1. How to Choose the
Best Business Entity
by
Alan D. Campbell
Ph.D., CPA, CMA, CFP®
alancampbell@elmore.rr.com
Author of the forthcoming book
Tax Savings Prescriptions
2. 2
Objectives
• Explain how to
choose the best
business entity:
– Sole proprietorship
– Partnership
– Limited liability
company
– S Corporation
– C Corporation
4. 4
Characteristics
• Easy to form and
operate
• The owner has
unlimited liability
• The owner has
limited ability to
raise capital
5. 5
Formation
• The owner may
operate under a
fictitious name
(a d/b/a)
• The owner may
have to file a
fictitious name
registration with the
county or parish
6. 6
Formation
• The individual owner
owns the assets
• No owner recognizes
any gain or loss on
the transfer of
personal use assets to
the business
7. 7
Income Tax Treatment
• Only one level of
income tax
• Income and expenses
retain their character
• The net income is
taxed at the owner’s
marginal tax rate
8. 8
Income Tax Treatment
• The owner reports
income and expenses
on Form 1040,
Schedule C
• Losses (except passive
losses) are deductible
against the owner’s
other income
9. 9
More Than One Business
• Income and expenses
from each different
business are reported
on separate
Schedules C
• A net loss from one
active business may
offset net income
from other businesses
10. 10
Self-Employment Tax
• Reported on Form
1040, Schedule SE
• The net income is
multiplied by 92.35%
• The resulting amount
is multiplied by the
SE tax rate of 15.3%
• Half of the SE tax is
deductible for AGI
11. 11
Passive Losses
• A passive loss may be
deducted only against
passive income for
both income tax and
self-employment tax
purposes
• Unused passive losses
are carried forward
12. 12
Employing One’s Children
• Can reduce income
taxes and the self-
employment tax
• Wages paid to one’s
children under age 18
are exempt from
employment taxes
13. 13
Employing One’s Spouse
• Salaries are subject to
income taxes and
employment taxes
• Can be useful in saving
self-employment tax on
health insurance
premiums and income
tax and SE tax on
medical expense
reimbursement plans
14. 14
Employing One’s Spouse
• Can make business
travel costs for the
accompanying spouse
deductible
• Can provide the
spouse with earnings
that can be tax
sheltered with
pension plans such as
a SIMPLE plan
15. 15
Section 179 Deduction
• The Section 179
deduction reduces
income tax and the
self-employment tax
• Wages count as
business income for
purpose of the
income limitation
16. 16
Net Operating Losses
• May generally be
carried back two
years and forward for
up to 20 years for
income tax purposes
• Are not deductible
for self-employment
tax purposes
17. 17
Transferring the Business
The owner cannot
transfer a part of the
equity in the business
without first changing
it to another type of
entity
18. 18
Sale of the Business
• A sale of a sole
proprietorship is
treated as a sale of
its assets
• Part of any gain
will be ordinary
income
19. 19
Transferring the
Business to Reduce Estate Taxes
• Bequeath the
business to the
surviving spouse
• Sell the business
outright and make
annual gifts from
the proceeds
20. 20
Transferring the
Business to Reduce Estate Taxes
• Sell the business
for a private
annuity
• Sell the business
for a self-canceling
installment note
23. 23
Characteristics
• Partnerships have
relatively simple
administration and filing
requirements compared
to corporations
• Partnerships are often
much more complex for
tax purposes than are
other entities
24. 24
Formation
• Transfers of property to a
partnership in exchange for
an interest in the
partnership are generally
tax deferred
• The receipt of a
partnership interest for
services is taxable as
determined under Section
83
25. 25
Tax Year
• The partnership must
use the same tax year
as used by partners
that own more than
50% of the interest in
the partnership
• If not possible, use the
tax year of all the
principal partners
26. 26
Tax Year
• If not possible, use the
tax year with the least
amount of income
deferral
• The IRS may approve
a different tax year if a
business purpose
exists
27. 27
Tax Year
The partnership may
elect a different tax year
if the partnership makes
the required payment
and the deferral period is
three months or less
28. 28
Income Tax Treatment
• Partnerships have a great
deal of flexibility in
allocating income
between or among the
partners
• Single level of taxation
• Partners, not the
partnership, pay taxes
29. 29
Income Tax Treatment
Income is taxed to the
partners even if the
partnership makes no
distributions of cash
or other assets
30. 30
Employment Tax Treatment
For general partners,
the distributive share
of ordinary income
and any guaranteed
payments are subject
to the self-
employment tax
31. 31
Reporting Partnership Income
• The partnership
must file Form
1065
• Income is reported
to each partner on
Schedule K-1
• Ordinary income or
(loss)
32. 32
Reporting Partnership Income
• Separately reported
items include
portfolio income,
capital gain/loss,
and the Section 179
deduction
• Net earnings from
self-employment
33. 33
Losses
• Losses flow through
to the partners to the
extent of each
partner’s
– Amount at risk
– Adjusted basis in the
partnership interest,
which includes the
partner’s share of the
partnership’s debts
34. 34
Losses
• Passive losses are
deductible only to the
extent of passive
income
• Losses from a limited
partnership interest
are generally passive
losses
35. 35
Distributions
from the Partnership
• Distributions include
distributions of cash
and other assets
• A net decrease in a
partner’s share of the
liabilities is treated as
a cash distribution
36. 36
Distributions
from the Partnership
• Distributions are
deemed to occur at
the end of the year
• All other items that
affect basis are taken
into account before
distributions
38. 38
Distributions
from the Partnership
• Distributions of cash
are a reduction in the
basis of the partner’s
interest in the
partnership
• Distributions of cash
in excess of basis
result in a recognized
gain
39. 39
Sale of a Partnership Interest
A sale of a
partnership interest is
treated as a sale of a
capital asset except to
the extent of “hot
assets”
40. 40
Optional Basis Adjustment
• The partnership may
elect to adjust a
partner’s outside basis
when
– A partner acquires the
interest of another
partner or
– The partnership
distributes property to
a partner
41. 41
Sale of the
Assets of the Business
• The partnership can
sell the assets of the
business
• The gain or loss on
each asset must be
calculated and
characterized
42. 42
Termination of a Partnership
A partnership
terminates for legal
purposes on the
death, withdrawal, or
bankruptcy of any
partner
43. 43
Termination of a Partnership
• A partnership terminates
for tax purposes
– When at least 50% of the
interest in the partnership
is transferred in any 12-
month period or
– When no business activity
is carried on by any
partner
44. 44
Transferring the
Business to Reduce Estate Taxes
• Form a family limited
partnership
• Make a lifetime gift of
the general partnership
interest or sell it
• A corporation or LLC
could be formed to be
the general partner
45. 45
Transferring the
Business to Reduce Estate
Taxes• Retain a limited
partnership interest
• The value of the
retained interest will
receive discounts for
– Lack of marketability
and
– Lack of control
46. 46
Four Types of Entities
May Be Taxed as Partnerships
• General partnership
• Limited liability
partnership (LLP)
• Limited partnership
• Limited liability
company (LLC)
47. 47
General Partnership
• All partners have
unlimited liability
• Each partner is taxed
on the partner’s
distributive share of
– The partnership’s
ordinary income
– The separately stated
items
48. 48
Limited Liability Partnership
• Used by
professional
services firms
• All partners have
unlimited liability
for the normal
business debts of
the partnership
49. 49
Limited Liability Partnership
Partners are not liable
for the professional
negligence of another
partner unless the
other partner is under
their direct
supervision
50. 50
Limited Partnership
• Limited partners have
limited liability
• Limited partners
cannot take part in
management
• Limited partners are
often a source of a
large amount of capital
51. 51
Limited Partnership
• Must have at least
one general partner
• The general partner is
often a corporation or
LLC
• Limited partners pay
self-employment tax
on guaranteed
payments only
53. 53
Characteristics
• None of the
members is
personally liable for
the debts of the LLC
• All members have
the legal right to
participate in
management
54. 54
Characteristics
• LLCs may have an
unlimited number
of members
• Any taxpayer can
be a member of an
LLC (corporations,
non-resident aliens,
trusts, partnerships)
55. 55
State Law
• Little established case
law exists to interpret
the various state
statutes
• Uncertainty exists for
LLCs that operate in
more than one state as
to which state’s law
will prevail
56. 56
Formation
• Transfer of property
to an LLC in
exchange for an
ownership interest is
– Generally governed by
the partnership tax
provisions
(Subchapter K)
– Generally tax deferred
57. 57
Income Tax Treatment
• One member LLC
is taxed as
– A disregarded
entity (sole
proprietorship)
– A corporation if the
LLC so elects
58. 58
Income Tax Treatment
• LLC in the USA
with two or more
members is taxed
as
– A partnership
– A corporation if the
LLC so elects
59. 59
Employment Tax Treatment
If the LLC elects to be
taxed as a corporation,
the salaries of the
members who work for
the LLC will be subject
to FICA tax and income
tax withholding
60. 60
Employment Tax Treatment
If the LLC elects to be
taxed as a corporation,
the LLC will be subject
to FICA tax and
unemployment taxes
61. 61
Employment Tax Treatment
If an LLC owned by
one individual is taxed
as a disregarded entity,
all of the net income
will be subject to self-
employment tax
62. 62
Employment Tax Treatment
If an LLC is taxed as a
partnership, the
members who are
equivalent to general
partners will be subject
to self-employment tax
on their distributive
share and on any
guaranteed payments
63. 63
Employment Tax Treatment
Members who are
equivalent to limited
partners will be subject
to self-employment tax
only on their guaranteed
payments
64. 64
LLCs Taxed as Partnerships
• The flexibility of a
partnership
• The limited liability
of a corporation
65. 65
LLCs vs. S Corporations
• LLCs are NOT
subject to the taxes
on built-in gains and
excessive passive
income
• LLCs are NOT
limited as to the
number of members
66. 66
Selling the Assets of the
Business and Liquidating the LLC
• The gain or loss on each
asset must be calculated
and characterized
• The treatment of
liquidating distributions
depends on how the
LLC is taxed
67. 67
Sale of a Membership in the LLC
• If the LLC is taxed
as a partnership, the
interest in the LLC
is a capital asset
• Capital gain or loss
results, except to
the extent of the
sale of “hot assets”
68. 68
Sale of a Membership in the LLC
A loss on the sale of a
membership in an
LLC taxed as a
partnership or
disregarded entity
cannot qualify for
ordinary loss
treatment under
Section 1244
69. 69
Sale of a Membership in the LLC
• If the LLC is taxed as a
corporation, the sale of
the LLC membership
should result in capital
gain or loss
• Possible limited ordinary
loss treatment under
Section 1244
71. 71
Eligibility Requirements
• Must be a domestic
(USA) corporation
• Must be eligible to
elect S status (not an
insurance company or
non-qualifying bank)
73. Eligibility Requirements
• A husband and wife
count as one
shareholder
• Certain family
members may elect to
be treated as one
shareholder, up to six
generations
73
74. 74
Eligibility Requirements
• Only one class of stock
• Stock with different
voting rights is allowed
• Disproportionate
distributions can be
deemed to indicate that
the corporation has more
than one class of stock
75. 75
Eligibility Requirements
• Generally, nonresident
alien shareholders are
NOT allowed
• An exception applies if
the nonresident alien is
married to a U.S. citizen
or resident alien and elects
to be taxed as a resident
alien
76. 76
Trusts That Can
Own S Corporation Stock
• Grantor trusts
• Voting trusts
• Testamentary trusts
• Qualified Subchapter S trusts
• Qualified retirement plan
trusts
• Small business trusts
• Beneficiary-controlled trusts
77. 77
Characteristics
• Limited liability
• Unlimited life
• Centralized management
• Limited transferability of
interests without losing
the S election
• Subject to more
government regulation
78. 78
Formation
• The transfer of assets in
exchange for the
corporation’s stock is tax
deferred if the persons
who transfer property own
80% or more of the stock
immediately after the
transfer
• The transfer of assets for
the debt of the corporation
is taxable
79. 79
Formation
• The receipt of stock in
exchange for services
is taxable as
determined under
Section 83
• Service provider may
make election under
Section 83(b) if stock
is restricted
80. 80
Making the S Election
• File Form 2553
with the IRS
• All shareholders
must consent
• The election must
be timely and
properly filed
81. 81
Deadline for the S Election
• The corporation may
make the S election at
any time in the year
before it is to become
effective
• The corporation may
make the S election on
or before the 15th day of
the third month of the
tax year of the year it is
to be effective
82. 82
Deadline for the S Election
• A new corporation may
make the S election on
or before the 15th day of
the third month of its
first tax year
• The first tax year begins
on the day the
corporation has assets,
shareholders, or begins
business
83. 83
Deadline for the S Election
If the corporation makes
the S election late, the
IRS may treat the
election as timely if the
corporation had
reasonable cause
84. 84
Deadline for the S Election
• The election is faulty if
the corporation failed to
qualify or did not obtain
shareholder consents
• However, the IRS may
honor the election if the
corporation corrects the
problem within a
reasonable time
85. 85
Tax Year
• An S corporation
generally must use the
calendar year
• A fiscal year is allowed if
it has a business purpose
• The corporation may also
use the same year as used
by shareholders who own
more than 50% of its
stock
86. 86
Tax Year
• The S corporation may
also elect to use a
different tax year
• The maximum deferral
of income is three
months
• Requires payments to
the IRS to compensate
for the deferral
87. 87
Ownership of C Corporations
• A C corporation may
NOT own stock in an S
corporation
• However, an S
corporation may own
stock in a C corporation
• No consolidated return
allowed with a C
corporation
88. 88
QSubs
• An S corporation
may have qualified
S corporation
subsidiaries
(QSubs)
• The QSubs are
disregarded for tax
purposes
89. 89
QSub Criteria
• Must qualify as an S
corporation
• The S corporation
parent must own all
of its stock
• The parent elects to
treat it as a QSub
90. 90
Income Tax Treatment
• No corporate income
tax except for
– Built-in gains
– Excessive net passive
income
– LIFO recapture tax
– Recapture of
investment tax credit
91. 91
Penalty Taxes
• An S corporation Is
NOT subject to
– The accumulated
earnings tax or
– The personal
holding company
tax
92. 92
Income Tax Treatment
• The S corporation
must file Form 1120S
by March 15th
• Income is allocated to
the shareholders on
Schedule K-1
93. 93
Income Tax Treatment
• Income is taxed to the
shareholders at their
marginal tax rates
• Capital gains, tax-
exempt income, and
other separately stated
items retain their
character
94. 94
Income Tax Treatment
• Income is taxed to the
shareholders on a per
share per day basis
• Therefore, S
corporations are not
as flexible as
partnerships
95. 95
Splitting Income
• S corporation stock can be
given to family members
to split income among the
family members
• However, the S
corporation must pay
reasonable compensation
to family members who
provide services or capital
to the corporation
96. 96
Splitting Income
The IRS may ignore gifts of
stock to family members if
the IRS determines that the
donor retains the economic
benefits and control of the
stock
98. 98
Treatment of
Certain Fringe Benefits
• Statutory fringe
benefits are included
in the gross income of
more than 2%
shareholders
• The S corporation
may deduct the fringe
benefits as business
expenses
99. 99
Employment Tax Treatment
• Shareholders who work
for the corporation are
employees
• Salaries are subject to
FICA tax and income tax
withholding
• The corporation Is
subject to FICA tax and
unemployment taxes
100. 100
Reducing Employment Taxes
The S corporation can
reduce employment
taxes by paying the
lowest amount of a
range of reasonable
salaries to
shareholder-
employees
101. 101
Treatment of Losses
• Losses flow through
to the shareholders to
extent of each
shareholder’s:
– Basis in stock
– Basis in loans to
the S corporation
102. 102
Tax Planning for
Loss Deductibility
The shareholder can
loan money to the S
corporation or make a
contribution to capital
before the end of the
year if necessary to
deduct the loss currently
103. 103
Treatment of Losses
• The treatment of
losses is favorable for
new businesses that
are likely to incur
losses
• When the corporation
becomes very
profitable, the
shareholders can
revoke the S election
104. 104
Treatment of Losses
• Losses subject to
– Amount at risk
rules
– Passive activity
loss rules
– Hobby loss rules
105. 105
Treatment of Losses
• Losses of an S
corporation are often
more limited than are
losses of a partnership
• The basis in a
partnership interest
includes the partner’s
share of the debts of
the partnership
106. 106
Treatment of Distributions
• Distributions are a
tax free recovery of
basis to the extent
of the shareholder’s
basis in the stock
• The basis in debt
does NOT absorb
distributions
108. 108
Treatment of
Distributions of Property
• Distributions of
appreciated property
result in gain
recognition by the
corporation
• However, no losses
may be recognized
109. 109
Treatment of
Distributions of Property
• The amount of the
distribution of
property is its
– Fair market value
– Minus any debts
assumed or taken
subject to by the
shareholder
110. 110
Former C Corporations
• Former C corporations
with accumulated earnings
and profits (E&P) keep an
accumulated adjustments
account (AAA)
• AAA is the total of income
and loss from the S period
(except tax-exempt
income and related
expenses)
111. 111
Former C Corporations
• Distributions come
first from the AAA
and reduce the basis
in the shareholder’s
stock
• Distributions come
next from E&P and
are taxable
112. 112
S Election Remains
Until Revoked or Lost
• Voluntary revocation is easy and requires the
approval of a majority of the shareholders
• Involuntary revocation occurs when
– A new shareholder with over one half of the stock
refuses to consent to the election
– The corporation no longer qualifies as a small
business corporation
– The corporation does not meet the passive
investment income limitation
113. 113
Termination of the S Election
for Excessive Passive Income
• Passive income
greater than 25% of its
gross receipts for three
consecutive years and
• C corporation earnings
and profits exist for
each of the three years
114. 114
Preserving the S Election
• Management and
shareholders should
know the factors that
affect S status
• Avoid passive
investment income
limitation violations
• Restrict transfer of stock
to avoid loss of S status
115. 115
Inadvertent Terminations
• The IRS may
continue to allow the
S election if
– The termination is
inadvertent and
– The corporation takes
the necessary steps to
meet the eligibility
criteria within a
reasonable time
116. 116
New Election
• If the S election is
terminated, the
corporation must
– Wait five years to
make a new
election or
– Obtain the consent
of the IRS
117. 117
Sale of the Business
• You can structure
the sale of the
business as
– A sale of stock or
– A sale of assets
followed by a
corporate
liquidation
118. 118
Sale of the Business
• A sale of the stock
should result in
capital gain or loss
• Possible limited
ordinary loss
treatment under
Section 1244
119. 119
Liquidation
• Liquidation of an S
corporation is
governed by the
provisions of
Subchapter C
• No double tax
occurs except to the
extent of built-in
gains
123. 123
Formation
The transfer of assets to
the corporation in
exchange for its stock is
tax deferred if the
persons who transfer
property own 80% or
more of the stock
immediately after the
transfer
124. 124
Formation
• The transfer of services
to the corporation in
exchange for its stock is
taxable as determined
under Section 83
• The transfer of property
in exchange for the
corporation’s debt is
taxable
125. 125
Fringe Benefits
• Many fringe
benefits are
deductible by the
corporation
• They are often tax
free or tax deferred
to the shareholders-
employees
126. 126
Passive Activity Loss Rules
• Apply only to
– Personal service
corporations
– Closely held
corporations
127. 127
Net Operating Losses
• Do NOT flow
through to the
shareholders
• Can generally be
carried back two
years and then
forward for up to
20 years
128. 128
Capital Losses
• Are deductible only
to the extent of
capital gains
• Are carried back
three years and then
carried forward for
up to five years
130. 130
Sale of the Business
• Sale of stock
– No corporate tax
– Shareholder
realizes capital gain
or capital loss
– Possible limited
ordinary loss
treatment under
Section 1244
131. 131
Sale of the Business
• Sale of assets
– Corporation
recognizes gain or
loss on sale of each
asset
– Distributions are
taxed to the
shareholders as
capital gain or capital
loss
132. 132
Double Taxation
• Income is taxed at
the corporate level
• Dividends are taxed
to shareholders
when distributed
133. 133
Reducing Double Taxation
• Avoid distributing
dividends
• Make cash
payments to the
shareholders that
are deductible by
the corporation
134. 134
Reducing Double Taxation
• Make cash
payments to the
shareholder that are
a tax free recovery
of basis
• Make the S election
136. 136
Cash Payments That Are
a Tax Free Recovery of
Basis
• Principal payments
on debt
• Stock redemptions
treated as a sale
• Liquidating
distributions
138. 138
Double Tax on the Sale
of the Assets of the Business
• The corporation
recognizes gain or
loss on the sale of
the assets
• The shareholders
recognize capital
gain on the
distribution of the
proceeds
139. 139
Conclusion
• The best entity for a
your business depends
on many factors,
including state income
tax rules
• You should make the
decision with guidance
from your attorney and
tax professional
141. 1. Banks Require Cosigners
• Banks will usually
require major
shareholder(s) to
consign any corporate
loans
• Thus, there would be
no limited liability for
bank loans
141
142. 2. Piercing the Corporate Veil
• Most corporations keep
poor records such as
minutes and resolutions
• Many stockholders of
small corporations
commingle personal and
corporate assets
142
143. Shareholders Become Liable
• A plaintiff’s attorney
may be able to pierce
the corporate veil
• If so, the shareholders
could be personally
liable for any
corporate debt
143
144. 3. Defending a
Lawsuit Is Expensive
• Even if a corporation
keeps good records
and does not
commingle assets
• The corporation would
have to pay to defend
a lawsuit, except to the
extent that an
insurance company
will pay 144
145. 4. Breach of Fiduciary Duty
• Even if the corporation
keeps good records and does
not commingle assets
• You can be sued
individually for breach of
fiduciary duty as a director
or officer of the corporation
• You can insure such risk,
but it can be expensive
145
146. 5. Foreign Corporation Fees
• A corporation is an
artificial person that has
received a charter from a
particular state
• To do business in another
state, the corporation
must register with that
state and pay a fee as a
“foreign corporation”
146
147. 6. Few Additional Deductions
• Section 162 authorizes
deductions for business
expenses
• It applies to all types of
businesses
• There are few deductions a
corporation may claim that
are not allowed to other
types of business entities
147
148. 7. Employment Taxes for
Children Under Age 18
• If your children are
under age 18 and they
work for your sole
proprietorship, their
wages are not subject
to employment taxes
• If your children work
for your corporation,
their wages are subject
to employment taxes 148
149. 8. More
Government Forms to File
• If you operate as a
corporation, you have to
file more forms and pay
more fees to federal and
state governments
• Complying with all the
rules takes additional
time and money away
from your business
149
150. 9. Can Lose Stock
to Personal Judgments
• A court may not force
a creditor to be a
partner with someone
• If someone gets a
judgment against an
LLC member or
partner, usually all the
creditor gets is a
charging order
150
151. Judgment Creditor Can
Seize Stock to Satisfy Judgment
• A personal judgment
creditor of a
shareholder may be
able to take the stock
to satisfy the judgment
• You can buy personal
umbrella liability
insurance to hedge
against this risk
151
152. 10. Payroll Tax
Penalties on Your Own Salary
• If your corporation pays
you a salary and does
not deposit the payroll
taxes timely, the
corporation could be
subject to large penalties
• And you as an individual
could be subject to the
trust fund recovery
penalty 152
153. 11. Possible Tax on
Transfer of Appreciated Assets
• If you transfer
appreciated assets to a
corporation that you
control and if you do
not comply with
Section 351
• You could owe
income tax just for
placing the assets in a
corporation 153
154. Conclusion
• Think carefully and
get excellent advice
before you form a
corporation
• Corporations do have
some benefits
• But many of the
alleged benefits are
myths and half truths
154
155. Credits
This presentation was created using
PowerPoint® presentation graphics program,
a Microsoft® software. PowerPoint® is a
Windows®-based and Mac®-based
application. All clip art is used with permission
from Microsoft®. Microsoft®, Windows®, and
PowerPoint® are either registered trademarks
or trademarks of Microsoft Corporation in the
United States and/or other countries.
155
156. Disclaimers
Alan D. Campbell (d/b/a Campbell
Education) is an independent entity and is not
affiliated with, nor has he been authorized,
sponsored, or otherwise approved by
Microsoft Corporation.
156
