Choice of Entity – Income Tax Issues

Partnership (Partnerships and LLCs not electing to be treated as Corporations)

Advantages:

  • One level of tax (pass through) — earnings increase basis and generally may be distributed tax-free.
  • Flexibility as to ownership and allocations of the economic benefits of the business.
  • Property can generally be contributed and distributed without triggering gain.
  • Refinancing proceeds may be distributed tax-free because partner’s tax basis in partnership interest includes share of partnership debt.
  • Purchasers and estates who acquire partnership interests can obtain basis step-up of partnership assets.
  • Acquirer of partnership business can obtain step-up of assets.
  • Partners may deduct partnership losses against other income, subject to passive activity loss limitations and other requirements.
  • Employees can be awarded partnership profits interests without triggering tax.

Disadvantages:

  • Insolvency and bankruptcy exceptions to debt discharge income are tested at partner level.
  • Except for limited partners and certain non-active LLC members, partnership active business income (not investment income) allocable to individuals is subject to self-employment tax.
  • Partnership cannot merge tax-free with public company.
  • Pennsylvania capital stock/franchise tax applies to LLCs but not partnerships. Distributions to LLC owners who materially participate in the business are deductible from income for purposes of calculating this tax.

 

S Corporations

Advantages:

  • One level of tax (pass through) — earnings increase basis and generally may be distributed tax-free.
  • Acquirer of S corporation business can obtain basis step-up of assets.
  • Corporation can merge tax-free with public company.
  • Shareholders may deduct S corporation losses against other income, subject to passive activity loss limitations and other requirements.
  • Insolvency and bankruptcy exceptions to debt discharge income are tested at entity level.

Disadvantages:

  • Limitations on ownership — shareholders must be individual U.S. citizens or residents, estates, certain trusts, an ESOP or other tax-exempt entity, and only 100 shareholders are permitted. (All family members count as just 1 shareholder for purposes of 100 shareholder limit.).
  • Single class of stock requirement (but can have voting and non-voting).
  • S corporation cannot distribute refinancing proceeds in excess of shareholders’ basis in stock without triggering tax.
  • Purchaser/estate cannot obtain step-up in inside basis of assets unless entire corporation is acquired.
  • Distribution of appreciated property triggers taxable gain.
  • Pennsylvania capital stock/franchise tax applies to corporations.

 

C Corporation

Advantages:

  • Corporation can merge tax-free with public company.
  • Flexibility as to ownership and classes of stock.
  • Net operating losses may be carried forward up to 20 years for federal tax purposes.

Disadvantages:

  • Two levels of tax — dividends are taxable to shareholders; shareholder basis is not increased by undistributed corporate earnings; acquirer cannot obtain step-up in basis of corporate assets.
  • Distribution of appreciated property by corporation triggers taxable gain at corporate level and taxable dividend income to shareholders.
  • Shareholders cannot deduct losses of C corporation.
  • Closely held C corporation may be subject to accumulated earnings tax on retained earnings in excess of business needs or personal holding company tax if corporation earns mostly passive investment income.
  • Corporate deductions for compensation expense paid to shareholders may be disallowed if compensation paid is unreasonably high.
  • No preferential rate for capital gains. Corporate-level capital gains taxed at same rates as ordinary income.
  • Pennsylvania corporate income tax rate (9.9%) is more than three times greater than personal income tax rates that apply to pass through entities (3.1%).

Questions Every Business Must Ask

Q. Has your business recently reviewed its legal structure to determine whether it is set up in the most advantageous manner for legal and tax purposes, considering recent developments and changes in the law?

Q. Do the owners of your business have a current, updated buy-sell agreement which controls how ownership interests in the business are to be transferred in the event of an owner’s death, disability or termination of employment?

Q. Have the owners of your business developed a succession plan to define how ownership and authority will transition upon the death or retirement of the present owners?

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