Previous posts have discussed the many factors entrepreneurs should consider when forming and organizing a new business enterprise. One of those factors is whether the business is initially expected to generate profits or losses and the tax consequences of those profits and losses on the founders and other investors. The tax consequences of the profits earned and losses suffered by your new enterprise will have an impact on whether the entity you select is a taxable entity of a pass through entity. One form of pass through entity you may wish to consider for your new enterprise is a form of partnership, which could include a general partnership, limited partnership or limited liability partnership.
Partnerships do not pay federal income tax. Instead, the partnership’s income and deductions flow through to, and are taxed to or deducted by, the partners. Income and deductions normally retain the character they had in the partnership. Consequently, partnership income is not subject to potential double taxation, and partnership losses can be fully deductible by the individual partners, but not in excess of their adjusted tax basis in the partnership interest, and subject to the at-risk and passive loss rules in the Internal Revenue Code. Such flow-through treatment can be a disadvantage for the owners of a profitable partnership that reinvests a significant portion of its profits since the partners would be taxed on their allocable share of the profits without receiving cash distributions from which to pay the tax.
Distributions of cash or property by a partnership to its partners are not normally taxable events, either to the partnership or the individual partners. However, distributions of cash or property, including deemed distributions resulting from the reduction in a partner’s share of partnership debt, will be taxable if and to the extent the value of the distribution exceeds the partner’s adjusted tax basis in his partnership interest immediately before the distribution. A partner’s basis in his partnership interest is reduced by the amount of distributions made to the partner. Generally, a partner takes an adjusted tax basis in any property distributed to him by the partnership equal to the partnership’s adjusted tax basis in the property immediately prior to the distribution.
A partner’s disposition of all or any portion of his partnership interest is generally a taxable event. Gain or loss is recognized in an amount equal to the difference between the value of money and property received for the partnership interest and the partner’s adjusted tax basis in the partnership interest. Generally, the gain or loss is treated as resulting from the disposition of a capital asset. Consequently, gain on the sale of a partnership interest held for at least 12 months will be subject to the lower maximum rate for federal income tax purposes, and losses may be subject to the capital loss limitations.
On liquidation, a partnership does not ordinarily experience a tax recognition event, and the partners are generally taxed only to the extent that the value of the money and property received in liquidation of their partnership interest exceeds the partners’ adjusted tax basis. Thus, partnerships generally do not experience double taxation on liquidation. The individual partner’s recognition of gain or loss on liquidation of the partnership interest is generally treated as a capital gain or loss. Therefore, the gain on liquidation of a partnership interest held for at least 12 months may be subject to the lower maximum rate for federal income tax purposes, and any loss may be subject to the capital loss deduction limitations.
If your business is expected initially to generate losses, then a tax flow-through entity may be the entity of choice because it allows the owners of the company to deduct the losses from their taxable income. For example, information technology or biotechnology companies frequently operate at a loss because of the high costs of developing products. This is particularly true of biotechnology companies, which must incur the cost of developing products, conducting clinical trials and obtaining approval from the U.S. Food and Drug Administration before generating its first dollar of revenue. IT and biotech companies may experience several years of substantial losses before becoming profitable. Depending on the investors who have bankrolled the new enterprise, a flow-through entity may be attractive because it allows the investors to deduct the start-up losses against taxable income. Otherwise it may be several years before the business earns a profit and can use tax loss carry forwards to reduce its tax burden.
This post discusses just some of the most significant tax issues you should consider when selecting the form of business entity for your new venture. Before you make a final decision, we strongly recommend that you consult with knowledgeable corporate and tax counsel, and a knowledgeable tax accountant, to make sure you have thought through all the possible tax consequences that could flow from your new business, at least as you’ve contemplated the venture in your business plan.
Finkel Law Group, with offices in San Francisco and Walnut Creek, has provided comprehensive corporate and tax counsel to many different forms of business enterprises starting up in many different types of industries for more than 10 years. We have the knowledge and experience to help your company navigate California’s complex corporate laws and federal and state tax laws. When you need intelligent, insightful, conscientious and cost-effective legal counsel to assist you with forming and managing your new business enterprise, please contact us at (415) 252-9600, (925) 274-9600, or firstname.lastname@example.org to speak with one of our attorneys about your matter.