In each issue of the BAHV Newsletter, Thomas S. Tripodianos, Esq. provides our members with answers to their commercial litigation, real estate and construction law questions.
William A. Brenner, CPA provides members with information on a variety of business management, profitability and tax topics, intended to increase member awareness and stimulate thought about issues that can greatly affect profitability, business growth and quality of life.
Both Tom and Bill have often given the advice that no one professional can properly satisfy all your needs. Rather, a "Management Team" should be assembled to address the multitude of issues facing your business. At a minimum your team should consist of an attorney, accountant, and insurance professional.
In this special joint installment of their columns Bill and Tom explore the pros and cons of the various organizational forms available to business owners.
Tax Implications – Pass Through vs. Double Taxation
It is important to consider the legal attributes when choosing an entity type for your business, but careful consideration should also be given to the income tax implications. Here are the basic tax related characteristics of the various entities.
Sole Proprietorship. From a tax perspective this is the simplest form of business entity. All income, deduction, gain or loss is reported on Schedule C the individual’s personal tax return. The one downside, however, is that net profits are subject to self employment tax, which is typically 15.3% of net income, in addition to federal and state income tax.
Partnerships in General. There are several types of partnerships, all of which share many of the same tax attributes. Partnerships are pass through entities for tax purposes. This means that any income, deduction, gain or loss from partnership activities is passed through to the individual partners, who typically report it on Schedule E of their personal returns. The partnership itself files an informational return with the IRS and state to report basic partner information.
With pass through entities, the distributive share of partnership taxable income is taxed at the partner level regardless or whether or not any actual cash distributions are made to the partners. Depending on the partnership it is possible to pay tax on income that you have not yet received. This is called phantom income, and partnership managers generally try to distribute enough cash to at least cover the partner’s tax on reported taxable income. The great thing about partnerships from a tax perspective is their flexibility. Partnerships can allocate income, deduction, gain or loss to each partner in any amounts, regardless of each partner’s ownership percentage. This also applies to cash distributions. It is important to have a written operating agreement that allows these types of specific allocations. This is an important consideration where partners do not generate equal amounts of partnership profits and want to allocate income and distributions fairly.
There are two basic types of income passed through to partners – guaranteed payments and ordinary income. Guaranteed payments are payments made to partners without regard to profitability, and are similar to an employee’s salary. Ordinary income is the net profit of the partnership (after deducting the guaranteed payments), which is allocated to each partner. Generally speaking, both ordinary income and guaranteed payments are subject to self employment tax.
Another important tax consideration for partnerships is that the contribution of cash or property to the partnership in return for an ownership interest is not a taxable event. The same holds true for distributions of partnership property to partners in liquidation of the partnership. This is not the case with corporations.
The “basis” and “at-risk” rules that apply to pass through entities are complicated, and you should discuss their implications with your tax advisor. For the purposes of this discussion, having “basis” in the partnership allows you to receive an allocation of partnership losses. Once you have passed the basis hurdle, you must be “at-risk” to deduct the losses allocated to you on your personal tax return. If you don’t have basis or are not at-risk, the losses are not lost, just carried to future years.
The following are specific tax attributes associated with each type of partnership that we have discussed, in addition to the basics described above:
* General Partnership. Typically all income
is subject to self employment tax. Since each partner is liable for the
partnership debts, their allocable share of partnership liabilities
increases their basis for allowing the allocation of partnership losses.
* Limited Partnership. The general partner’s distributive share of income is typically subject to self employment tax. Guaranteed payments to Limited Partners are subject to self employment tax, while their distributive shares of ordinary income are generally not. Limited Partners do not have basis in their allocable shares of partnership liabilities because they are not liable for partnership debt. The most they can lose is their investment in the partnership. However, the general partner is liable for the partnership debt, which does give the general partner basis for the allocation of partnership losses.
* Limited Liability Companies and Limited Liability Partnerships. All income and guaranteed payments allocated to each member or partner is generally subject to self employment income. Members and partners typically have no exposure for LLC or LLP liabilities. As such they have no basis in their allocable share of these liabilities. However, if any member or partner personally guarantees debt of the LLC or LLP, they have basis and are at-risk to the extent of the guarantee.
* Now, let’s look at the two types of corporations and how their owners are treated from a tax perspective.
C Corporations. Shareholders of C corporations who participate in the day to day operations generally receive their compensation through payroll. Like any other employee, wages are reported on their individual income tax returns. C Corporations are not pass through entities. Therefore, any net income is taxed at corporate rates, which can near 50%, federal, state, and city combined, making good tax planning crucial. For this reason, many C corporations try to eliminate net profits by paying bonuses to their shareholders at year end through payroll. In the event that a corporation has net income, and pays tax on it, the accumulated profits can be distributed at a later date to shareholders in the form of dividends. Unfortunately these dividend distributions are taxable to the shareholder at the 15% qualified dividend tax rate.
S Corporations. If a C corporation meets certain criteria, it can make federal and state elections to be treated as an S corporation. S corporations are pass through entities, just like partnerships. Income, deductions, gain or loss are passed through to the individual shareholders and then taxed on their individual tax returns. The main difference between an S corporation and a partnership with respect to the allocation of income is that while there is flexibility with partnerships, corporate income or loss must be allocated prorata based on share ownership. The same holds true for cash distributions. As with other pass through entities, owners are taxed on income even if no cash is actually distributed. The major difference is that income passed through from an S corporation to a shareholder is not subject to self employment tax. To make sure that shareholders pay their fair share of social security and Medicare taxes (the self employment tax), the IRS requires shareholders to receive reasonable compensation in the form of salary. With a few exceptions, S corporations pay no federal corporate tax and typically pay a small minimum state and or city tax.
For basis purposes, shareholders of S corporations must consider their original investment, plus their share of cumulative corporate earnings and additional investments, less their share of cumulative corporate losses and distributions. Additionally, any amounts loaned to the corporation directly by the shareholder can be considered basis for allowing the deduction of pass through losses on the shareholder’s individual tax return.
In most cases, contributions of cash or property to a corporation in exchange for stock can be structured in a tax fee manner. However, the distribution of corporate assets to shareholders in liquidation of their interests is a taxable event. For example, if a corporation distributes equipment to a shareholder in liquidation, it is treated as if the equipment was sold for fair market value by the corporation. The equipment is distributed to the shareholder, along with the income from the deemed sale. This can become a big issue if the corporate assets have appreciated over time, which can result in large amounts of income on distribution, with no actual cash to go along with it.
With the wide variety of entity choices as well as legal and tax consequences, we strongly recommend that you consult with your “management team” to make sure you have the information needed to make the right choice.
If you would like more information regarding this topic, please contact Thomas S. Tripodianos at TTripodianos@wbgllp.com, or by phone at 845-294-5500 x 317. Bill Brenner can be reached at , or by phone at 914-949-2990 x 313.
Please understand that this column provides general information only, and should not be construed as legal or tax advice to anyone under any circumstances. While we encourage you to contact us, you should not disclose to us any information that you consider confidential unless and until we have formally established an attorney-client or accountant-client relationship, and agreed to represent you in your particular matter. The opinions expressed in this column are of the individual authors, and not necessarily those of the Builder’s Association of the Hudson Valley.
Thomas S. Tripodianos is a partner at the law firm of Welby, Brady & Greenblatt, LLP. Welby, Brady & Greenblatt, LLP emphasizes the practice of Construction Law, representing general contractors, subcontractors, sureties, developers, owners, suppliers, engineers, homeowners and other entities connected with the construction industry in transactions, litigation, arbitration, mediation, public and private construction contracts, mechanic's liens, surety law and environmental law. Welby, Brady & Greenblatt, LLP has its principal office in White Plains, New York, and also has offices in New Jersey and Connecticut. Mr. Tripodianos resides in Orange County.
Bill Brenner is a manager at the accounting and consulting firm of Citrin Cooperman & Company, LLP. Ranked among the top 40 accounting firms in the U.S., Citrin Cooperman provides business consulting, tax and accounting services to business owners in the Tri-state area and Hudson Valley. The Firm has offices in White Plains, mid-town Manhattan, and Springfield, New Jersey.