This blog was prepared with the assistance of Peter A. Weitsen, CPA, partner at WithumSmith+Brown, PC.
When you create and operate a business, there are many challenging decisions to make, ranging from which employees you hire to how you market your products and/or services. And one of the most important decisions centers on how to structure the business—a decision that has important implications for how much you end up paying in taxes and how complicated the process of filing taxes becomes. Keep in mind that the choice of which structure is best for you has been affected in important ways by the Tax Cuts and Jobs Act that took effect mostly in 2018. The more you know, the better off you will be. And it makes sense to meet with a knowledgeable tax adviser and attorney before making any final decisions, which in many situations would be irrevocable.
Some common characteristics and general rules you need to know:
- Businesses may need TINs, which are tax identification numbers.
- Choosing a state to organize in is a special issue that will depend on the type of business and where it will operate. Generally, if the operations will all take place in a single state, then that should be the state you choose. Organizations with multi-state and international operations should choose the state carefully to minimize state, and possibly federal, tax exposure.
- If the entity operates in states other than where it is organized, it will need to register as a “foreign” corporation in each of those states—or another type of entity— and also get a registered agent in every other state it does business in. It also needs to make sure it registers for sales tax in each state.
- Whatever type of structure you use, you should have annual meetings with minutes kept and maintained.
- If the organizing document provides for periodic distributions of operating results or other data, it is important to make sure you comply with that instruction. For example, youmight need to provide annual financial statements to all owners…or if the document says that certain issues must be voted upon by the owners or that they must be given timely notice of owners’ meetings, then plan for that.
- If there is more than one owner, it is a best practice to have an operating and buy-sell agreement.
- A name will need to be chosen that is not being used by any other organization of that entity type.
- Some entities have ownership limitations, which will be explained in that section below.
- The owners of all entities have limited liability except sole proprietorships, general partnerships, general partners in a limited partnership and situations where there is any debt that is personally guaranteed.
- Management is usually by the sole proprietor, by all general partners or managing members or by anyone so designated by the board of directors of a corporation.
- Corporations, limited partnerships and LLCs are generally recognized as separate legal entities.
- Interests in all entities can be freely transferred unless there is a specific restriction on transfers.
- The entities need to maintain proper accounting records and a set of books.
- Any earnings retained in an unincorporated entity would be currently, or have been previously, subject to taxation by the individual owners.
- If there are foreign owners, special reporting requirements must be complied with, including filing specific forms with the IRS.
Here are the different structures you can choose from:
These are established by a single person that will operate either in his/her own name or an assumed name that is registered with the county clerk where he/she will be doing business or where he/she resides. The assumed name is usually called a D/B/A (doing business as). In lieu of obtaining a TIN, it is possible that the owner’s Social Security number would be used. I don’t recommend this. A TIN should be obtained to be used for business bank accounts, payroll payments and to issue 1099s.
Keep in mind that the owner has unlimited liability for all business obligations and will report the operations on Schedule C of IRS Form 1040. The net income is subject to self-employment tax in addition to income tax. The net income is eligible for retroactive SEP deductions or current year Solo 401(k) contributions and for self-employed medical insurance deductions on the owner’s individual tax return, Form 1040.
Make sure you are clear with all the rules, limitations and restrictions for retirement plan contributions and all of the deductions the owner is eligible for, as well as alternative forms of entities to operate under. Losses are deductible to the extent of the owner’s investment in the sole proprietorship and debts the owner is liable for. Sole proprietorships must use a calendar year. Sole proprietors cannot receive salary—the business income is what they report.
These are established when two or more people or entities want to operate a business. Other than there being more than one owner, and a TIN that must be obtained, the organization rules are similar as for sole proprietorships. One requirement, or best practice, is to have a partners’ agreement that is usually called a buy-sell agreement. Also, annual meetings should be held in accordance with the partnership agreement. Partnerships must use a calendar year except under certain limited exceptions that are not discussed here.
Many times, people engage in a business activity as a partnership or joint venture where they do not formally organize the entity or activity. These are nevertheless partnerships and would need to obtain a TIN and file a partnership tax return–Form 1065. It is not mandatory that a partnership have an agreement or organizing document, although that is certainly a best practice.
The applicable portion of the net income or losses and other reportable items is to be reported on each partner’s individual tax returns. Losses are deductible to the extent of the partner’s basis, which includes his/her investment in the partnership and possibly certain debts of the partnership. General partnerships terminate when a general partner dies, as do sole proprietorships when the owner dies or terminates his/her ownership interest. Partners do not receive salary for their services—the income they earn is reported on the Form K-1. General partners have a fiduciary duty to the other partners.
General partnerships that are owned by a husband and wife do not have to file a Form 1065 but could choose to file two Schedules Cs as part of their joint tax return. Each would report his/her share of all the income and expenses on the Schedule C. This eliminates the need for that extra tax return filing.
These partnerships, organized under the laws of the state they will operate in, provide for at least one general partner and one partner that has limited liability. Limited liability means that the limited partner will not be liable personally for partnership debts unless he/she specifically obligates himself or herself to be liable for that debt. The general partner will have unlimited liability. A TIN must be obtained. The net income or losses are treated the same as for general partnerships on the partners’ tax returns except that losses that are considered passive might not be fully deductible by the limited partner. There are special rules that should be reviewed with the preparer of your tax returns. Limited partners can have no role in managing the partnership, which is solely managed by the general partners, which can be an individual, C or S corporations, LLCs or trusts. Typically, the limited partners provide the capital to the partnership. Limited partnerships have a date when they terminate, which is determined when they are organized.
Limited Liability Companies (LLCs)
These must be organized under a state’s law and the members are not liable for debts of the entity. The tax treatment of income and losses and the basis for losses are similar to those of limited partners as is the Form 1065 filing. Husband and wife owners must file a Form 1065 and cannot avoid this with two Schedule Cs as general partnerships can. These have termination dates.
One Person LLCs
There is an exception to the LLC rules for one person LLCs. They are treated as a disregarded entity by the IRS for tax purposes and do not need to obtain a TIN (and can use the owner’s SSN, which I do not recommend) and would report the transactions on Schedule C.
Publicly Traded Partnerships
These are limited partnerships whose ownership interests trade the same as stocks. They are limited partnerships and the investors receive a voluminous Schedule K-1 to report their share of the income or loss and other tax attributes. It is quite possible that the income the investor is taxed on is greater than the cash distributions. Also, the K-1s could be 10 pages or more, making it more time consuming and costly to have tax returns prepared. Note: Hedge funds and private equity funds could have up to 30-page K-1s. Also, operating income from a PTP is business income and can be taxed in a tax-deferred or Roth retirement plan account as unrelated business income.
These are the basic entity for publicly held companies. The C refers to Subchapter C of the Internal Revenue Code (IRC). A C corporation is a separate legal tax-paying entity with net income taxed at a flat 21% regardless of the amount of income. Most states also tax corporations. The funds remaining in the corporation after the tax payments are called retained earnings. When distributions are made from the retained earnings, they are subject to a second tax, which is paid by the owners receiving the dividends. Individuals pay tax on those dividends at rates similar to the capital gains rates, which could range from 0% tax up to 23.8%—lower rates than ordinary or earned income.
Qualified C corporation dividends received by another C corporation are subject to a “dividends received deduction”of 50% to 100% depending upon the nature of the ownership of the corporation that is receiving the dividends in the corporation that is paying the dividends. Dividends from a less than 20% owned domestic corporation are permitted a 50% deduction, making the tax rate on the dividends 10.5% (50% of 21%). However, the remaining funds will eventually be taxed again when they are distributed. Stockholders are not taxed on any corporation income except when dividends are distributed. Any person or any entity can be a stockholder without limitation or restriction. Corporations have an unlimited life span not terminating upon the death of any stockholder and not needing to state a termination date. Shareholders that work for the corporation receive a salary similar to any employee. A board of directors is established and the directors hire the officers. Directors will have a fiduciary duty for their actions. A C corporation can choose a fiscal year instead of using a calendar year.
These are corporations electing under Subchapter S of the IRC to not be taxed. All taxable income, losses and credits and certain other attributes pass through to the stockholders to be reported on their individual tax returns. The passive-loss rules can prohibit deductions by the individual shareholders, and this should be reviewed with a tax adviser. There is a limit of 100 shareholders, and they cannot be foreigners. In general, they must be individuals, although certain trusts can be stockholders and estates can be stockholders for a limited period. Corporations cannot be stockholders. There can only be one class of stock, but different voting and nonvoting shares are permitted, and there cannot be any differences in liquidation and dividend rights. Direct loans from a shareholder can increase basis. The stockholders receive a K-1 with the information they will need to report on their individual tax return. Stockholders that are employed receive salary. There is special taxation by S corporations that were once C corporations and have excess net passive investment income. S corporations must use a calendar year (with certain limited exceptions).
Entity Classification Changes
No matter how an entity is organized, it is possible under certain situations to make changes to be taxed as a different form of entity. This is done on IRS Form 8832, Entity Classification Election. Making such changes involves serious thought and management and should be discussed with a knowledgeable tax adviser beforehand.
There are many other ways to structure a business, including the following, which we won’t go into detail about here:
- Regulated investment companies
- Real estate investment trusts
- Personal holding companies
- Professional corporations or professional LLCs
- Employee benefit plans
- Employee stock ownership plans (ESOPs)
- Not-for-profit corporations
- Charitable foundations
- Religious corporations
- Trusts–various types and variations
There is more that those organizing entities will need to explore, including whether there will be different classes of shares, for instance common and preferred, whether shares would be held in a voting trust, whether there will be different liquidation rights and different and disproportionate income and loss allocation percentages.