Decide How Your Small Business Will Be Taxed

Understanding and choosing how a small business is taxed is an important decision for business owners.  The stakes are very high as an incorrect choice may prove costly to correct.  By making the proper choice, a business owner can minimize taxes paid to Uncle Sam and put more cash in their pockets.

The Tax Entities

A Sole Proprietorship is a single owner tax entity.  It is the simplest and easiest form of tax entity because it doesn't require any legal organization or a separate tax return.  Business income and expenses are reported on the owner's federal tax return.  In addition to federal income taxes, self-employment tax of up to 15.3% generally applies.

A Partnership is a multiple owner tax entity.  A separate tax return is required; however, the owners pay federal income taxes on business income via their personal tax returns. This is called the pass-through taxation concept (more on this later).  In addition to federal taxes, self-employment tax of up to 15.3% generally applies to owners who participate in the activities of the business.  Partnerships allow for disproportionate allocations of tax items and distributions making it a very flexible tax entity compared to S corporations.

An S Corporation can be a single or multiple owner tax entity.  A separate tax return is required however S corporations follow the pass-through taxation concept just like a partnership.  Self-employment tax does not apply to pass through income.  Reasonable wages must be paid to owners for services rendered to the business.  These wages are subject to employment and income taxes.  There are restrictions on the number and type of shareholders.  Distributions of profits must be proportionate to ownership interests.

A C Corporation can be a single or multiple owner tax entity.  A separate tax return is required.  Owners of C corporations can experience double taxation, with profits taxed once at the entity level and again at the owner level when dividends are paid to owners.  For small businesses, C corporations are seldom used because of the double taxation issue and the fact the IRS eliminated the C corporation's biggest tax advantage by providing other tax entities and their owners with the ability to fully deduct certain fringe benefits.

Pass Through Taxation

One of the most misunderstood areas for new business owners is the pass through taxation concept.  Essentially, the owners (instead of the business entity) pay federal income taxes on business net income. Owners receive a Form K-1 from the business that reflects their share of business income, deductions and other tax items that must be reported on their individual income tax return. Pass through taxation applies to Partnerships and S corporations

Legal Considerations

Most small business owners organize their business as a separate legal entity in order to protect personal assets and limit their liability.  It's important for these business owners to realize that the choice made for the legal structure of a business does not necessarily commit a business to a particular form of tax entity.  For example, if a business owner wants to incorporate, then the C corporation or the S corporation are possible tax entity choices.  The Limited Liability Company is a very popular legal structure in part because it can be taxed as a Sole Proprietorship, Partnership, S corporation or a C corporation depending on certain factors.

Formation Considerations

Frequently, the "business deal" will influence the choice of tax entity.  For example, multiple owner small businesses can include owners providing the initial cash to fund a business (i.e. cash equity owners) while other owners will provide services in exchange for ownership (i.e. sweat equity owners).  Further, the cash equity owners will want to be allocated all tax losses since their cash is at risk.  In this instance, a partnership may be the preferred form of tax entity because it allows (and the Internal Revenue Code typically requires) the business losses to only be allocated to the cash equity owners.  This special allocation would not be possible in a C or S corporation.  In addition, partnerships do not require income to be recognized by the sweat equity owners for so called "profits interests" issued to them in exchange for services, as would generally be required in a C or S corporation.

Operating Considerations

New business owners should look into the future to the operating phase of a business and determine how their choice of tax entity will affect their business.  For example, some small businesses anticipate incurring losses during its initial years.  The ability to deduct these losses on the owner's personal tax return could be a significant advantage, as it should provide tax relief for the owners of the business.  C corporations do not pass tax losses or other items through to owners.  However, sole proprietorships, partnerships and S corporations can provide their owners with the ability to deduct business losses on their personal tax return (limited to the owner's investment or tax basis in the business).

Termination Considerations

Business owners will eventually sell their business and the form of tax entity plays a major role in how much cash will end up in an owner's pocket.  The taxation of the sale of a business is very complex and outside the scope of this article.  However, in general, a C Corporation is the least desired tax entity because of double taxation.  All the other forms of tax entities are generally more favorable and typically provide similar tax results from the sale of a business.

Making the Decision

As one can see, deciding on the best form of tax entity for a business requires in-depth consideration.  Business owners should seek the advice of an attorney and an accountant before making this complex decision.  As previously mentioned, the stakes are very high, as an incorrect choice may prove costly.  Although changes can be made from one form of tax entity to another after the initial choice has been made, that change will require professional help and could trigger additional and unnecessary income taxes.

I look forward to answering your questions on this or any other tax topics.

Peter C. Lachance, CPA

Pete is a Tax Manager with William Steele & Associates, P.C., a firm of certified public accountants serving businesses and individuals throughout New England.  He advises the firm's clients on federal and state income tax planning, tax return preparation, estate planning and trusts.  His clients include technology, manufacturing, real estate, trust administration and professional service companies and non-profit organizations. 

Pete is currently finishing his Masters degree in Taxation from Bentley University.  He also holds an MBA from the University of Massachusetts - Lowell and a BS in Actuarial Mathematics from Worcester Polytechnic Institute.

Pete is a member of the Amoskeag Business Incubator's business support committee.  His other community activities include the Manchester YMCA Finance Committee and the Manchester Young Professional Network.  Pete is also serving as the Chairman of the New Hampshire Society of CPA's Charity Golf Tournament Committee and he is a member of the society's Young Professional Committee.

Pete can be contacted at peter@wmsteele.com or 603.610.8013.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

QUESTION: Does NH have single member LLCs? If so and you elect to be taxed as a Sole propietor- is it necessary to set up separate bank accts & an EIN for P/R tax purposes? We are a single member LLC in MA who recently moved here. We will be switching over to an NH entity in the near future. The business is set up as a Sch C with it's own EIN, bank acct, etc.  We were told by an atty it wasn't necessary to change the bank accounts, EIN, etc. and just file as a Sch C leaving the EIN the same for P/R tax, etc. I question this and want to get everything right when we switch to NH. Thanks!

QUESTION: If I sell a stock at a loss, but then repurchase it within 75 days I am not allowed to declare the loss for tax puropses. So is my cost basis for the repurchased stock what it was before the loss?

QUESTION: My company is an LLC whose model is to build and spin-out startup companies. I would like to understand the tax consequences of forming daughter companies "on day 1" vs. forming them when they're ready to be spun out.

ANSWER: Excellent question!  The answer depends on the form of tax entity of the current business.  If the daughter companies are formed on day 1 as separate entities, generally the formation of the separate entities will be tax free for all the various forms of tax entities.  One exception to this general rule occurs if liabilities exceed the adjusted tax basis of contributed assets transferred to a corporation.  In this instance, gain is triggered.  However, one disadvantage of setting up the daughter companies on Day 1 is the increased administrative costs associated with running the daughter companies. 

If the daughter companies are spun out of the current business, targeted assets (e.g. the "idea") and liabilities can be transferred from the current business to a successor entity and that transaction may trigger gain depending on the form of tax entity.  If the current business is taxed as a C or S Corporation, then the transfer of assets (and liabilities) to Newco may trigger a gain and could also trigger dividend income to the shareholders depending on the circumstances.  However, if the current business is a partnership or a sole proprietorship then the transfer will generally be tax free.

I would normally recommend the partnership or sole proprietorship form of tax entity to a company that plans on spinning out daughter companies in order to avoid taxes on the transfer of assets to the new daughter entity.

QUESTION: My home was demolished by the tornado last July.  Is there anything I can claim on my taxes this year? 

ANSWER: I am very sorry to hear about your home.  The good news is the IRS does provide tax relief for taxpayers affected by natural disasters.

A casualty loss deduction is available for the damage or destruction of property from an identifiable event that is sudden, unexpected or unusual.  The destruction of a personal residence by a tornado certainly would qualify as a casualty loss.  However there are limitations on the amount of the deduction.  In general the starting point for the deduction is the lesser of (1) a taxpayer's investment in their residence OR (2) the decrease in the fair market value of the residence as a result of the casualty event.  Then, any insurance or other reimbursements must be subtracted.  Finally, the deduction is reduced by $100 and further reduced by 10% of a taxpayer's adjusted gross income (AGI).

Furthermore, if the President of the United States designated your area as a federally declared disaster area there are several additional tax relief provisions available for both individuals and businesses.  One of the major relief provisions is the removal of the 10% of AGI limitation in the casualty loss deduction.  Also, a taxpayer can elect to take the casualty loss deduction in the year before the date of the disaster by filing an amended tax return.  You can visit the Federal Emergency Management Agency (FEMA) website at http://www.fema.gov/ to determine if your area is a federally declared disaster area.

QUESTION: I have a Delaware LLC, I do business in NH and live in NH, I get some consulting income from MA. After I do the pass through, do I have to pay MA state income tax? Also, do I have to pay any NH state income tax after the pass through? Since NH has 0% state income, that means there is no state income on my pass through LLC profit?

ANSWER: Based on your question it appears your LLC is a service business generating consulting income.  If that is the case, then the general rule is the service business LLC will be required to apportion its income among the various states in which it is doing business and the pass-through owners will be subject to tax in those states.  The authority for a state to impose a tax on business activity is conditioned on a taxpayer having "nexus" with a state. Nexus is a complex state tax concept that very simply means a business or person has reached a certain level of presence or activity within a state such that the state has the authority to impose a tax on the business activities.  A service business typically establishes nexus with a state if the services are physically performed in a state.  However, every state has different nexus rules and there may be exceptions for certain types and amount of services.  I recommend consulting with your tax advisor regarding the MA nexus rules.

Regarding your question about NH state taxes, NH does not have an individual income tax; however, business organizations (like your LLC) are subject to the state's Business Profits and Business Enterprise Tax.  In your case, the LLC could be subject to both of these business taxes.  NH allows the LLC to claim a deduction for compensation related to the value of the services preformed by its members that are individuals.  This compensation deduction could reduce or eliminate the LLC's exposure to the NH Business Profits Tax.