By Zoel W. Daughtrey and Frank M. Messina
Accountants are constantly bombarded with questions concerning entity choice. Should a company incorporate? If so, should it remain a C corporation or elect S status? Remain unincorporated and simply elect status under the “check the box” procedures? File a certification of organization with the state and form a limited liability company (LLC)? Many factors must be considered in solving the entity choice dilemma.
Federal tax law does not recognize LLCs as separate tax entities and, therefore, they must fall into one of the two recognized tax categories: partnership or corporation. In fact, the “check the box” regulation, IRC section 301.7701-3(b)(1)(I), notes that an unincorporated organization with two or more owners is classified as a partnership by default. An unincorporated group could elect out of the default status and be treated as a C corporation by filing Form 8832. If the group then wished to be an S corporation, it could formally incorporate and file Form 2553 to elect S status. In addition, it should be noted that a single-member LLC is treated as a sole proprietorship for federal tax purposes and would report business results on Form 1040, Schedule C.
No single entity is perfect for all companies, but CPAs should understand the basic effects of certain transactions on the various entity types and owners. The following transactions can result in different—and potentially troublesome—tax consequences, depending on the entity.
Abe and Bill own a calendar-year, accrual-based manufacturing enterprise. They wish to contribute their product (fair market value: $20,000, basis: $8,000) to a qualified charity.
C corporation. Assuming the corporation makes a timely payment and the property is qualified, the charitable deduction is limited to 10% of taxable income before the dividends-received deduction, loss carrybacks, and charitable contribution [IRC section 170(b)(2)]. In an accrual-based C corporation, a deduction of $8,000 would be allowed even if the contribution was not yet made (it must be accrued by year-end and made on or before the initial due date of the return). Fair market value would only come into consideration if the property was contributed to an organization for the care of the needy, the ill, or infants or consisted of computers and related equipment contributed to a school, grades K–12.
S corporation. The deduction for the contribution will pass through to the shareholders, Abe and Bill, at basis ($8,000) in the year the contribution is actually made and would reduce each shareholder’s basis in stock in an amount equal to the shareholder’s allocable share of the deduction.
LLC. The rules are essentially the same as the S corporation: The contribution deduction will pass through to the partners, Abe and Bill, at basis in the year the contribution is actually made. The amount allocated to each partner would be determined according to the partnership agreement.
Change in Income Allocation
Cindy, David, and Ernie—equal owners of a business—wish to change the allocation of income to each of the owners.
C corporation. Income is determined at the corporate level and allocation to shareholders is based on dividend distribution in accordance with ownership shares. If all the partners work in the business, income reallocations could be accomplished through salary, bonus, or other special compensation agreements.
S corporation. Weighted average share ownership determines ownership allocation, unless there is a change in share ownership during the year. Special compensation agreements, such as bonuses and salaries, could be used; otherwise, it is impossible to change income allocation.
LLC. A guaranteed payment could be used, or the partnership agreement could be changed if it meets the IRS “substantial economic effect” test [Regulations section 1.704-1(b)(2)(ii)(a)]. LLCs provide the most flexible structure to accommodate desired changes in income allocation.
Frank and Garrett are equal owners of a business venture with a six-figure taxable income. They desire that the business make contributions to a qualified retirement plan.
C corporation. The corporation could easily establish 1) a qualified defined contribution pension plan that would contribute up to 25% of compensation to each owner, generally not to exceed the yearly limit allowed by tax law for the plan (currently $30,000), or 2) a defined benefit plan that might increase the annual limit.
S corporation. The S corporation can provide the same plans as a C corporation, assuming that income is distributed as salary payments.
LLC. The LLC is not allowed to maintain a pension plan itself, but it could establish a Keogh plan for the owners, who would then be treated as partners. Twenty percent of each “partner’s” self-employment income could be contributed, up to $30,000. The partners would claim the resulting deduction on their individual Form 1040s.
Hillary and Isabel wish to have their business pay their health insurance premiums.
C corporation. Health insurance premiums that qualify as nondiscriminatory are considered ordinary, necessary, and reasonable expenses for a corporation and are deductible and excludible from gross income for shareholders.
S corporation. The S corporation can pay premiums for shareholders, which must include the amount in gross income. For practical purposes, the premium cost should be recorded as noncash compensation on the shareholder’s W-2 so that the shareholder can qualify for the partial self-employed health insurance deduction on Form 1040 and can also avoid FICA tax on the amount of the premiums.
LLC. The LLC would be allowed a deduction, but would have to treat the premium cost as “guaranteed payments” to Hillary and Isabel, which would be considered taxable self-employment income. The partners would be entitled to the self-employment health insurance deduction of 60% on Form 1040 and the remaining 40% would qualify as itemized deduction medical premiums, subject to the 7.5% of adjusted gross income limitation (2000).
Passive Activity Income
June, Kelly, and Leon own equal stakes in a business where the vast majority of the income is generated by security investment activities.
C corporation. Given the substantial amount of income from investment activities, the corporation (if it meets both the income and ownership tests) will be considered a personal holding company (PHC). The C corporation would then be subject to an additional tax on the undistributed PHC income at a rate of 39.6%.
S corporation. The S corporation status should present no problem to June, Kelly, and Leon; passive income would simply flow through to the shareholders. However, if the S corporation was formerly a C corporation that had accumulated earnings and profits, passive income must not exceed 25% of gross receipts. The corporation (not shareholders) would have to pay a 35% tax on excess passive income. If passive income exceeds 25% of gross receipts for three consecutive years, the corporation could lose its S election status.
LLC. Based on the partnership agreement, the income will pass through to the partners. There are no PHC problems associated with partnerships.
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner
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