This blog was prepared with the assistance of Peter A. Weitsen, CPA, partner at WithumSmith+Brown, PC.
When you create and operate a business, there are
many challenging decisions to make, ranging from which employees you hire to
how you market your products and/or services. And one of the most important
decisions centers on how to structure the business—a decision that has important
implications for how much you end up paying in taxes and how complicated the
process of filing taxes becomes. Keep in mind that the choice of which
structure is best for you has been affected in important ways by the Tax Cuts
and Jobs Act that took effect mostly in 2018. The more you know, the better off
you will be. And it makes sense to meet with a knowledgeable tax adviser and
attorney before making any final decisions, which in many situations would be
Some common characteristics and
general rules you need to know:
- Businesses may need TINs, which are tax
a state to organize in is a special issue that will depend on the type of
business and where it will operate. Generally, if the operations will all take
place in a single state, then that should be the state you choose. Organizations
with multi-state and international operations should choose the state carefully
to minimize state, and possibly federal, tax exposure.
the entity operates in states other than where it is organized, it will need to
register as a “foreign” corporation in each of those states—or another type of
entity— and also get a registered agent in every other state it does business
in. It also needs to make sure it registers for sales tax in each state.
type of structure you use, you should have annual meetings with minutes kept
the organizing document provides for periodic distributions of operating results
or other data, it is important to make sure you comply with that instruction. For
example, youmight need to provide annual financial statements to all
owners…or if the document says that certain issues must be voted upon by the
owners or that they must be given timely notice of owners’ meetings, then plan
there is more than one owner, it is a best practice to have an operating and
name will need to be chosen that is not being used by any other organization of
that entity type.
entities have ownership limitations, which will be explained in that section
owners of all entities have limited liability except sole
proprietorships, general partnerships, general partners in a limited
partnership and situations where there is any debt that is personally
is usually by the sole proprietor, by all general partners or managing members
or by anyone so designated by the board of directors of a corporation.
limited partnerships and LLCs are generally recognized as separate legal
in all entities can be freely transferred unless there is a specific
restriction on transfers.
entities need to maintain proper accounting records and a set of books.
earnings retained in an unincorporated entity would be currently, or have been
previously, subject to taxation by the individual owners.
there are foreign owners, special reporting requirements must be complied with,
including filing specific forms with the IRS.
Here are the different structures you can choose
are established by a single person that will operate either in his/her own name
or an assumed name that is registered with the county clerk where he/she will
be doing business or where he/she resides. The assumed name is usually called a
D/B/A (doing business as). In lieu of obtaining a TIN, it is possible that the
owner’s Social Security number would be used. I don’t recommend this. A TIN should
be obtained to be used for business bank accounts, payroll payments and to
in mind that the owner has unlimited liability for all business obligations and
will report the operations on Schedule C of IRS Form 1040. The net income is
subject to self-employment tax in addition to income tax. The net income is
eligible for retroactive SEP deductions or current year Solo 401(k)
contributions and for self-employed medical insurance deductions on the owner’s
individual tax return, Form 1040.
sure you are clear with all the rules, limitations and restrictions for
retirement plan contributions and all of the deductions the owner is eligible
for, as well as alternative forms of entities to operate under. Losses are
deductible to the extent of the owner’s investment in the sole proprietorship
and debts the owner is liable for. Sole proprietorships must use a calendar
year. Sole proprietors cannot receive salary—the business income is what they
are established when two or more people or entities want to operate a business.
Other than there being more than one owner, and a TIN that must be
obtained, the organization rules are similar as for sole proprietorships. One requirement,
or best practice, is to have a partners’ agreement that is usually called a
buy-sell agreement. Also, annual meetings should be held in accordance with the
partnership agreement. Partnerships must use a calendar year except under
certain limited exceptions that are not discussed here.
times, people engage in a business activity as a partnership or joint venture
where they do not formally organize the entity or activity. These are nevertheless
partnerships and would need to obtain a TIN and file a partnership tax return–Form
1065. It is not mandatory that a partnership have an agreement or organizing
document, although that is certainly a best practice.
applicable portion of the net income or losses and other reportable items is to
be reported on each partner’s individual tax returns. Losses are deductible to
the extent of the partner’s basis, which includes his/her investment in the
partnership and possibly certain debts of the partnership. General partnerships
terminate when a general partner dies, as do sole proprietorships when the
owner dies or terminates his/her ownership interest. Partners do not receive
salary for their services—the income they earn is reported on the Form K-1.
General partners have a fiduciary duty to the other partners.
partnerships that are owned by a husband and wife do not have to file a Form
1065 but could choose to file two Schedules Cs as part of their joint tax
return. Each would report his/her share of all the income and expenses on the
Schedule C. This eliminates the need for that extra tax return filing.
partnerships, organized under the laws of the state they will operate in,
provide for at least one general partner and one partner that has limited
liability. Limited liability means that the limited partner will not be liable
personally for partnership debts unless he/she specifically obligates himself
or herself to be liable for that debt. The general partner will have unlimited
liability. A TIN must be obtained. The net income or losses are treated the
same as for general partnerships on the partners’ tax returns except that
losses that are considered passive might not be fully deductible by the limited
partner. There are special rules that should be reviewed with the preparer of
your tax returns. Limited partners can have no role in managing the partnership,
which is solely managed by the general partners, which can be an individual, C
or S corporations, LLCs or trusts. Typically, the limited partners provide the
capital to the partnership. Limited partnerships have a date when they
terminate, which is determined when they are organized.
Limited Liability Companies (LLCs)
must be organized under a state’s law and the members are not liable for debts
of the entity. The tax treatment of income and losses and the basis for losses
are similar to those of limited partners as is the Form 1065 filing. Husband
and wife owners must file a Form 1065 and cannot avoid this with two Schedule Cs
as general partnerships can. These have termination dates.
One Person LLCs
is an exception to the LLC rules for one person LLCs. They are treated as a
disregarded entity by the IRS for tax purposes and do not need to obtain a TIN
(and can use the owner’s SSN, which I do not recommend) and would report the
transactions on Schedule C.
Publicly Traded Partnerships
are limited partnerships whose ownership interests trade the same as stocks. They
are limited partnerships and the investors receive a voluminous Schedule K-1 to
report their share of the income or loss and other tax attributes. It is quite
possible that the income the investor is taxed on is greater than the cash
distributions. Also, the K-1s could be 10 pages or more, making it more time
consuming and costly to have tax returns prepared. Note: Hedge funds and
private equity funds could have up to 30-page K-1s. Also, operating income from
a PTP is business income and can be taxed in a tax-deferred or Roth retirement
plan account as unrelated business income.
are the basic entity for publicly held companies. The C refers to Subchapter C
of the Internal Revenue Code (IRC). A C corporation is a separate legal tax-paying
entity with net income taxed at a flat 21% regardless of the amount of income.
Most states also tax corporations. The funds remaining in the corporation after
the tax payments are called retained earnings. When distributions are made from
the retained earnings, they are subject to a second tax, which is paid by the
owners receiving the dividends. Individuals pay tax on those dividends at rates
similar to the capital gains rates, which could range from 0% tax up to 23.8%—lower
rates than ordinary or earned income.
C corporation dividends received by another C corporation are subject to a “dividends
received deduction”of 50% to 100% depending upon the nature of the
ownership of the corporation that is receiving the dividends in the corporation
that is paying the dividends. Dividends from a less than 20% owned domestic
corporation are permitted a 50% deduction, making the tax rate on the dividends
10.5% (50% of 21%). However, the remaining funds will eventually be taxed again
when they are distributed. Stockholders are not taxed on any corporation income
except when dividends are distributed. Any person or any entity can be a
stockholder without limitation or restriction. Corporations have an unlimited
life span not terminating upon the death of any stockholder and not needing to
state a termination date. Shareholders that work for the corporation receive a
salary similar to any employee. A board of directors is established and the
directors hire the officers. Directors will have a fiduciary duty for their
actions. A C corporation can choose a fiscal year instead of using a calendar
are corporations electing under Subchapter S of the IRC to not be taxed. All taxable
income, losses and credits and certain other attributes pass through to the
stockholders to be reported on their individual tax returns. The passive-loss
rules can prohibit deductions by the individual shareholders, and this should
be reviewed with a tax adviser. There is a limit of 100 shareholders, and they
cannot be foreigners. In general, they must be individuals, although certain
trusts can be stockholders and estates can be stockholders for a limited
period. Corporations cannot be stockholders. There can only be one class of
stock, but different voting and nonvoting shares are permitted, and there
cannot be any differences in liquidation and dividend rights. Direct loans from
a shareholder can increase basis. The stockholders receive a K-1 with the
information they will need to report on their individual tax return.
Stockholders that are employed receive salary. There is special taxation by S
corporations that were once C corporations and have excess net passive
investment income. S corporations must use a calendar year (with certain
Entity Classification Changes
matter how an entity is organized, it is possible under certain situations to
make changes to be taxed as a different form of entity. This is done on IRS
Form 8832, Entity Classification Election. Making such changes involves serious
thought and management and should be discussed with a knowledgeable tax adviser
are many other ways to structure a business, including the following, which we
won’t go into detail about here:
estate investment trusts
corporations or professional LLCs
stock ownership plans (ESOPs)
types and variations
is more that those organizing entities will need to explore, including whether
there will be different classes of shares, for instance common and preferred, whether
shares would be held in a voting trust, whether there will be different
liquidation rights and different and disproportionate income and loss allocation