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How Tax Planning Software Can Help You Select the Right Entity for Your Clients

Sole proprietorships, corporations, and partnerships all have different tax consequences. Do your clients understand the differences?

Entity selection is one of the most important decisions your clients will make. And even though business owners make their entity selections for legal reasons – to limit liability, to have certain ownership options, or something else – they need to understand how their selections will impact their tax positions. If you discuss business structure with your clients, here are a few talking points to consider.

Business Entities are Legal Definitions First and Foremost

Forming a business entity is a legal action taken by a new business owner. Corporations, limited liability companies, partnerships, and sole proprietorships are common entity types to choose from, although there are additional entity structures that vary by state like professional associations or limited liability professional corporations. In the following categories, we can draw comparisons between the main types of entities you are likely to encounter as an advisor: sole proprietorships, partnerships, LLCs, and corporations.

Liability

Liability is often the most pressing matter for new business owners, and for good reason. Sole proprietorships and general partnerships do not limit business owners’ liabilities, which means owners are personally responsible for all business debts. Limited partnerships limit owners’ personal liabilities, but only for partners not participating in management decisions. LLCs and corporations provide the most protection by protecting owners’ personal assets from business debts beyond what they personally invested into the business.

Ownership Options

Sole proprietorships can only be owned by one individual. Partnerships must have at least two partners but can have no more than 50. LLCs and corporations can be owned by any number of individuals.

Duration of Existence

When the owner of a sole proprietorship dies, the business is dissolved. The same rule applies when one or more partners in a partnership die unless a specific clause is written into the partnership agreement. Limited partnerships, corporations, and LLCs (in most states) exist in perpetuity.

Ability to Raise Capital

Sole proprietorships and partnerships almost always get their initial capital investments from the owners. Partnerships may be able to sell partnership interest in exchange for capital, but only if the partnership agreement explicitly allows for it. Similarly, LLCs can sell ownership interest in exchange for capital if the operating agreement allows for it. Corporations have the simplest time raising capital; they only need to sell outstanding shares or issue new ones.

Formation Documents

Sole proprietorships and partnerships do not need to file any formation documents with the state. In contrast, both LLCs and corporations are required to register with the Secretary of State and file annual informational returns. But there are other formation documents businesses should consider. Partnerships, for example, should draft a partnership agreement that outlines responsibilities and expectations of the partners. Corporations and LLCs file similar documents; corporations call them “shareholder agreements” and LLCs call them “operating agreements.”

Legal Entities are Different Than Tax Entities

A business’s choice of legal entity will influence how it is taxed. The IRS taxes most businesses in one of the following three ways.

  • They can be taxed as disregarded entities. This is when business income gets reported directly on an individual’s tax return.
  • They can be taxed as flow-through entities like partnerships and S corporations. This is where business revenues are reported on separate informational tax returns, and the specific tax attributes flow down to the tax returns of the individual owners. The individual owners are responsible for paying the associated taxes.
  • They can be taxed as C corporations. C corporations are entities separate from their owners, which means the entity files its own return and pays its own tax.

Each legal business entity is taxed one of these three ways by default, but they can often elect to be taxed differently. For example, just as our tax planning software shows, a multi-member LLC will be taxed as a partnership by default, but the LLC members can elect for their business to be taxed as a C corporation by filing Form 8832, or as an S corporation by filing both Form 8832 and Form 2553.

*Source

This means that selecting a legal entity is only part of the business formation process. Once legal entity is determined, your clients must decide how they want to be taxed.

Tax Structures Determine Tax Outcomes

A business owner’s tax position is highly dependent on their entity classification. Consider the following:

Double Taxation

C corporations are the only tax entity whose revenues get taxed twice: first at the corporate level, then again when those revenues get distributed to the shareholders as dividends. Partnership, S corporation, and Schedule C businesses are only taxed once when business income, gains, and losses are passed through to the owners.

Self-Employment Taxes

Self-employment tax is an additional 15.3% tax on the business earnings of self-employed persons. Sole proprietors and partners in a partnership are liable for self-employment tax on the portion of business earnings allocated to them. This is true whether they’ve taken cash distributions or reinvested their share of the profits into the business. S corporations are a bit different. S corporation shareholders active in the business often receive two forms of payment from their business: shareholder distributions and salaries. Only the amount of their pay classified as salary would be subject to self-employment tax. C corporation shareholders do not owe self-employment taxes on their corporate dividends they receive.

Alternative Minimum Tax

The corporate Alternative Minimum Tax (AMT) was abolished when Congress passed the Tax Cuts and Jobs Act (TCJA) at the end of 2017, so C corporations are not subject to this minimum tax. Individuals reporting pass-through income from partnerships and S corporations (and sole proprietors) may be subject to the AMT on their individual income tax returns.

Profit and Loss Allocation

C corporations are self-contained entities, so tax attributes like profits, gains, losses, and credits do not need to be allocated to individual shareholders. But for all pass-through entities, allocation matters. Tax attributes are generally allocated to owners in the same proportions as their investment, regardless of entity type, with one exception: partnerships. Partnerships can allocate tax attributes in whatever manner they choose – within reason – if it is written into the partnership agreement. The IRS will reject partnership allocations that exist solely to avoid taxation but does allow for creative allocations when there is an economic reason for doing so.

When you get new tax clients, entity selection is a great place to start the conversation. But you should also pay close attention to your existing clients’ entity selections. It is helpful every few years to check in with them and see if it is serving them well. Changing entities may not be a simple process, but a tax planning software like the one we offer at Corvee can make it easier for you to show the client how much they can save by changing their entity.  

However, getting your clients to understand the implications of an important change like this is crucial. That’s why Corvee Tax Planning software also lets you create a ready-to-send-PDF in minutes that fully explains how much each entity change can save them. In short, this means you can show your client how much money you can save them, down to the dollar, if they should choose to change their entity. 

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