Choice of Entity

Choosing The Right Business Entity

There are only three main taxable entities:

1- Sole proprietor which files a form 1040 and reports the income on the schedule C
2- Partnership which files a form 1065 and has multiple members. There are no single member partnerships, so a single member LLC cannot be a partnership.
3- Corporation which files a form 1120 or 1120S

Filing The Correct Tax Return

It is important to file the correct tax return for your new or existing entity. Filing the wrong tax return will nullify your filing effort and you will be considered a non filer. Therefore, it is possible to file the wrong return for several years and then get a letter from the IRS saying you need to file a tax return for your company. Responding to this, you will eventually end up filing the correct return type with the IRS resulting in late filing penalties. Remember these rules:
1- Corporations formed under state law must file a form 1120 corporate tax return by default unless they make a special election (form 2553) to be taxed as under subchapter S (S-Corp) filing a form 1120S. You should have written permission from the IRS before filing the 1120S return. Its not always necessary, but very wise to do so. You can also elect (form 8832) to be taxed as a partnership, filing a form 1065.
2- Multi member LLC's must file a form 1065 partnership tax return by default unless they make a special election (form 8832) to be taxed as as a corporation filing a form 1120 or 1120S. You should have written permission from the IRS before filing the 1120 / 1120S return. Its not always necessary, but very wise to do so. Therefore, if you are a member of a multi member LLC, you should ask the accountant in charge if a form 1065 is being filed and if not, ask to see the IRS letter authorizing the corporate filing of a form 1120/1120S.

Tax Facts Regarding These Entities

1- Businesses are taxed twice, sometimes thrice on the same income they earn (income and employment), and most people are unaware of this. We can limit the amount of multiple taxation, but not eliminate it.
2- Partnerships filing a 1065 and corporations filing 1120S returns are considered pass through entities, where the income is passed through on a k-1 report to your personal form 1040 tax return, and the income tax is then paid.
3- Corporations filing 1120 tax returns pay income taxes at the corporate level. Owners receive their income as wages or dividends.
4- Phantom income can be a serious problem with owners holding minority interests in closely held pass through entities such as S-Corps and partnerships. Accordingly, it is possible for the individual receiving the K-1 report, to have more taxable income in box 1, than that person actually received in cash as distributions from the company. Therefore, the reportable income on that individual's personal tax return is more than the actual cash received from the business.
5- Losses can only be taken on your personal 1040 tax return, up to your tax basis in the particular entity you have ownership in, and only up to the amount you are deemed at risk. This second at risk limitation must also be evaluated before losses are claimed on a personal return.

C-Corp  v  S-Corp Factors

1- Deductibility of Operating Losses
A C-Corp may deduct operating losses only up to taxable income, but S-Corp losses pass through to shareholders on the K-1 form, allowing a deduction on the shareholder's personal return, up to the shareholder’s stock and debt basis in the company.

2- Capital Losses
A C-Corp incurring significant capital losses will be able to deduct them only up to the capital gains for that year, the excess is carried forward five years and if not used within the five year period, they are lost forever. S-Corps may deduct 3,000 in capital losses each year as a flow through item to the shareholders to offset ordinary income.

3- Accumulated Earnings Tax on Accumulated Earnings and Profits (AEP)
A C-Corp is subject to an extra 15% tax on the accumulated earnings retained by the C-Corp beyond the reasonable business needs of the corporation. This is profit that has been retained by the C-Corp on the books and not distributed to employees and shareholders. S-Corps however, are not subject to this extra 15% tax.

4- Tax Exempt Interest Earned by The Corporation
Tax exempt interest raises the C-Corp Earnings and profits that IRC Section §301 dividend classification is dependent on. Accordingly, when a distribution is made by a C-Corp to the shareholders, the corporate earnings and profits that were raised by the tax exempt interest may cause the distribution to be classified as a taxable dividend at the shareholder level.
In an S-Corp, however, the interest retains its tax exempt status when passed through to the shareholders on the K-1 forms.

5- Alternative Minimum Tax
C-Corps are subject to the Alternative Minimum Tax (AMT) Adjusted Current Earnings (ACE) adjustments where certain deductions are added back to income as adjustments at the corporate level, while S-Corps are not. S-Corps do not pass through the ACE adjustments to shareholders on the K-1 form either.

6- Double Taxation
The C-Corp shareholder is taxed twice on the same income, once at the Corporate level when the form 1120 corporate tax return is filed and then again when the profits are distributed to the shareholders as wages or dividends.

7- Excess Net Passive Income Tax (ENPI)
S-Corps are subject to the 15% ENPI tax if passive income exceeds 25% of ordinary business income and there are accumulated earnings and profits.

Partnership v S-Corp Factors

1- Shareholder Basis acquired from Assumption of Debt
A partner in a partnership will enjoy a basis increase for assuming partnership debt, regardless if the debt is recourse of non-recourse, while an S-Corp shareholder will not. The S-Corp shareholder must first borrow the money personally, and then lend the money to the S-Corp to get a basis increase. Therefore, having S-Corp debt on the balance sheet is not going to give shareholders stock basis.
2- Share of Income
A partners distributive share of partnership income is considered income from self employment and thus subject to the self employment tax where the S-Corp allocation of income is not.
3- Cancellation of Debt
Insolvency defense relating to IRC Section 108 for cancellation of debt income at the business level, is determined at the partner level for partnerships and at the corporate level for s-corps. What this means is, if your partnership related business fails and the large note that was taken out at the partnership level is canceled by the bank for a default, the IRS is going to apply the insolvency test to you personally instead of the failed company.