Previous posts have discussed the many factors entrepreneurs should consider when forming and organizing a new business enterprise. Of all those factors, three issues are particularly important when selecting the form of business entity for your new venture: (1) Who will be the owner of the business; (2) how will the earnings of the business be returned to its owners; and (3) is the business expected initially to generate profits or losses. Two prior posts – February 24 and March 22, 2013 – addressed the first two questions. The next three posts will address the third question including some of the most significant tax issues to consider when selecting a form of business entity for your new venture. This post is focused on tax issues facing a C-corporation (C-Corp) or S-corporation (S-Corp).
The three most popular forms of business enterprises are corporations, limited liability companies, and partnerships. A corporation is created as either a C-Corp or S-Corp. The different tax elections affect distributions and taxation on the company and its shareholders. A partnership is created as a general partnership, limited partnership or limited liability partnership. The different structures affect the extent of the partners’ potential personal liability. A limited liability company is created as either a member managed enterprise – for smaller companies – or a manager-managed enterprise – for larger more complex companies. A properly structured LLC combines the pass through tax treatment of a partnership with the liability protections of a corporation.
A C-Corp is a tax-paying entity that must pay income tax on its taxable income. An S-Corp is a “flow-through” entity that reports items of income, loss, deduction, gain and credit allocated to the individual shareholders based on their percentage ownership of the enterprise. The other entities – general partnerships, limited partnerships, LLPs, or LLCs – may elect to be taxed as a corporation or flow-through entity. Whether an enterprise is an entity separate from its owners, and eligible to elect tax treatment as a corporation or flow-through entity, is determined by federal tax law regardless of whether it’s recognized as a separate entity under state law. The election governs for California tax purposes as well.
The net income of a C-Corp is subject to taxation at the corporate level at rates up to 35 percent federal and 8.84 percent California. Dividends paid to shareholders are not deductible by the corporation and are taxable to the receiving shareholder at the federal income tax rate applicable on the individual’s tax return (limited to capital gains rates of 15 percent) and California ordinary income rates of up to 9.55 percent. The bottom line is that income distributed to shareholders is subject to double taxation at an effective tax rate in excess of 50 percent.
A C-Corp can reduce or even avoid double taxation by paying reasonable wages to shareholder employees, interest on debt owed to shareholders, or rents or royalties on property leased or licensed from shareholders. The corporation can deduct these payments as ordinary expenses. The shareholders will recognize the payments as ordinary income. Beware of these types of transactions, however, because the IRS frequently scrutinizes them to determine if they are disguised dividends.
Double taxation may not be an issue for a C-Corp that reinvests its income, rather than pay dividends, because the corporate tax rate is frequently lower than the individual tax rate. Retaining corporate earnings within the company for necessary capital investments can be beneficial to the company. Accumulating earnings without a reasonable business purpose or to avoid taxes due on distributions, however, could lead to IRS scrutiny of the transactions. Retained earnings in excess of the corporation’s anticipated needs may subject the corporation to an accumulated earnings tax or treatment as a personal holding company.
If a C-Corp loses money during the taxable year, the loss will be trapped in the corporation and cannot be deducted by the shareholders. The net operating loss deduction can be carried back two years and carried over for 20 years as a deduction against the corporation’s future income.
The net income of an S Corp is not taxable at the corporate level. Instead, it flows through to the individual shareholders. The shareholder is taxed on his share of the corporation’s income, regardless of whether or not the income is distributed to the shareholder. The corporation’s items of income and deductions are allocated to the individual shareholders in proportion to their stock ownership. The shareholder’s adjusted tax basis in his stock is increased by the share of income recognized, and decreased by the share of deductions taken. The shareholder’s loss deduction is limited to the basis he has in the stock, plus the basis of any debt owed to him by the corporation. In addition to the individual shareholders paying California income tax based on the income and deductions flowing through from the S-Corp, the corporation itself pays California income tax equal to 1.5 percent of the S-Corp’s taxable income.
A shareholder’s disposition of shares of corporate stock generally constitutes a taxable event. Gain or loss is recognized equal to the difference between the value of the money and property received for the stock and the shareholder’s adjusted tax basis in the stock. The gain or loss will generally be treated as resulting from the disposition of a capital asset, and will be taxed at the lower capital gains rate rather than the higher ordinary income tax rate. The sale of a shareholder’s stock of the corporation is not a taxable event to the corporation.
Upon the liquidation of the entire corporation each shareholder will recognize capital gain or capital loss equal to the difference between the fair market value of cash and property received and the shareholder’s adjusted tax basis in the shares. At the same time, to the extent that the distribution to the shareholder is made in property, the corporation must recognize gain on an amount equal to the fair market value of the property being distributed less the corporation’s adjusted tax basis in the property. Consequently, the liquidating distribution may result in double taxation.
The merger of a corporation into another entity may result in a tax-free reorganization if it is properly structured under the Code. Consequently, it may be advantageous to structure a business as a corporation if the owners believe the company may be acquired by another entity sometime in the future.
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 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 state corporate law 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.