Medicare taxes, there is a reasonable compensation requirement for the officers to pay themselves what the IRS calls a reasonable salary through a W-2.
Unlike the C corp, which can have multiple classes of stock, S corps are only allowed one class of stock. What this means is that all income allocations and distributions need to be done based off of their prorated ownership percentage.
Compared to other entities, the S corporation has restrictions regarding who can be an owner. To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates
- May not be partnerships, corporations, or nonresident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)
Partnerships file Form 1065, U.S. Income Tax Return for a Partnership. Like an S corporation, partnerships are a flow-through entity. Income taxes are not paid at the partnership level. Instead, the activity of the partnership “flows through” to the partners in proportion to the owners’ respective interests in profits, are reported on the individuals’ tax returns, and are only taxed once.
The unique aspect of a partnership is that it can specially allocate profits/loss/capital and debt to different partners provided there is a substantial economic effect. This can be an important reason for using a partnership over an S corporation. Another positive aspect of partnerships over S corporations is the ability to have Sec. 743(b) adjustments in the case of a sale or exchange of a partnership interest for which a Sec. 754 election is in place.
This would allow for an adjustment to eliminate the difference between the inside basis of the property within the partnership and the outside basis of the partnership interest for the transferee partner. This is especially important if appreciated assets such as real estate is put into a partnership.
From an income tax perspective for those partners who are actively participating in the partnership, the ordinary income that flows through to them will be subject to self-employment taxes in addition to their ordinary income taxes.
Single Member Limited Liability Company (SMLLC) (or Sole Proprietorship)
SMLLCs are disregarded for federal income tax purposes, meaning they do not file a separate federal tax return. Instead, the income and expenses are typically reported on the individual owner’s Form 1040 tax return either on Form 1040 Schedule C Profit or Loss From Business or 1040 Schedule E Supplemental Income and Loss.
If the income is reported on Schedule C, the income is going to be taxed at ordinary income tax rates and would be subject to self-employment taxes on the net income from those activities.
If the income is reported on Schedule E, then the income will typically be subject to ordinary income tax rates, and in most cases, will also be subject to passive activity rules under IRC 469.
Before advising the client on a choice of entity, the practitioner should be aware of the client’s proposed business operations and end goals for the business. Some considerations include the nature of the business, the number of shareholders/partners, the assets within the entity (appreciating assets), and exit strategies.
Selecting the right business entity for tax purposes in the USA is a critical decision for any new business owner. By understanding the different entity types, considering your business goals and needs, evaluating the tax implications, reviewing state-specific requirements, and seeking professional advice, you can make an informed decision and set your business up for success.
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