TABLE OF CONTENTS
- Which kinds of business organization or business entity will limit my liability to business creditors?
- What is the “corporate double tax” and how can it be avoided?
- Which types of business entity are best for tax purposes?
- Which are the “pass-through” entities?
- What entities will let me both limit my liabilities and avoid the double tax?
- What’s so great about limited liability companies (LLCs)?
- What special considerations are there if my business is a professional practice?
- What are the federal tax consequences of changing your form of business organization?
- Do state business entity rules follow federal tax rules?
WHICH KINDS OF BUSINESS ORGANIZATION OR BUSINESS ENTITY WILL LIMIT MY LIABILITY TO BUSINESS CREDITORS?
Corporations, limited liability companies (LLCs), limited partnerships, and limited liability partnerships (LLPs) are the three most common business entities that limit liability. General partnerships and sole proprietorships don’t limit owners’ liability. Limited partnerships limit the liability of some partners (limited partners) and not others (general partners).
Double taxation of corporations results in a significant tax burden on corporate income. Often referred to as the “corporate double tax,” it occurs when a business corporation (or an entity treated for tax purposes as a business corporation) pays a federal tax on its income, and tax is also paid by its owners in the form of individual income tax on capital gains and dividends when they collect corporate profits.
Double taxation occurs even if the corporation retains its after-tax earnings (as opposed to distributing them as dividends) because the value of the stock increases to reflect an increase in assets held by the corporation. Shareholders that decide to sell their stock will realize a capital gain and pay tax on that gain.
The tax on the corporation is called an “entity level tax” and an entity so taxed is called a “C-corporation” (C-corp). The double tax can be avoided one of two ways:
- By electing to be an S-corp. While this doesn’t change its nature under state business law, but in most cases eliminates federal tax at the corporate level.
- By postponing profits distributions to corporate owners, the second tax (on the owners) can be postponed.
It depends. Generally speaking, the “pass-through” type of entity saves tax overall by eliminating tax at the entity level. pass-through entity owners are taxed directly on their share of entity profits. Another pass-through advantage is that owners can take tax deductions for startup or operating losses, against their income from investments or other businesses.
You have much control over whether the entity you choose is treated as a pass-through entity for federal tax purposes (see below), but the leading pass-through forms are general partnerships, limited partnerships, LLPs, LLCs, S-corps, and sole proprietorships.
If your business is in the form of a partnership (any type) or limited liability company, you may choose whether your business is treated for tax purposes as a corporation or a partnership (or, if you’re the only one in the LLC, as a corporation or disregarded for tax purposes). Tax and business advisors call this choice the “check-the-box” system. If it’s actually incorporated, or you choose to have it treated as a corporation, you may qualify to have it treated as a pass-through by electing S-corp status.
Your choice under check-the-box is binding. That is, if you choose one entity (say, corporation) in one year and another (say, partnership) the next year, you must pay tax as if you sold last year’s entity and put the proceeds into this year’s.
S-corps (usually) and all of the following, assuming that you don’t choose to have them treated as corporations: LLCs; LLPs; and limited partnerships, for the limited partners. For sole owners, the choice is limited to S-corps or, in states that allow single-owners, LLCs.
LLCs combine limited liability with pass-through tax treatment. They can offer benefits unavailable from S-corps, their nearest rival (for businesses other than professional practices). The key benefits:
- A way to allocate certain tax benefits disproportionately among owners.
- Opportunity for greater loss deductions.
- Avoiding or reducing tax when a new owner joins the business or when distributions are made to owners in business liquidation.
State law varies when it comes to allowing single-owner LLCs; some states allow it and some states don’t. Where it is allowed, the owner can choose under check-the-box rules to have the LLC disregarded for tax purposes (without losing LLC limited liability), and pay tax directly on LLC income.
In states where single member LLCs aren’t allowed S-corps are a good alternative, and they can also postpone tax, as compared to LLCs, where the business is to be bought out by a corporate giant.
Limitation of liability, especially malpractice liability, is a major concern. No entity will protect you against liability for your own malpractice. But LLCs, Professional Limited Liability Companies (PLLCs), and LLPs, where available for professional practices, will protect you against liability for malpractice of co-owner professionals in the firm, and maybe (depending on state law) for other debts. Professional Corporations (PCs) may not protect against liability for a co-owner’s malpractice, depending on state law.
The tax rules governing those in LLCs, PLLCs, and LLPs are about the same, and somewhat more liberal than those for PCs.
This is a critical decision that should be studied carefully with professional guidance, but briefly stated:
- There’s no tax on a change from C-corp to S-corp or vice versa.
- There is no tax on a change from LLC, partnership or sole proprietorship to a C or S-corp.
- There is no tax on a change from a proprietorship or partnership to LLC or vice versa.
- There is a tax on a change from C or S-corp to an LLC, partnership or sole proprietorship.
Keep in mind the difference between state business law and state tax law. The tax status you choose for your entity under the federal check-the-box system doesn’t make it that entity for state business law purposes. So, for example, choosing corporate tax treatment for a partnership won’t bring corporate limited liability.
There is a trend for states to treat the entity chosen under federal check-the-box as the entity recognized for state tax purposes, but this is optional with the state.
State law may accept pass-through status for an entity (such as an S-corp or an LLC) and still impose a tax of some kind on the