Whether you are at the formation stage, in growth mode, or you are considering a sale of your business, it is always the right time to consider the income tax implications of your organizational structure. Your structure could be as simple as a sole proprietorship or as complex as a multi-tier set of partnerships and corporations, or any number of options in between. Millions of dollars may hinge on your decision.
For this article, we will consider three entity types in the middle of the above spectrum: partnerships, S corporations and C corporations. (Limited liability companies may be taxed as partnerships or either type of corporation.)
- Advantages. C corporations remain the simplest of the three entity types to administer. There is no flow-through income to track and report. In addition, one low flat rate of 21% applies to taxable income. Also, on a sale of C corporation stock, the qualified small business stock exclusion may shield a significant portion of tax on gain and, to the extent not shielded, capital gains rates normally will apply (as opposed to the sale of a partnership interest, which may have an ordinary income component). Another benefit many overlook is the ability to implement incentive stock options, ESOPs, and other qualified plans.
- Disadvantages. Despite the above, most small to midsize businesses are not C corporations, primarily because two levels of tax apply: After the 21% corporate-level tax, there is a tax on dividends. In addition, unlike S corporations and partnerships, C corporations pay Florida corporate income tax. Beyond the multiple levels of tax, C corporations generally cannot distribute appreciated assets tax-free. This makes it difficult to split up a C corporation tax-free.
- Advantages. S corporations are more difficult than C corporations to administer, although allocating profits and losses is simple — they must be allocated pro-rata based on ownership percentage. There is normally only one level of tax, at the shareholders’ tax rate, although it could be as high as 37%. Depending on several factors, the qualified business income (QBI) deduction of up to 20% may apply, possibly reducing the top tax rate to 29.6%. A significant reason why many choose the S corporation over the partnership is to pay employment tax only on reasonable compensation, as opposed to on all of the profits of the business. As with C corporations, capital gains rates apply on the sale of stock, as long as no election is made to treat the sale as an asset sale.
- Disadvantages. S corporations are rigid, in that special allocations of profits and losses are not permitted. Only U.S. citizens and residents, certain trusts
and estates, and certain tax-exempt entities can be shareholders, and only one class of stock is permitted, although voting and nonvoting shares are permitted. Also, the same issue identified above for C corporations applies on distributions of appreciated property.
- Advantages. As with S corporations, only one level of tax applies and the QBI deduction may be available. Unlike S corporations, partnerships offer flexibility in ownership, special allocations of profits and losses, and disproportionate distributions. Importantly, unlike for S corporations, liabilities are included in partnership interest basis, allowing partners to potentially use higher amounts of losses than with an S corporation, which is especially useful in long-term real estate projects.
- Disadvantages. With such great advantages comes a high level of complexity. Partnership tax expertise is required to draft the partnership agreement and to ensure the allocations are respected. On exit, unlike a stock sale, a partnership interest sale is taxed similar to an asset sale, potentially subjecting a portion of the gain to tax at ordinary rates.
What if circumstances change — for instance, you want to add an investor that is not qualified to be an S shareholder? Can you change your tax status? Yes, but be careful. For example, if you convert a corporation directly to a partnership, a significant tax might apply, as if the entire business were distributed in a taxable liquidation. Careful planning is required to ensure you avoid the tax traps on a change.
As the above discussion shows, there is a great deal to consider when it comes to the tax implications of choosing your tax entity. Each situation is unique. The above discussion is a general discussion and does not replace a review by a qualified tax advisor.
Pete Schoemann is a partner in the Orlando office of the law firm Nelson Mullins Broad and Cassel and a member of the firm’s corporate group and tax team. Since 1999, he has specialized in corporate and tax law. He can be reached at firstname.lastname@example.org.