Business circumstances may also raise important tax issues that could justify a change of entity. The following are among the situations that might trigger an evaluation of the pros and cons of changing entity:
- Your business’s profits are growing substantially, or conversely, your business is experiencing substantial losses
- You or one of your fellow owners has experienced a major change in personal income, either favorable or unfavorable
- You, and perhaps other owners, plan to contribute substantial property to the business
- Your business is instituting or expanding a fringe benefit program
- Your business is preparing to liquidate
Typically, these issues will most affect the owner of a C corporation because C corporations face double taxation (tax at the entity level and at the owner level), while other forms of business entity face taxation strictly at the owner level. Not only are C corporations subject to double taxation, but corporate tax rates differ from individual tax rates. However, most corporation shareholder-owners receive fringe benefits tax free, while partners, LLC members, and 2 percent S corporation shareholders may pay taxes on their fringe benefits.
Note: Several pieces of legislation have mitigated at least some of the double taxation burden of a C corporation. These laws provide that dividends received by an individual shareholder from domestic corporations (and qualified foreign corporations) are taxed at lower long-term capital gains tax rates. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Capital gains and qualified dividends are generally taxed at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the 25% to 35% tax brackets. However, starting in 2013, dividends and capital gains are generally taxed at 20% for taxpayers in the new 39.6% tax bracket for high-income taxpayers. Also, as a result of the Affordable Care Act of 2010, beginning in 2013, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.
Further Considerations for Partnerships and LLCs that are Taxed as Partnerships
In addition to the preceding list of events that might suggest a change in corporate entity, there are additional considerations if you own a partnership or LLC that is taxed as a partnership:
Partners, LLC members, and S corporation shareholders can deduct business losses from their taxable income. Since partnerships, LLCs, and S corporations are generally treated as pass-through entities (unlike C corporations) and business profits are personal income to their owners, they can also deduct business losses from their individual income, subject to limitations in the tax code.
Only partners and LLC members can specially allocate deductions so that owners in the highest tax bracket can take disproportionately higher deductions.
Example(s): Liz is a 25 percent general partner, and the partnership agreement allocates 50 percent of all losses to her so as to save her some money in taxes. The partnership has had $50,000 in losses this year alone. Liz can deduct 50 percent of this $50,000 ($25,000) on her personal tax return. If, instead, Liz were an S corporation shareholder, her deduction would be limited to her percentage of ownership in the corporation (25 percent).
Caution: The IRS may question a disproportionate allocation of losses to one or a few partners, particularly if you can’t show a business rationale for doing so. Loss allocations must also have substantial economic effect or they will not be respected for tax purposes.
Partners and LLC members can increase the tax basis for their ownership interests by their share of any entity recourse liabilities (liabilities for which the partner or member bears an economic risk of loss). In addition, to the extent that no partner or member bears an economic risk of loss for a liability (called a nonrecourse liability), the liability is generally allocated to all partners or members in the same proportion as they share profits. The more basis is increased, the more losses that can be deducted. (While basis may increase with increased liabilities allowing more losses to be deducted, basis will be subsequently reduced as liabilities are paid down or when the business is sold and the liabilities are paid off.)
Example(s): Ken paid $1,000 for his 50 percent general partnership interest. Thus, Ken’s basis in the partnership is $1,000. Subsequently, the partnership borrows $20,000 from a third party. Ken, who assumes partnership liabilities in proportion to his ownership interest, now has a basis of $11,000 ($1,000 + $20,000/2).
Partners and LLC members can more easily contribute appreciated property to their businesses tax free. You can contribute property to an LLC, for instance, in exchange for an ownership interest. Such a contribution is tax free even if the property has appreciated in value since you first purchased it. An example of such a transfer is when a member exchanges an office building she owns—for use by the LLC—for an ownership interest in the LLC. However, there may be later consequences for a partner or member who contributes appreciated property, including possible recognition of gain. Note that it is also possible for shareholders to contribute appreciated property tax free to corporations, but such arrangements are subject to strict limitations.
If you have questions,contact the Experts at Henssler Financial: experts@henssler.com or 770-429-9166.
Disclosures
The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
