Choice of business entity requires customized approach
Looking at a business, one can’t necessarily determine its tax-reporting status.
The legal status determination is often easier, as business names typically include “Inc.,” “Corp.” or “LLC.” A corporation is generally either an S corporation or C corporation for U.S. federal tax purposes. The business name does not necessarily provide any clear insight into the entity’s tax status.
The choice or type of business entity can impact both tax and legal considerations. For many businesses and its owners, the decision is driven by the desired tax results of the entity. Some consider the legal considerations and consult with legal counsel on the merits of operating in a specific business form. And in some other situations, the legal and tax items are behind a specific commercial or regulatory objective or requirement.
Earlier this month, the Joint Committee on Taxation issued a report on business entities and tax reporting. The JCT is a committee authorized under the Internal Revenue Code and consisting of members of the House of Representatives and the U.S. Senate. It has certain duties assigned to it. The staff provides periodic reports on various topics.
The latest JCT report, Choice of Business Entity: Present Law And Data Relating to C Corporations, Partnerships and S Corporations, utilizes IRS tax return data in its report. The data provides a historical snapshot of the use of business entities by U.S. taxpayers.
A business can generally operate as a sole proprietorship, a partnership, S corporation or C corporation for U.S. federal income tax purposes. Many sole proprietorships and partnerships have been organized as limited liability companies, or LLCs, for legal and liability purposes. Other than C corporations, the business results of these business forms typically result in the owner paying income tax on the business profits on the owners’ tax returns.
This is contrasted by C corporations that pay federal income tax at the entity level. C corporation owners pay tax on any distributed profits (dividends) of the C Corporation. This results in what is often referred to as the “double tax” in operating as a C corporation. This double tax impact was mitigated in 2003, in some part, with the enactment of the qualified dividend income rules, which provide a lower rate of tax on qualified dividend income. Since 2003, the rate of tax on qualified dividend income is linked to the long-term capital gains tax rate.
There are a significant number of businesses operating in the U.S. The JCT report indicates that, based on 2012 tax return data, 23.5 million of the 34.6 million business returns were filed as sole proprietorships. Additionally, 4.2 million S corporation returns, 3.4 million partnership returns and 1.8 million farm returns were filed in 2012. By comparison, 1.6 million C corporation returns were filed in 2012.
This has changed significantly since 1986. The number of S corporation and partnership filers in 1986 was approximately the same (in total) as the number of C corporation filers: 2.6 million C corporation filers and 2.6 million combined S corporation and partnership filers.
It is pretty clear the trend of the type of business entities used since 1986 has favored pass-through entities rather than C corporations.
A number of reasons are attributable to the change to pass-through entities over the past 25 or 30 years. These reasons are noted in some respects in the JCT report.
The Tax Reform Act of 1986 reduced both individual (and corporate) federal tax rates. Changes in S corporation rules in the 1980s and 1990s made the use of S corporations more attractive to business owners. The introduction of the entity classification regulations (or “check the box” rules) in 1996 allowed taxpayers to elect the U.S. tax status for certain business entities. Also, the introduction of LLCs in most states in the late 1980s and early 1990s also has impacted the choice of a pass-through business entity rather than a C corporation structure.
The LLC impact can be demonstrated in the proportion of partnership returns that are general or limited partnerships and those that operate as LLCs. In 1993, only 17,000 out of more than 1.4 million partnership tax returns were LLCs. In 2012, the number of LLC returns increased to 2.2 million returns out of the 3.4 million partnership tax returns filed with the IRS. Many sole proprietorship also operate in LLC form.
The decline in the proportion of business entities operating as C corporations as well as the absolute number of entities operating as C corporations also has impacted corporation income tax receipts to the federal government.
We often hear reports or statements that corporate tax receipts as a percentage of GDP has declined over the years. Pass-through taxation has impacted this in some part. The JCT report indicates business entities operating as pass-through entities now (in 2012) account for 46 percent of the total business income reported in the U.S. That means nearly $1 trillion of business income is not subject to federal corporate income tax. This has an impact of federal corporate income tax receipts at the U.S. Treasury.
State taxation may also impact business entity selection decisions. Some states tax the entity on its income regardless of its federal tax status. Other states only assess income tax on C corporations and provide for the owners of pass-through entities to be taxed on their individual state tax returns. Michigan’s recent changes in its corporate income tax took this into consideration.
The choice of business entity shouldn’t be solely based on tax considerations. There are commercial, legal liability, state law and regulatory considerations that also need to be taken into account. Exit considerations may also impact the entity choice.
Engaging in discussions with legal counsel and other professional advisers should be done whenever evaluating the choice of a particular business entity. There typically isn’t a cookie-cutter approach. Most situations require a customized approach, taking into account a number of factors or considerations. Taking some time upfront will likely avoid issues later on with a particular choice of business entity.
Bill Roth is a tax partner with BDO USA LLP. The views expressed are those of the author and not necessarily of BDO. The comments are not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult their professional advisers before acting on any items discussed herein.