Forming an entity is normally a tax-free endeavor. Starting a proprietorship never has any tax consequences. However, contributing noncash assets to a corporation, a partnership, or a limited liability company may lead to a taxable transaction. The owner recognizes earned income for contributed services and may recognize a taxable gain if (1) noncash assets encumbered by debt or (2) appreciated assets are contributed and distribution is taken soon thereafter. Under certain circumstances, contributions of noncash property to a C corporation may be treated as a sale of the assets to the corporation.
Gain is recognized by the transferor (partner or shareholder) to the extent the aggregate amount of liabilities assumed by the entity exceeds the transferor’s basis in the entity.
When forming a new entity, there are several tax considerations to keep in mind. These include:
- Type of entity: The type of entity you choose, such as a sole proprietorship, partnership, limited liability company (LLC), corporation, or S corporation will determine the tax implications for the business and its owners.
- Business structure: The structure of the business will also impact tax considerations.
- Tax classification: The tax classification of the entity will determine how it is taxed. For example, an LLC can be taxed as a sole proprietorship, partnership, or corporation.
- Employee benefits: Employee benefits, such as health insurance and retirement plans, may have tax implications for the business and its employees.
- Business deductions: The types of expenses that can be deducted as business expenses can have a significant impact on the business’s taxable income.
- Depreciation: The method used to calculate the depreciation of assets can affect taxable income.
- Tax compliance: Ensuring that the business is in compliance with all federal, state, and local tax laws is important to avoid penalties and interest charges.
The income of a sole proprietorship, general partnership, limited liability partnership, limited liability company, or S corporation is taxed at the individual level. A C corporation pays tax at the corporate level.
The income and loss of a sole proprietorship are reported by the taxpayer on Schedule C of the owner’s Form 1040.
Partnerships offer the flexibility of dividing income between the partners based on a method other than the partners’ ownership interests. Limited partnerships, limited liability partnerships, and LLCs taxed as partnerships pass through taxable and deductible items to the partners. Partnership income (loss) is reported on Form 1065.
S corporations must allocate the income or loss of the entity to the owners based on their ownership percentages. Both C corporations and S corporations must make distributions based on stock ownership. Corporate income (loss) is reported on Form 1120-S for an S corporation and Form 1120 for a C corporation.
The owner’s share of business income in sole proprietorships and general partnerships is generally subject to self-employment taxes.
Limited partners are not subject to self-employment tax on partnership ordinary income, with the exception of guaranteed payments to the limited partner for services rendered. LLC members are subject to self-employment tax on their share of the ordinary income unless they are classified as limited partners.
Wages paid from a C or an S corporation to an owner/employee are subject to Social Security tax and unemployment taxes. Non-compensation distributions to shareholders from an S corporation are exempt from employment taxes. These distributions represent a significant advantage of S corporations.
Wages paid by a sole proprietorship (or a partnership where the only owners are married to each other) to the owner’s (owners’) children under age 18 are exempt from both the employer and employee portions of FICA, and wages paid to those children under 21 are exempt from FUTA.
Loss Pass-Through Implications
Losses and deductions are passed through from sole proprietorships, partnerships, and S corporations to the owners. However, the losses and deductions are limited to the owner’s basis in the entity and the owner’s at-risk basis. The passive losses are deductible up to the owner’s passive income.
Employee fringe benefits, such as accident and health insurance, are fully deductible by a C corporation and nontaxable to the owner-employee. Generally, fringe benefits paid on behalf of a partner, an S corporation shareholder, or a sole proprietor are not tax deductible at the business level, although personal deductions may be allowed. It is possible for a sole proprietor or a partnership to deduct fringe benefits paid to a spouse.
Sole proprietorships cannot be transferred. If the business is sold, the owner reports the sale as if each asset were sold.
Partners can transfer their ownership interests in the entity to other individuals or entities if approved by the other partners. Alternatively, the partnership can buy the partner’s interest in the partnership. A partner is not allowed to assign rights to specific partnership property. Thus, a partner’s individual creditors may not attach to specific partnership property. Only a claim against the entire partnership allows specific partnership property to be attached.
A corporation’s shareholders are free to transfer their ownership interests in the entity to other individuals or entities.
Simply terminating a sole proprietorship does not result in any taxable income to the owner. However, if the assets of the sole proprietorship are sold, the sale is taxable to the extent the fair market value of the assets exceeds their basis.
The termination of a partnership generally does not result in taxable gain to the partners.
The termination of an S corporation requires the shareholders to exchange stock for assets distributed by the corporation. The distribution of appreciated assets from an S corporation triggers gain recognition to the corporation. The gain flows through to the shareholder where it also increases the basis. This basis increase generally is eliminated by any subsequent gain when the shareholder surrenders the stock.
A C corporation recognizes gain on the distribution of the assets to the shareholders. In addition, the shareholders recognize gain to the extent the net value received exceeds their basis in the stock.
Estate Tax Considerations
Upon the death of an owner, there is a step-up in the basis of the ownership.
The assets of the sole proprietor receive a step-up in basis equal to the fair market value of the assets at the time of the owner’s death.
A partner’s basis in the partnership receives a step-up in basis at the time of the partner’s death. However, the partnership must make an election under Sec. 754 to increase its share of the inside basis of partnership property.
A shareholder’s basis in the stock of the corporation receives a step-up in basis at the time of the shareholder’s death. The corporation is not allowed to step up the basis of the assets.
An executor of the owner’s estate includes the fair market value of all ownership interests held upon the date of death in the owner’s gross estate. The alternate valuation date can also be used 6 months after the date of death.
Before starting a new business you need to understand and be able to answer questions about the tax implications.