A substantial amount of financial planning is concerned with choosing amongst different legal forms of business entities and arranging these forms in particular structures. The way income is taxed in each form is a major consideration in choosing the right form for a business. Good, proactive planning up-front can save many dollars and headaches down the road. Small, closely-held businesses generally choose to do business in forms that allow income to be “passed-through” to the business owners rather than taxed first at the entity level and then taxed again when distributed to the owners.
There are two major tax regimes for these pass-through entities: Subchapter “K” of the Internal Revenue Code for partnerships and Subchapter “S” of the Internal Revenue Code for “S” corporations (hence the name). Due to developments in the law of business associations over the last two decades, limited liability companies (LLCs) are now the fastest growing form of business entity. These entities are generally taxed as partnerships. Although many business people now believe that the number of LLCs must have surpassed the number of S Corporations, the statistics don’t bear this out. Consider the most recent data reported by the IRS’s Statistics of Income Division regarding the filing of Forms 1065 and 1120S:
There are more S Corporations and these entities generate slightly more in total receipts. However, the total assets held in partnerships dwarfs that of S Corporations. This point goes back to planning: often it is advantageous to hold investment securities and real estate in partnerships, but not in S Corporations.
There are many distinctions between the income taxation of partnerships and S Corporations. For instance, differences exist in the following areas:
- The computation of an owner’s “basis” in their interest in the business and the related deductibility of losses
- The treatment of contributions to the business
- The ways income may be allocated amongst the ownership group
- The rules governing compensation of owner-employees
- The treatment of property distributions and liquidations
- Applicability of self-employment taxes
- Permissible forms of capital structure and ownership
- How subsequent changes in ownership are governed
There isn’t a “one size fits all” solution in choosing the right form of business entity. Various trade-offs must be prioritized and balanced. These trade-offs will differ for each individual based on their overall circumstances, objectives, and values. Levin, Swedler & Company has focused on the unique needs of small businesses and their owners for more than three decades and has developed the expertise to assist business owners in structuring their financial affairs in the manner most advantageous to their unique circumstances. Levin, Swedler & Company helps business people answer what the “right” form of business entity is for each of their endeavors.
Written By: Brian Spencer