Choice of Entity Chart: Tax Considerations
Choice of Entity Chart: Tax Considerations
Establishing A Business
| C Corporation | Limited Liability Company | Limited Partnership | S Corporation | |
| Formation | File Certificate of Formation with proper state office. | File Certificate of Formation with proper state office. | File Certificate of Formation with proper state office. | File Certificate of Formation with state and Form 2553 with the IRS. |
| Tax Year | Any tax year if not a personal service corporation (PSC). PSCs use calendar tax year or can make Section 444 election. | Majority interest rule, principal member rule, or least aggregate deferral of income rule; or make Section 444 election. | Majority interest rule, principal partner rule, or least aggregate deferral of income rule; or make Section 444 election. | Calendar tax year or other business purpose tax year; or make Section 444 election. |
| Accounting Method | C corporations cannot use the cash method. However, personal service corporations and corporations meeting an annual gross receipts test can use the cash method. | LLCs that are a tax shelter or have C corporation member cannot use the cash method. However, LLCs meeting an annual gross receipts test can use the cash method. | Partnerships that are a tax shelter or have C corporation partner cannot use the cash method. However, partnerships meeting an annual gross receipts test can use the cash method. | S corporations that are a tax shelter cannot use the cash method. However, S corporations meeting an annual gross receipts test can use the cash method. |
| Ownership and Capital Structure | Unlimited number of shareholders; flexible capital structure (e.g., can issue common and preferred stock). | Single member LLCs are disregarded for federal tax purposes while multi-member LLCs are treated as partnerships unless an election to be taxed as a C or S Corporation is made. | Requires at least two partners; otherwise no limitation on “who and how many.” Can have general partners and limited partners. | No more than 100 shareholders, and limitations on who can own stock. Can only have one class of stock. |
| Owner’s Ability to Make Tax-free Contributions | Tax-free if Code Sec. 351 rules are met (e.g., must be in control after transfer). | Generally tax-free, although some contributions may trigger gain. | Generally tax-free, although some contributions may trigger gain. | Tax-free if Code Sec. 351 rules are met (e.g., must be in control after transfer). |
Operational Tax Issues
| C Corporation | Limited Liability | Limited Partnership | S Corporation | |
| Deductibility of Losses | Losses deducted by corporation to extent of gross income. Any remaining losses can be carried back or forward to reduce those years’ income. | Losses passed through to members, and are deductible under the basis, at-risk, and passive activity loss rules, in that order. | Losses passed through to partners, and are deductible under the basis, at-risk, and passive activity loss rules, in that order. | Losses passed through to shareholders, and are deductible under the basis, at-risk, and passive activity loss rules, in that order. |
| Passive Activity Loss Rules | Apply to personal service corporations and closely held corporations. | Apply at the member level; do not apply to the LLC. | Apply at the partner level; do not apply to the partnership. | Apply at the shareholder level; do not apply to the S corporation. |
| Section 179 Dollar Limitation | Applies at the corporate level | Applies at the LLC level and the member level. | Applies at the partnership level and the partner level. | Applies at the S corporation level and the shareholder level. |
| Fringe Benefits for Owners | No special rules for shareholders although nondiscrimination rules apply to key employees and highly compensated employees. | Health and some other benefits for members treated as guaranteed distribution. | Health and some other benefits for partners treated as guaranteed payment or a distribution. | Health and some other benefits for shareholders owning more than 2% of stock treated as compensation or a distribution. |
| At-risk Rules | Apply to closely held corporations. | Apply at the member level. | Apply at the partner level. | Apply at the shareholder level. |
| Unreasonable Compensation | Unreasonably high compensation can be paid to reduce corporate income tax. | Not an issue, although IRS may question member’s status as employee. | Not an issue, although IRS may question partner’s status as employee. | Unreasonably low compensation can be paid to shift income to family members or avoid employment taxes |
General Tax Issues
| C Corporation | Limited Liability | Limited Partnership | S Corporation | |
| Ownership and Capital Structure | Unlimited number of shareholders; flexible capital structure (e.g., can issue common and preferred stock). | Default for single member LLCs is disregarded for federal tax purposes while multi-member LLCs are treated as partnerships. | Need at least two partners; otherwise no limitation on “who and how many.” Limited partnerships have one or more limited partners | No more than 100 shareholders, and limitations on who can own stock. Can only have one class of stock (but voting differences allowed). |
| Limited Liability for Owners | Shareholders are not liable for debts incurred by the corporation. Their liability is generally limited to amount invested. | Like shareholders, members are not liable for debts incurred by the LLC, whether a single member LLC or a multimember LLC. | General partners are personally liable for all partnership debts. Limited partner’s liability is generally limited to amount invested. | Shareholders are not liable for debts incurred by the corporation. Their liability is generally limited to amount invested. |
| Continuity of Life | Usually unlimited life, unless otherwise limited in Articles of Incorporation. | Depends on state law or articles/agreement. Multi-member LLC termination governed by partnership rules, while single member LLC ends/dissolves when owner dies. | Depends on state law or entity agreement. Terminates for federal tax purposes if 50% or more of capital and profits interests are transferred within a 12-month period. | Usually unlimited life, unless otherwise limited in Articles of Incorporation. But a number of eligibility rules must be monitored and met to retain S status. |
| Management of Entity | Managed by board of directors who appoint the corporate officers. | LLC can be member-managed, in which case all members share responsibility for the day-to-day operations, or manager-managed. | In a general partnership, the partners specify each person’s role. In a limited partnership, the general partners manage the business. | Managed by board of directors who appoint the corporate officers. |
| Transferability of Ownership Interests | Transferable, although may be limited by buy/sell agreement. | Transfer rights are governed by state law and the operating agreement. | Transfer rights are governed by state law and the partnership agreement, if one exists. | Transferable, but may be limited by buy/sell agreement. Also, transfer must not terminate S status. |
Tax Issues for Owners
| C Corporation | Limited Liability Company | Limited Partnership | S Corporation | |
| Creditor Access to Ownership Interest | Shareholder’s creditors can gain access to stock. | Member’s creditors generally limited to charging order. | Partner’s creditors generally limited to charging order. | Shareholder’s creditors can gain access to stock. |
| Owner’s Ability to Make Tax-free Contributions | Tax-free if Code Sec. 351 rules are met (e.g., must be in control after transfer). | Generally tax-free, although some contributions may trigger gain. | Generally tax-free, although some contributions may trigger gain. | Tax-free if Code Sec. 351 rules are met (e.g., must be in control after transfer). |
| Owner’s Tax Basis | Increased by additional investments, and decreased by nontaxable return of capital, if any | Increased by profits, contributions, and increase in share of debts. Reduced by losses, deductions, distributions, and decrease in share of debts. | Increased by profits, contributions, and increase in share of debts. Reduced by losses, deductions, distributions, and decrease in share of debts | Increased by profits and additional contributions, and decreased by losses, deductions, and distributions. |
| Owner’s Ability to Receive Tax-free Distributions | Taxable dividends to extent of corporate E&P. Distribution of appreciated property results in corporate gain. | Nontaxable to extent of basis, although a number of special rules and exceptions can result in the recognition of gain. | Nontaxable to extent of basis, although a number of special rules and exceptions can result in the recognition of gain. | Nontaxable to extent of stock basis; AE&P can create dividend. Appreciated property distribution results in corporate gain. |
| Deductibility of Losses | Losses deducted by corporation to extent of gross income. Any remaining losses can be carried back or forward to reduce those years’ income. | Losses passed through to members, and are deductible under the basis, at-risk, and passive activity loss rules, in that order. | Losses passed through to partners, and are deductible under the basis, at-risk, and passive activity loss rules, in that order | Losses passed through to shareholders, and are deductible under the basis, at-risk, and passive activity loss rules, in that order. |
| Special Allocations Among Owners | Cannot be made since C corporation is not a pass-through entity | Can be made but must have substantial economic effect | Can be made but must have substantial economic effect. | Cannot be made; pass-through based on stock ownership |
Taxation Issues
| C Corporation | Limited Liability Company | Limited Partnership | S Corporation | |
| Entity-level Penalty Taxes | Personal holding company tax and accumulated earnings tax. | No income taxes of any kind can be assessed against LLC taxed as partnership. | No income taxes of any kind can be assessed against partnership. | Built-in gains tax, tax on excess net passive investment income, and LIFO recapture tax. |
| Income Taxation of Entity | Income taxed to the corporation and then taxed again when distributed to the shareholders. | In single member LLC, owner is taxed. In multimember LLC, income taxed once to members | Income taxed once to the partners. | Income taxed once to the shareholders, although some S corporations are subject to built-in gains tax. |
| Income Taxation of Individual Owners | Corporation taxed on income. Distributions taxed at maximum rate of 20% or 39.6% | LLC items and distributions taxed at maximum rate of 20% or 39.6%. | Partnership items and distributions taxed at maximum rate of 20% or 39.6%. | Pass-through and distributions taxed at maximum rate of 20% or 39.6%. |
| Self-employment (SE) and Payroll Taxation of Individual Owners | No SE tax, unless shareholder also performs services as an independent contractor. Wages subject to payroll taxes, while dividend distributions subject only to income tax | Members generally treat their share of business income and guaranteed payments for services or use of capital as SE income. Members treated as limited partners only report guaranteed payments for services as SE income. | General partners treat their share of business income and guaranteed payments for services or use of capital as SE income. Limited partners only report guaranteed payments for services as SE income. | No SE tax. Wages subject to payroll taxes, while dividend distributions subject only to income tax. However, risk that distributions will be classified as wages subject to payroll taxes if reasonable wages are not paid. |
| Capital Gains and Losses | Regular corporate income tax rates apply to corporate capital gains. | Passed through to members who may be eligible for reduced tax rate. | Passed through to partners who may be eligible for reduced tax rate. | Passed through to shareholders who may be eligible for reduced tax rate. |
| Alternative Minimum Tax (AMT) | Owed at corporate level unless small corporation exception applies. | Owed by members; entity must provide AMT information to them. | Owed by partners; entity must provide AMT information to them. | Owed by shareholders; entity must provide AMT information to them. |
Disposition of Sale of Interests
| C Corporation | Limited Liability Company | Limited Partnership | S Corporation | |
| Termination of Status | Not a factor, since C corporations have no special tax status under the Internal Revenue Code. | Terminates for federal tax purposes if 50% or more of capital and profits interests are transferred within a 12-month period. | Terminates for federal tax purposes if 50% or more of capital and profits interests are transferred within a 12-month period. | Transfer of stock can terminate S status if the transferee is an ineligible shareholder or there are more than 100 shareholders after the transfer. |
| Gain on Sale of Interest | Capital gain, although some or all may be excludable from income if qualified small business stock rules are met. | Capital gain, except for selling member’s share of unrealized receivables and appreciated inventory | Capital gain, except for selling partner’s share of unrealized receivables and appreciated inventory | Capital gain, although method of allocating pass-through in year of sale will affect stock basis and thus amount of gain. |
| Loss on Sale of Interest | Capital loss unless stock qualifies as Section 1244 stock. | Capital loss. | Capital loss. | Capital loss unless stock qualifies as Section 1244 stock. |