Decisions, Decisions: Choice of Entity vs. Choice of Tax Classification

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Before forming any entity, founders need to make two fundamental decisions: which entity type is best for their business operations and which tax classification is best for the owners. Although the entity type and tax classification can be changed after formation, some forethought before forming a business can reduce expenses, taxes, and headaches.

Choice of Entity

Sole Proprietorships: A sole proprietorship is not technically an entity. A sole proprietorship is formed when an individual begins operating a business without forming an entity or filing entity-formation documents with a state. Sole proprietors can conduct business in their individual names or under any other legal name — colloquially, this is often referred to as a “DBA” because the sole proprietor is “doing business as” the fictional name. Often there are still state requirements to register the fictional name. Sole proprietorships are essentially a means by which the sole owner may conduct business under its own name or another name, with all rights, powers, and liabilities remaining with the owner.

Partnership: A partnership is formed under state law in several ways. General partnerships are the default classification for partnerships in many states, and often a general partnership is not required to file any documents with the state at formation.[1] All partners in a general partnership are general partners, who each can exercise control over the partnership and each have unlimited liability regarding the debt and obligations of the partnership. Limited partnerships (“LPs”) and limited liability partnerships (“LLPs”), by contrast, must be formed by filing documents with the state and offer greater protection from liability. In an LP, there must be at least one general partner, but an LP can have any number of limited partners, who cannot exercise control over the LP but whose only risk is their investment in the LP. In an LLP, however, there is no general partner and all partners have limited liability protection. The governing document for any form of partnership will be a partnership agreement, which will specify the terms and conditions of the partnership relationship for all the partners, including provisions for contributions of capital, distributions of income, and management authority. However, state law creates the default rules that will apply if a partnership agreement is not formalized, including when a general partnership is inferred, or if the agreement is silent as to certain matters.

Corporation: A corporation is formed under state law by filing documents with the state. Corporations can take a variety of forms, including nonprofit corporations and benefit corporations, but all typically provide limited liability to owners and officers for the debts and obligations of the corporation. Shareholders’ risk is limited to loss of their investment, unless they hold any role as an officer or director. Officers’ and directors’ liability will vary, depending on the activities of the corporation, whether the decisions they made were within their authority, and compliance with applicable law. Voting rights are vested in at least one class of shareholders and in the board of directors in almost all corporate forms. Nonprofit corporations are an outlier; as nonprofit corporations do not have shareholders, the members and/or board of directors hold voting authority. The governing documents for a corporation will be a corporate charter, the bylaws and shareholder agreements. The corporate charter is typically a certificate of formation or articles of incorporation, which will include specific restrictions and rights relative to ownership and operation of the corporation. The bylaws are adopted by the board of directors or shareholders and will specify how the corporation is to be operated, officer roles, classes of shares, and additional corporate governance terms. Shareholder agreements are not required but have become a commonly-used document for corporations where shareholders desire to establish additional terms and conditions to ownership of shares, authority of owners, and alienation of ownership. State law will set default terms for ownership, management and voting rights, in the absence of any governing document addressing such rights.

Limited Liability Company: A limited liability company (“LLC”) is formed under state law by filing documents with the state. LLCs are a relatively new form of entity, with the first LLC Act being passed in 1977 in Wyoming because shareholders wanted the limited liability afforded to corporations without the strict formalities and bureaucracy that comes with operating a corporation. LLCs have the flexibility in management and ownership of a partnership but have limited liability for all of its members. Due to the flexibility of management, an LLC can be managed by its owners (like a partnership) or by third party managers (like a corporation). This flexibility continues into the realm of taxation, as will be discussed below, because an LLC can be structured to be taxed under any tax classification. The governing document will be an operating agreement which will spell out the terms of the members’ and managers’ involvement in the company, much like a partnership agreement. Although state formation and annual fees for LLCs are often more expensive than other entity forms, LLCs offer more opportunities to craft the operating agreement to suit the purposes of the business and its owners, beyond the typical corporate or partnership forms.

Choice of Tax Classification

Disregarded: If an entity is disregarded for federal tax purposes, it will not be treated as separate from its owner for tax purposes. Sole proprietorships will be treated as disregarded, and all of the tax attributes of the business will typically be reflected on Schedule C of the owner’s tax return. Likewise, a single-member LLC will be categorized as a disregarded entity by default. However, unlike sole proprietorships, LLCs can elect to be taxed differently.

Partnership: State-law partnerships and multi-member LLCs are by default treated as partnerships for federal tax purposes.[2] Entities taxed as a partnership will be taxed under Subchapter K of the Internal Revenue Code of 1986, as amended (the “Code”), which results in tax attributes flowing through to the partners. The allocations of the tax attributes will be reflected on each partner’s Schedule K-1 that they will receive from the partnership after each tax year.

The allocation of taxable items of income, gain, loss and deduction do not need to be made proportional to ownership, however. If a partnership has depreciation from assets and only one partner would benefit from using that depreciation on her tax return, the partners can agree to allocate 100% of the depreciation to that partner while still splitting income and other deductions evenly. This flexibility in tax allocation is a major advantage that is unique to partnership taxation.

C-Corporation: There are two tax classifications that are considered a corporate tax classification: C-corporations (taxed under Subchapter C of the Code) and S-corporations (taxed under Subchapter S of the Code). State-law corporations will default to being taxed as a C-corporation for federal tax purposes, but LLCs can elect to be taxed as a C-corporation by filing with the IRS. C-corporations are subject to “double taxation,” which means the corporation will pay income taxes on its income, but shareholders will also need to pay income taxes on dividends when received from the C-corporation. The corporate tax rate is typically lower than the individual tax rate, and the individual tax rate on dividends is typically lower than the individual tax rate on ordinary income (i.e. wages).

S-Corporation: State-law corporations and LLCs can elect to be taxed as S-corporations for federal tax purposes by filing an S election with the IRS.[3] S-corporations allow for a single-level of tax (i.e. all income flows through to the shareholders and is taxed to the shareholders). This tax classification, however, comes with additional restrictions.

To be taxed as an S-corporation, the entity must also meet the following requirements: (1) the entity can have no more than 100 shareholders, (2) all shareholders must be U.S. citizens or residents (for tax purposes), (3) only individuals and certain types of trusts and estates can be shareholders, (4) the entity can have only one class of stock, (5) the profits and losses must be allocated pro rata to the shareholders in proportion to their ownership interests, and (6) the entity cannot be an ineligible corporation (such as certain financial institutions, insurance companies, or domestic international sales corporations). If an entity treated as an S-corporation violates one of the above requirements, the S Election will be revoked and the entity will immediately revert to being treated as a C-corporation (absent any other tax election being made).

This passthrough taxation for S-corporations is similar to partnerships, with a few meaningful differences. All tax attributes have to be allocated pro rata for S-corporations; whereas partnerships can disproportionately allocate different tax items. However, there are additional self-employment taxes that are typically paid by partners in a partnership-taxed entity; whereas S-corporations have flexibility in categorizing payments as wages or distributions.

A summary of the eligible combinations of tax classifications and legal entities as set forth below. For some of the combinations, there are additional requirements that must be met.

State-Law

Entity Choice

Federal Tax Classification Eligibility
Disregarded Partnership C-Corp S-Corp
Sole Proprietorship X
Partnership X X X
Corporation X X
LLC X X X X

 

Changes in State-law Entity and Tax Classification Generally

If an entity’s tax classification changes, either by election or by operation of law, then this may have tax implications, depending on its old and new classifications. If an entity taxed as a C‑corporation converts to partnership taxation, this can be treated as a liquidation of the entity and trigger significant taxes for the owners (even though no distributions were actually made). If a single-member LLC that was taxed as a disregarded entity has a new member join, then it will automatically be treated as a partnership (absent any other tax election being made).

Likewise, if an entity fails to follow the proper formalities, the state-law entity classification may change. For instance, if two sole proprietors begin to work together toward a common goal, this may qualify as a state-law partnership. If an LLC fails to file its annual reports and the state of incorporation revokes the entity status, then the continued operations may be treated as a partnership or sole proprietorship.

While there are instances where changing tax classification or the state-law entity happens accidentally, it is more common for businesses to choose to convert. A Florida LLC taxed as a partnership may prefer to convert to a Delaware corporation taxed as a C-corporation; likewise, a Delaware LLC taxed as a disregarded entity may prefer the tax benefits of a Florida LLC taxed as an S-corporation. While changes to the tax classification and state-law entity are possible, there can be significant transaction costs and the conversion may have adverse tax consequences – often these costs and consequences can be avoided by having the correct state-law entity and tax classification when the business commences operations.

Conclusion

As discussed, founders can start their business ventures on a strong footing by planning ahead and selecting the best entity type and tax classification for their business based on their goals and particular situation. State-law corporations, partnerships, LLCs, and sole proprietorships all have their place, and each allows for particular tax classifications which — depending on the business — can help business owners achieve their goals.

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[1] If two sole proprietors begin working together for a common purpose, this can be interpreted as a general partnership under state partnership laws; consequently, sole proprietors should take precautions against a partnership being inferred as discussed further in footnote 2.

[2] Business owners should be careful to ensure that if they do not intend to form a partnership with another individual or entity with whom they have business interactions, that they take precautions to avoid a partnership being inferred by the taxing authority, such as by defining the contours of their relationship or otherwise disclaiming the intent to form a partnership in any relevant documents (e.g. a loan agreement or lease).  In addition, for federal tax purposes, business owners that are members of an unincorporated organization meeting certain requirements can elect not to have the organization treated as a partnership for tax purposes.

[3] It is theoretically possible for a state-law partnership to elect S-corporation status if the S-corporation requirements are met and an S election is made, but this is uncommon.