"Flow-through" entities for tax purposes 9/14/07
Selecting an entity involves many considerations, and one important consideration is tax treatment.
See: IRS – Choosing a Business Structure FS-2008-22 Choosing a Business Structure FS-2008-22 7/22/08
C corporation "double tax"
One possible "down-side" to corporations is the "double tax". If a corporation does not elect "S" status (see below), it is taxed under subchapter C and is referred to as a "C corporation". C corporations file an income tax return (form 1120) and pay tax on their income. There is no current deduction for dividends paid to shareholders, so the corporation pays tax on money distributed as dividends to shareholders. Shareholders (except to a limited extent, corporate shareholders) also pay tax on dividends, so in effect the money is taxed twice, at both the corporate and shareholder levels.
Some entities do not pay tax themselves. Instead, the entity's income and expenses "flow-through" to and are reported by their principals, e.g., corporate shareholders, partners or limited liability company ("LLC") members. These entities typically file an information return (form 1120S for an S corporation, or 1065 "partnership" return for partnerships and LLCs), and issue a form K-1 to the principals showing the principals' portion of the entity's income and expenses. The principals report their portion on the entity's income and expenses on the principals' own income tax returns (form 1040 for individuals). Single member LLCs are "disregarded entities" for tax purposes. No form 1065 is filed and the single member reports the income and expenses on their own form 1040, schedule C (for individuals).
Election to be taxed as a corporation
Partnerships and most limited liability companies ("LLC") are "flow-through" entities by default. They can elect to be taxed as a corporation and not be a flow-through entity. They then can also elect whether to file an S election, below.
With certain restrictions, partnerships and LLCs are more flexible, and in some cases can make "special allocations" of income and or expense that flow through to principals in a percentage different from the ownership or "profit and loss ratio(s)".
Limits on certain benefits and self-employment tax
There can be also be"down-sides" to flow-through entities. S corporations (but see S distributions, below), partnerships and LLCs are not able to provide certain pre-tax fringe benefits, such as employer-provided health insurance to 2% or greater shareholders, partners or members. Partnership or LLC income that flows through to principals is self-employment income subject to self-employment taxes.
Basis adjustment on sale of owner interest
On redeeming or purchasing a partner or member interest, an election can be made to adjust the "inside" basis of the assets owned by the entity which affects, e.g., depreciation deductions. This election is not available for a corporation, and any tax benefit from the amount paid for shares in excess of the basis of assets "inside" the corporation must wait for disposition of the stock.
While if done correctly an S corporation can pay reasonable salaries to shareholders, subject to employment taxes, and then also make "S distributions" not subject to self-employment tax, there may be limitations on the ability to make S distributions that are not subject to self employment tax in some circumstances.
Tax without cash flow
Flow-through entity income is reported by the entity's principals and tax paid on it regardless of whether any "cash" is distributed. This disconnect between receipt of "cash" and reporting of income can result in hardship from having to pay tax on money you did not get. The principals can make a provision requiring that sufficient cash be distributed to the principals to pay the tax they must pay on the entity's income reported to them, but this may not always be the case.
Accumulated adjustments account and capital account
To avoid the income being taxed twice to the principals, income reported to them is tracked (in an "accumulated adjustments account" for an S corporation or a capital account for partnerships and LLCs. Income reported to them increases the balance, and losses or distributions decrease the balance). If there is a positive balance in the account due to prior income reported to the principals, an S distribution or partnership or LLC distribution will not result in taxable income. If there is not a positive balance, the distribution may be a return of basis (not taxed) or taxed as capital gain.
Most corporations are formed by filing Articles of Incorporation with the Office of the Secretary of State (some not for profit ("pro forma") corporations are formed by filing Articles of Agreement with the County Circuit Court).
S election (form 2553)
Corporations can elect to be a flow-through entity by filing form 2553, "S election", with the IRS to be treated under Internal Revenue Code ("IRC") subchapter "S" (hence the term "S corporation"). The corporation then files an "information" return (form 1120S) but does not pay tax (in most cases). The corporation sends a form K-1 reporting its income and expenses pro rata to the shareholders according to their percentage of share ownership. S corporations can not deviate from pro rata reporting. This avoids the double tax because tax is only paid once at the shareholder level.
Built in gain tax
A "built-in gain" ("BIG") tax limits the ability of a corporation to operate as a C corporation and then make an S election shortly before sale of its assets to avoid the double tax. When a corporation that has been a C corporation for some period since its formation makes an S election, the appreciation in its assets is subject to the separate corporate level tax for 10 years after the election. After 10 years the BIG tax does not apply.
"At risk" rules / other limitations
The ability to take losses from a flow-through entity on a principal's individual return may be limited by a number of rules, including the "at-risk" rules, basis limitation rules, passive activity rules and portfolio income rules.