The State of Your Business Structure

Different entity types have varying tax impact

Have you ever wondered how your year end tax planning might differ if your company operated under a different business structure? Although the variances among most of the major entity types aren’t drastic, they’re notable enough to make reviewing the state of your business structure a worthwhile endeavor. Let’s take a look at the fundamental tax impact of each of the major entity types in use today.

Corporations

Traditionally, many companies didn’t start life as a corporation but rather as a sole proprietorship. In fact, the sole proprietorship may still be the most common entity type, if only because so many small businesses begin this way. Its tax treatment is relatively simple: The owner reports business profits and losses on his or her personal income tax return — for income and self-employment tax purposes.

But sole proprietors are held personally liable for their companies’ debts and obligations, which can bring great risk. So many sole proprietors reach a point where they incorporate their businesses to better protect themselves and gain some tax advantages.

Incorporation has long come in two types: the C corporation and the S corporation. Both have a maximum federal tax rate this year of 35%, and individual owners of either generally aren’t subject to self-employment taxes.

But these two business structures have different tax bases. A C corporation must pay taxes on profits at the corporate level, and then shareholders pay tax at the personal level when they receive dividends or upon liquidation (so-called “double taxation”). S corporations, on the other hand, are “pass-through” entities, meaning the company’s profits and losses pass through to the shareholders, who report the income (or losses) on their personal returns.

Being a pass-through entity has long been viewed as an advantage for the S corporation structure — and it certainly can be. But S corporations are limited to a maximum of 100 shareholders, which can inhibit efforts to attract equity investors. And a C corporation may be able to mitigate the negative effects of double taxation via wage and benefits deductions.

Partnerships

Of course, not every company follows the sole-proprietorship-to-corporation formula. Many businesses begin as — and stay — partnerships between two or more individuals. Again, two types tend to dominate here: general and limited.

A general partnership is similar to a sole proprietorship in that partners retain personal liability for the company’s debts. In a limited partnership, the limited partners face liability only up to the amount of their investment. The general partners, however, have the power to make strategic business decisions for the partnership and do assume personal liability for the business’s debts.

Like corporations, the partners of both general and limited partnerships currently face a maximum 35% tax rate. And, in either case, a partner is taxed based on his or her allocable share of the partnership’s income, whether distributed or not. That income flows through from the company to the partner’s personal return. Only general partners are subject to self-employment taxes.

The latest on LLCs

For tax purposes, a limited liability company (LLC) is treated as a partnership as well. But this entity type has enough legal differences that it’s typically considered a business structure unto itself.

As is the case for S corporations and partnerships, LLCs are pass-through entities and thus the maximum income tax rate this year is also 35%. Individual owners are generally subject to self-employment taxes if not treated as limited partners.

LLCs took off in popularity largely because they allow flow-through taxation yet provide greater protection against liability for debts and obligations than partnerships do — while coming with fewer restrictions and administrative formalities than corporations have. They’re also fairly easy to set up.

One interesting issue involving LLCs that’s arisen of late is how owners under this business structure should be treated under the passive activity loss (PAL) rules. Created to limit the use of tax shelters, these rules prohibit taxpayers from offsetting losses from passive activities (such as limited partnerships or rental properties) against nonpassive income (such as wages, interest, dividends and business income).

Up until recently, the IRS generally treated LLC owners as limited partners for purposes of the PAL rules. But, just this year, the U.S. Tax Court and the U.S. Court of Federal Claims ruled that LLC owners should be treated as general partners. This facilitates their ability to deduct business losses. To qualify, however, owners must establish that they “materially participated” in the LLC per a series of seven tests. (Ask your tax advisor for details.)

Reasons to review your business structure

Over time, you may find that your current structure no longer suits the size or nature of your business. Or you might want to divide your company into separate entities or form a joint venture with another business. These are just a few of the reasons to stay up on the advantages and risks of these various business structures. Changing entity type typically isn’t easy and may trigger tax consequences, so be sure to discuss the possible ramifications with your tax advisor.

Depreciation breaks an option for any entity type

No matter what your business structure, a couple of tax breaks that are particularly important to consider this year are the Section 179 expensing deduction and bonus depreciation.

The Sec. 179 deduction allows you to expense, rather than depreciate, a specified dollar amount of qualified new or used asset acquisitions in a given year. For 2011, that amount is an impressive $500,000. But it’s scheduled to drop to $125,000 (indexed for inflation) in 2012. So there are big tax savings in the offing if the circumstances are right for your business to make qualifying asset purchases this year. Various limitations apply and, for 2011, the deduction starts to phase out dollar for dollar when total asset acquisitions for the tax year exceed $2 million.

Bonus depreciation allows you to simply claim an extra percentage of depreciation on a qualifying asset. This year, that percentage couldn’t get any bigger: You can deduct 100% of the cost of eligible assets acquired and placed in service this year (or by Dec. 31, 2012, for certain long-lived and transportation property). For 2012, bonus depreciation is scheduled to drop to 50%. And after Dec. 31, 2012, it’s currently scheduled to be eliminated. Various limitations apply here as well — notably that the property acquired must be new, not used.

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