A key issue facing start-ups is choosing an entity form. The primary options are: C Corporations, S Corporations, Partnerships and Limited Liability Companies (LLCs). Each has advantages and disadvantages, and each presents unique issues. This article will present only the tax consequences associated with each.
C Corporations are corporations subject to Subchapter C of the Tax Code. They are subject to federal income tax on their corporate earnings, usually at a rate of about 35%. The shareholders of a C Corporation are also taxed on distributions of after-tax earnings (i.e., dividends) at rates of about 15%. (The precise rate may change depending on the shareholder’s tax status.) Thus, it’s said that C Corporations are subject to “double-tax” under the current US Tax Code. This is true even where the shareholder does not receive corporate earnings as dividends, but instead sells shares and incurs Long Term Capital Gain (LTCG). LTCG is taxed at about 15%.
S Corporations are corporations subject to Subchapter S of the Tax Code. Before describing the tax consequences of electing to form an S Corporation, it is important to note several ways in which an S Corporation can lose its “S” status and be taxed as a C Corporation. These include: having more the one class of stock, having a foreign shareholder (ie, not a US citizen or resident), having more than 100 shareholders, or having a shareholder that is itself a corporation, partnership or LLC.
S Corporations are described as “flow through” entities, meaning that their earnings are not taxed at the entity level, but instead “flow through” to the shareholders. The amounts as well as their character flows to the shareholders. Thus, if the S Corporation has ordinary income and LTCG, these items will be taxed as such at the shareholder level (generally about 35% for ordinary income and 15% for LTCG).
Partnerships, like S Corporations, are flow through entities. There are several forms of partnerships, but the primary forms are General Partnerships (GPs) and Limited Liability Partnerships (LLPs). LLPs are generally preferred to GPs because they offer limited liability, ie the partners (shareholders) are not responsible for the entity’s liabilities.
As a flow through entity, a partnership does not pay entity level tax, but rather allocates its gain and loss to the partners, who report these items on their personal tax return. Again, these items retain their character as they flow to the partners. LTCG will be taxed as such, as will ordinary income.
Organizations formed as LLCs can elect to be taxed as Corporations or as LLCs under the so called “check the box” regulations. Assuming that the organization elects to be taxed as an LLC, the tax consequences will be similar to that of a partnership: the entity will not itself be subject to federal income tax. And instead, the equity owners of the LLC will report their share of the entity’s profits on their income tax returns. Note that this is true whether or not the entity actually distributes this profit. This will be the subject of a later article.
Related Reading: The Importance of Understanding Section §83 of the Tax Code