Tax Ramifications of Choice of Entity

By Team HRH | January 5, 2015
In addition to the legal distinctions between entities, the tax ramifications of entity choice will be a key component in achieving a client’s goals. This article outlines some of the basic tax differences between entity types and can be used as a reference for decision making.

The Limited Liability Company (LLC) and S Corporation are popular choices for smaller clients.  The focus of this article will be on these two types, with a general overview of some of the others.

We’ll begin with some of the more pertinent S Corporation tax advantages and disadvantages:

Tax Advantages:

  • Employee owners can be paid as employees with the appropriate federal and state income taxes withheld from their wages.  This is useful for owners that do not want to make quarterly estimated tax payments.
  • There is no Federal tax imposed at the entity level. The owner’s pro rata share of income and expenses (pass through income) is reported directly on their personal return and taxed at their individual rate.  This is an advantage over a traditional C corporation, which is taxed at the entity level and then again, at the individual level, when distribution is made to the shareholders.
  • Pass through income is not subject to self-employment taxes, since it is net of any reasonable wages paid to the shareholder.
  • If there is a pass through loss, the shareholder can take that loss on their personal tax return (up to their tax basis).  This is also an advantage over a traditional C corporation, where losses are trapped at the entity level.
  • Distributions are generally not taxable for Federal income tax purposes.
Tax Disadvantages:

  • Rules regarding allowed type and number of owners and restrictions on allocation of income and distributions to shareholders.
  • Restrictions on the use of corporate loans for tax basis, in computing deductible losses.

LLC’s are treated in the same manner as partnerships for Federal tax purposes by default, though an election can be made to be treated as a corporation. Some LLC (partnership) tax advantages and disadvantages are as follows:

Tax Advantages:

  • An LLC with one owner (single member) is disregarded for Federal tax purposes, by default. As a result, there is no separate Federal return at the entity level. Activity is reported on the member’s personal tax return and taxed at the individual rate.  This simplifies annual tax reporting, but tax results should be compared to other types of entities.
  • An LLC with multiple owners, similar to an S Corporation, pays no Federal tax at the entity level and losses can be taken up to an owner’s investment (tax basis) in the entity.
  • Special allocations of income and expenses can be made based upon the LLC operating agreement.  This is in contrast to the rules of an S Corporation, which require allocations in accordance with the shareholders ownership interest.
  • Owners are generally allowed to use the LLC’s debt in computing their tax basis, which may allow for greater loss deductions than with an S Corporation, which only allows direct shareholder loans to be taken into account for tax basis.
  • Distributions are generally not taxable for Federal income tax purposes and there are fewer restrictions on the allocation of distributions to members.
  • Many states do not restrict who can have ownership in an LLC, so there may be more flexibility as to who can be a member vs. an S Corporation.  There is also no limit on the number of members.
Tax Disadvantages:

  • Members involved in the business are not paid as employees and, as a result, any pass through income to them may be subject to self-employment taxes. As a result, owners will most likely need to pay quarterly tax estimates.
  • An LLC is a business structure allowed by state statute, which means in some states, an LLC may not be recognized.
  • The flexible structure of an LLC can sometimes make accounting for transactions and preparing tax returns more complex.
Additional entity choice options for the small business owner include the following:

  • Partnerships: These entities are similar to an LLC from a tax perspective.  The main disadvantage relates to legal liability.  In general, LLC’s allow for limited liability protection, similar to a corporation, which means members are usually liable only up to their investment in the entity.  Partners in a partnership have no such protection, in a worst case scenario, they risk losing both their business and personal assets.
  • Sole Proprietorships:  No separate entity is created; a person can just start operating their business.  The tax reporting is the same as a single member LLC however, like partnerships; this exposes the business owner to both business and personal risk.
  • C Corporation: Not usually recommended for smaller businesses, due to the double taxation issues noted earlier.
Choice of entity is a decision that will impact a business and its owner(s) for its entire existence and should be considered carefully.  To fully understand all of the potential tax consequences, a CPA can be an invaluable resource.

This information presented is only of a general nature, may omit many details and special rules, is current only as of its published date, and accordingly cannot be regarded as legal or tax advice.  Any tax advice contained in this communication is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Please contact our office (603-627-3838) for more information on this subject and how it pertains to your specific tax or financial situation.  Howe, Riley & Howe, PLLC would be happy to answer your tax and financial questions regarding these issues or other matters that may be of interest to you or your business. 

Share this post on...Share on FacebookShare on Google+Tweet about this on TwitterShare on LinkedIn