Corporate tax in the United States is a tax on the taxable income of a C corporation or an entity taxed as a C corporation. The corporate tax is the default tax levied on a business entity unless the entity qualifies to be taxed under different tax rules such as those for non-profit organizations and S corporations. The corporation is taxed under 26 U.S.C. § 11 and Subchapter C (26 U.S.C. § 301 et seq.) of Chapter 1 of the Internal Revenue Code.
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ALTERNATIVE BUSINESS ORGANIZATIONS - TAX DIFFERENCES
Business forms include corporations, partnerships, LLCs, Trusts and Proprietorships. Corporations can be business corporations, whether a C corporation or an S corporation. Corporations can also be non-profits, associations, cooperatives and foreign entities. Partnerships can be general (GP), limited (LP), limited liability (LLP), and limited liability limited (LLLPs). Trusts can be business and investment or personal and family trusts.
For purposes of comparing tax differences across the entities, only C corporations, S corporations, sole proprietors, partnership and LLCs are contemplated below. Only tax considerations are compared. Unless otherwise indicated, it is also presumed that an LLC has two members and is classified in default classification as a partnership for tax purposes.
1. Double Tax. The most important distinction amongst the entities is that C Corporations are subject to a double tax regime whereby the corporation is taxed on net income, and any funds that are distributed to shareholders from earnings and profits are taxed again as dividends. Assuming net profits of $10 million, and a federal tax rate of 35% and California tax rate of 9%, the effective tax to the corporation would be $4.4 million. Assuming the $5.6 million is then distributed as a dividend (out of earnings and profits), it would be subject to 15% federal tax and 9% California tax, or an additional tax of $1.34 million. The effect of the double tax is an effective tax rate of 57.4% resulting in total tax of $5.74 million. A pass through structure in such instance could result in tax avoidance of more than $1 million in savings.
2. Ownership Numbers. Sole proprietors can only have one owner, while partnerships need at least two. C corporations, S corporations and LLCs each can have only one owner. Except for S corporations (100 owners presently and 75 owners for those prior to 2005) and sole proprietorships (one owner), the other entities have no maximum limit on the number of owners. For purposes of calculating 100 owners for S corporations, husband and wife (and their revocable trusts) are treated as one shareholder, and families making an election can be treated as one shareholder as long as they are lineal descendants of common ancestor (6 generations removed from youngest generation) or a spouse thereof. §1361(c)(1).
3. Types of Owners. Except for S corporations and sole proprietorships, the other entities have no limit on the type of owners. Only US taxed individuals, certain trusts and certain tax-exempt organizations are eligible owners of S corporations (non-resident foreigners are not eligible). A corporation cannot have an ownership interest in an S corporation unless the holder of the ownership interest is also an S corporation and holds all (100%) of the available ownership interest. A sole proprietor must be owned by an individual.
4. Equity Structure. Except for S corporations and sole proprietorships, the other entities have no limit on the equity structure. A sole proprietorship does not have stock, while an S corporation is only permitted to have one class of stock, although it can have voting and non-voting stock.
5. Debt Structure. Except for S corporations, the other entities have no limit on the capital structure. A sole proprietorship does not have stock. Because an S Corporation is only permitted to have one class of equity stock (which can be voting and non-voting stock), certain debt can be problematic. In particular, unavailable to an S corporation is debt that could be structured in such a manner to be a second class of stock. The IRC provides a safe harbor rule for straight debt to S corporations. The rule requires an interest rate not contingent on profits, no convertibility of stock, and the lender is a person which is actively and regularly engaged in the business of lending, although such lender should not be a non-resident alien or ineligible trust.
6. S Election. In order to be treated as an S corporation, a corporation must complete and file Form 2553 by the 15th day of the third month of the initial taxable year or each fiscal year thereafter. If the election is late, it will apply to the following tax year unless the IRS determines that there was reasonable cause for the failure to timely make the election. While all of the owners must consent to the election, only ½ of the owners have to consent to the revocation. Note however that any shareholder can take action to cause the termination of the S election (e.g., they could transfer any of their shares), and care should be taken to subject the shares to restrictions.
7. Check the Box. Effective as of January 1, 1997, the IRS promulgated the "Check the Box" regulations. Prior to these regulations, the IRS would analyze factors of ownership (limited liability, centralization of management, continuity of interest and transferability of interest) in order to determine how to classify the entity for tax purposes. The Check the Box regulations simplified the process by creating a default classification with certain entities having the ability to elect into other tax classifications. For example, an LLC has a default classification of either a sole proprietorship or partnership depending on whether there are one or more owners. If the owner of the LLC is a husband and wife, they are considered one taxpayer (and cannot be a partnership) unless they are married and filing separately. An LLC can elect on Form 8832 to be treated as a corporation. The LLC can then file Form 2553 to elect to treat the LLC as an S corporation. This is done by some practitioners to reduce the FICA or self employment tax that would otherwise be payable on all amounts earned through an LLC classified as partnership or sole proprietorship. In California, an S corporation is subject to a 1.5% gross proceeds tax, which varies from the LLC gross proceeds staggered tax regime. In certain instances, an S corporation is not desired since negative tax consequences that can result that otherwise could be avoided. See Paragraphs 16 and 21 below. In that regard, efforts to save thousands of dollars in employment taxes could result in a painful price later if a distribution of appreciated property occurs in the future.
8. Tax Year. Any tax year is permitted for a C corporation, except for personal service corporations. Sole proprietorships are calendar years. Generally, all other entities (including S corporations) have calendar years. In certain instances, the taxpayer can justify a different tax year by establishing a business purpose to the IRS's satisfaction. Typically, the business purpose needs to indicate that a variance from a calendar year is appropriate (e.g., substantially all of the revenues come in by the close of a particular month as a result of seasonality in the business industry).
9. California Franchise Tax. All entities, other than sole proprietorship and general partnerships have to pay a minimum $800 franchise tax in California.
10. Other Tax Elections. With the exception of sole proprietorships, all tax elections are made at the entity level. However, with respect to S corporations, any shareholder can take action (if not otherwise restricted) that could jeopardize S status.
11. Pass Through of Income. Except with C corporations, all federal taxes are paid by the owners. Despite pass through treatment, LLCs and S corporations have entity level tax in California.
12. Net Operating Losses ("NOLs"). Except with C corporations, net operating losses flow-through to owners, although subject to passive activity loss limitations. The losses are also limited to the extent of the tax basis of owners, which is adjusted differently for owners of S corporations versus partnerships. Recourse liabilities of a partner in a partnership increase the basis of that partner and can result in freeing up losses. With S corporations, the only permitted recourse liability that adjusts the basis is a direct liability from the corporation to such shareholder. With C corporations, NOLs carry back two years and forward 20 years.
13. Allocations. Allocations are only relevant to entities classified as a partnership. Allocations must have substantial economic effect. Allocations are usually determined by the interest in the partnership unless the partnership agreement provides otherwise or if the allocation does not have substantial economic effect. § 704(b). Special allocations are any allocations that are not made in accordance with the interest in the partnership. Special allocations must have substantial economic effect to be respected by the IRS. § 704(b)(2). The substantial economic effect doctrine most often becomes relevant when a member's percentage interest in the LLC varies from the capital account balances. The most important special allocations that should be provided for in the operating agreement are (1) qualified income offset special allocation provision (QIO), (2) non-recourse liability minimum gain special allocation, and (3) minimum gain chargeback special allocation.
a. Objective Testing of Allocations. The "economic effect" test is an objective test measured by: (1) maintaining capital accounts in accordance with regulations (book-tax disparity since track FMV of contributed property at time of contribution but use book value for inside basis); (2) making liquidating distributions (including withdrawals) in accordance with the capital accounts, and (3) including an unconditional make-up of any deficit capital accounts. Because most persons are unwilling to agree to an unlimited restoration provision for deficit capital accounts, most operating agreements (other than general partnership agreement) will fail this economic effects test.
Recognizing this practicality, IRC regulations provide an "alternative" economic effect test, which is generally the same as the economic test but the third requirement of an unlimited deficit capital account restoration obligation is replaced with a qualified income offset (QIO) provision. The QIO requires a special allocation of income to reduce a deficit capital account.
The alternative test changes if the item to be allocated relates to a non-recourse liability. Recourse liability is a liability for which a member is individually liable and not sheltered by the LLC company shield, and must therefore be allocated to the members individually responsible. On the other hand, non-recourse liabilities (such as trade debt and deferred revenues) are not allocable to a particular member and can result in allocations of deductions to members that can result in a deficit capital account. If the LLC were to engage in transactions that can result in forgiveness of these non-recourse liabilities, the debt forgiveness can then trigger income. Because the IRC regulations allocate non-recourse liabilities but not the debt forgiveness, the gap creates odd results that can create allocations that do not have an economic effect. In order to address this issue, the drafter should include a standard special allocation concerning charging back this minimum gain. In other words, any debt forgiveness will be allocated to the members to whom non-recourse liabilities were previously allocated.
The allocations can get more complicated if the forgiveness of non-recourse liability overlaps with § 704(c) property or property that was contributed with built-in gain or loss. When this occurs, the accounting has to work through ordering rules to determine which allocations occur first, those relating to special allocation for minimum gain for non-recourse liabilities and, next for § 704(c) minimum gain.
If allocations fail the economic effect and alternative test, the IRC regulations have a third objective test where the allocations are tested for their economic equivalence to properly accounted allocations. This test simply analyzes whether the allocations match up to where they should have been allocated.
b. Substantiality Requirement. Special allocations must have "substantiality." Suspect allocations appear to be transitory (over more than one year) or shifting (over the same year) if the tax attributes have been put to use by those who have better use for them (e.g., available income to offset losses when allocated losses). Although the allocation must affect the dollar amounts to be received by the members or partners, the dollar effect test is trumped by the overall tax effect of the special allocation. Partnership accounting is tasked with contemplating whether or not the allocation would have result in a different capital account balance if not made, and whether it had an overall tax impact of reducing the collective tax liability of the member impacted.
14. Reasonable Compensation. In the context of C corporations, there is tendency to increase compensation to avoid the double tax that otherwise applies. On the other hand, with S corporations there is a tendency to decrease compensation to minimize employment related taxes. In the context of partnerships, compensation is referred to as guaranteed payments.
15. Distributions of Cash. For C corporations, distributions of cash from earnings and profits are considered a dividend and subject to tax. To the extent that there are no earnings and profits, the amount is considered a return of capital. Any excess amount thereafter is given capital gain treatment. The distribution of cash by a C corporation is not deductible to the corporation. A distribution of cash to a sole proprietorship has no significance. A distribution of cash reduces the basis of owners for other entities, and reduces the recipient's capital account balance.
16. Distributions of Property. For all corporations (including LLCs taxed as an S Corporation), distributions of property that has appreciated results in a taxable event whereby the corporation recognizes the transaction and recaptures any applicable deprecation. With respect to the recipient shareholder, the receipt of property is treated in the same manner as cash. A distribution of property in a sole proprietorship has no tax significance. A distribution of property to owners in partnerships will not result in tax consequences unless the assets are "hot assets" under § 751 (e.g., unrealized receivables, inventory items, etc.).
17. Partial Redemptions. A partial redemption of a shareholder's position in a C corporation results in a complicated analysis concerning whether or not the redemption should be treated as dividend. This issue does not arise with other entities.
18. Complete Redemptions. In the case of corporations and partnerships, complete redemptions generally receive capital gain treatment (with basis recovery), although in the context of partnership there may be ordinary income with respect to "hot assets" or other "guaranteed payments." It is not possible to redeem out an owner of a sole proprietorship, and that transaction would be characterized as a sale of each asset.
19. Contribution of Property. Unless qualified as an § 351 contribution (by a controlled party with 80% ownership interest), then the contribution of property to a corporation is a recognizable transaction. On the other hand, no gain or loss is recognized for a contribution of property to a partnership, although the built-in gain or loss needs to be tracked for seven years, and if a recognizable event occurs with respect to such property within those seven years, the gain or loss attributable at the time of contribution needs to be allocated to such contributing party. The partnership takes a carry-over basis in the property contributed.
20. Contribution of Services. The contribution of services in exchange for ownership is subject to tax, unless they are otherwise subject to a risk of forfeiture. § 83. (Consider availability of 83(b) election.) § 351 expressly excludes stock in exchange for services from non-recognition.
21. Liquidation. With all corporations, all appreciated property is subject to tax at the corporate level upon liquidation. The recipient receives the property as if an exchange for property. On the other hand, the liquidation of a partnership is generally not a taxable event. The basis in the partnership interest substitutes for the partners' basis in the property received, adjusted for any monies received.
22. Reorganizations. For non-recognition of reorganization involving corporations, the transaction must qualify as a reorganization under § 368 or qualify as a § 351 transaction. Mergers and combinations of partnerships generally do not result in taxable event. The combination of partnerships with corporations requires a closer analysis.
23. NOL Limitations. Corporations are subject to NOL limitations in connection with reorganizations. § 382. Partnerships are not subject to these limitations.
© 2008 Jay Bettinger, Esq. All Rights Reserved.
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