Business Entity Types
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Partnerships, S-Corps and Corps
S-corps and Partnership tax structures were designed for small businesses. These two types of entities do not pay corporate tax, whereas C Corps are more or less standalone entities and therefore pay their own tax, independent of their owners. Fund transfers in and out of Partnerships and C Corporations can result in tax consequences to their owners while S Corps have a bit more latitude. Earnings by partnerships are generally tax as Self Employment income and can create a secondary tax liability (roughly 15% of taxable income) to the Partners. S Corps do not create self employment tax responsibilities, however, this avoidance of self employment tax must be dealt with in the way of payment of a reasonable amount of W-2 wages.
Keep in mind that they are tax elections which are different from legal formations. So for example the same LLC could conceivably be classified as a Partnership, S Corp or C Corp.
Ownership and Distribution Issues
In an S corporation, ownership is limited to U.S. citizens or residents. These limitations do not apply to Partnerships and C Corps but having foreign ownership comes with a complex set of reporting rules and requirements on distributions to foreign partners and shareholders. S corporations cannot have more than one class of stock, therefore, income and losses are distributed according to the same criteria among all owners. Having one class of stock can prove to be an impediment when the business wants to obtain more capital. So if your intention is to seek outside capital from VC or other similar sources the C Corp structure is usually the requisite. Partnerships, on the other hand, have some flexibility in the way profits and losses are distributed.
The distributions from S Corps are largely not taxable as they have been taxed as the shareholder reports his/her income annually on his/her personal tax return. Distributions from S Corps are not deductible by the S Corp but are a return of capital. Partnerships follow the same format, however, distributions in favor of certain partners can be classified as Guaranteed Payments which are deductible to the partnership but income to the partner. Distributions from C Corps are characterized as dividends which are not deductible by the corporation and are income to its shareholders. Here is where the notion of double taxation comes into play. .
Special Tax Treatment
Borrowed Starting Capital and Tax Basis S-Corp owners are not allowed to include borrowed funds as owners' basis. Partners, on the other hand, can include their borrowed share of the money as a basis. This is significant because small-business owners can deduct business losses arising from the business on their personal income tax returns. The deductions are limited to each owner's tax basis. Therefore, businesses that borrow money and operate at loss in the initial years are better off as partnerships because the owners are more likely to save on taxes. This is especially where there are start-up expenses in software development companies or substantial depreciation allowances in acquired assets.
Tax Types Owners of Partnership and S Corp entity types must pay personal income tax on their share of the entity's net profits regardless of any money received. Active partners in a partnership are required to pay self-employment taxes as mentioned above. C Corp shareholders do not pay any tax, as the burden of taxation is paid by the corporation (the rate for C-Corps is a flat 21% right now).
Formation and Maintenance
Starting a partnership is relatively easy and generally does not require filing any paperwork with the state although it would be advisable to form an LLC for liability purposes.. A business that desires S Corp or C Corp treatment, however, is required to first register either as a corporation or a LLC with a state of their choosing.
Businesses treated as S Corps and C Corps must file annual or biennial reports with the state and some have income and franchise tax returns. Some states such as CA, NY, DC rise to the level of not being business friendly when it comes to compliance whereas others such as WY and SD have minimal requirements. Remember S Corps and C corps are corporations, and must hold formal meetings of shareholders and their board of directors. These requirements do not necessarily apply to partnerships.
Partnerships have minimal structural requirements. The basic requirement is that the partners have equal say even if their shares in the business are not equal. Partners can even agree on a profit and loss allocation method that is not based on their respective shares of the business. S Corps and C Corps that are registered as corporations are required to have a formal management structure that includes a board of directors and officers. This comes in handy when the management of the company wants to move forward on financing, and operational issues without having the sign off of each individual partner.
Usually, the tax entity selected is done at the formation of the company. Switching between entities needs to be carefully planned as they may trigger tax implications for the partners or shareholders. Various forms need to be filed with the IRS and along with the need to have some switches approved they all carry important dates as to when the election/change can be made.
Written by John M Matras CPA
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