Tax reform in 2017 is coming! While we do not know what the final tax law will be, we do know there have been consistent themes supported by the President and the Republican leaders in Congress. One of these themes is not just the change in the corporate rate structure, but also a new concept in how pass-through entities are taxed. These proposed changes will most likely have a significant impact on your tax management and strategies. In response to these key changes, most business owners will want to review and evaluate their entity structure and the related benefits and consequences of each. The purpose of this article is to summarize these issues to help you prepare for considering alternatives in your structure as a new tax and regulatory system is enacted.
A business will be organized in one of the following entity types: sole proprietorship, C corporation, S corporation, limited liability company, general partnership or limited partnership. No single form is right for every owner. Instead, the choice depends on the relative importance to you of several key issues. The initial major consideration relates to the extent to which you wish to shield personal assets from the liabilities of the business. If this type of protection is important to you, then a C corporation, S corporation or limited liability company might be appropriate. These forms generally would protect you and the other owners from losing more than your investment in the business.
A second consideration is whether you want the business to be taxed as a separate entity or whether you want the entity’s items of income, credit, loss, and deductions to be reported on your personal income tax returns. If you want the entity to be taxed separately, then a C corporation is the entity type. One current drawback to a C corporation is that earnings can be taxed twice — once at the entity level and again when earnings are distributed to you and the other shareholders. Sometimes, however, double taxation can be avoided if the corporation pays out all of its earnings as deductible salary, consultation or rent. If you expect the business to generate losses, then a pass-through entity, such as an S corporation, limited liability company or partnership might be appropriate. In most cases, this would allow you, as an active owner, to offset the losses incurred in the business against other personal income.
Currently, taxation among entities other than C corporations varies significantly. The earnings of sole proprietorships, limited liability companies and partnerships are subject to both income tax and self-employment tax. The earnings of S corporations are subject to income tax but NOT to self-employment tax. Included in some proposals is a cap on the income tax rate applied to undistributed pass-through income. These changes, if adopted, will be significant and as with most new legislation, we expect the final regulations to be lengthy and complex.
A third important issue is the extent to which you, as principal owner, want to allow other owners or investors to manage the business. If you wish to restrict this right, the a C or an S corporation might be appropriate because share ownerships can be separated from management of the business and shareholder voting can be limited to organic matters, such as mergers or election of the board of directors. A limited partnership, with you as the general partner, is also a good choice because limited partners cannot ordinarily participate in the management of a business. If you do not wish to restrict the right to manage the business, then a general partnership or limited liability company might be suitable. Note, however, that limited liability companies can be organized in such a way as to severely limit investor participation in management.
A fourth issue to be considered is the extent to which you want other owners to be able to transfer their shares to third parties without restriction. If the entity will have only a few owners, then it might be prudent to restrict an owner’s rights to sell to third parties without the prior permission of the other owners. There are a number of ways to achieve this result depending upon which form of business is selected.
A final issue relates to the type and number of owners you anticipate the business will have. Most forms of business do not have restrictions in this regard. However, S corporations are only permitted to have individuals (who are not nonresident aliens) and certain trusts and estates as shareholders. Also, S corporations can have no more than 100 shareholders at any one time. Thus, depending on the nature of the ownership structure you plan to create, an S corporation might be inappropriate. And finally, partnerships must have at least two owners.
As new legislation is enacted in the coming months, now would be an excellent time to reevaluate the structure of your business.