Tax
Aug. 9, 2002
When Determining Corporate Form, Owners Should Not Forget Tax Issues
Focus Column - By Stephen M. Loeb - In "The 7 Habits of Highly Effective People," Stephen Covey tells us to begin with the end in mind. This is excellent advice for people who are starting a business enterprise. Advance planning in the organizational portion of the entrance strategy for an enterprise can save a lot of money later on.
By Stephen M. Loeb
In "The 7 Habits of Highly Effective People," Stephen Covey tells us to begin with the end in mind. This is excellent advice for people who are starting a business enterprise. Advance planning in the organizational portion of the entrance strategy for an enterprise can save a lot of money later on. The business and tax needs of both the enterprise and the owners during each phase of the enterprise should determine both the method of ownership and the form of organization for a business.
Method-of-ownership considerations are such things as which family members would own interests in the business and which type of voting and repurchase agreements will be allowed.
Some of the more popular forms of organization for actively conducted businesses are corporations, partnerships, limited partnerships, limited liability companies, limited liability partnerships and sole proprietorships.
Federal tax law is by far the most important factor for tax planning because the federal tax rates are much higher than the state tax rates, and state tax law generally tracks federal law. However, there are differences in the state and federal tax treatment of various items, which vary from state to state.
There are also state fees and taxes with no federal counterpart. In considering the tax implications of any form of organization, counsel should evaluate the state tax costs for the state of organization and for every state in which the enterprise will be doing business.
The federal income taxation of business entities falls into three categories: corporations, partnerships and entities that are disregarded for tax purposes. Internal Revenue Code Section 7701.
Entities taxed as corporations include corporations, joint stock companies, joint stock associations, associations, insurance companies, banks and other entities that are treated as corporations for federal tax purposes. 26 C.F.R. Section 301.7701-2(b).
Usually, an entity other than those previously discussed is treated as a partnership if it has two or more owners and is disregarded as an entity separate from its owner if it has one owner. 26 C.F.R. Sections 301.7701-2(c), 3(b). However, one of these business entities can elect to be treated as corporation for federal tax purposes. 26 C.F.R. Section 301.7701-3(a).
It is also possible to change the tax treatment of a business at any time, either by changing the election, if allowed, or by reorganizing the business into a new entity. In any event, a change in the tax treatment of a business entity is a taxable event. Counsel should evaluate the implications of a change, both positive and negative, before making any change.
For tax purposes, a corporation is regarded as an independent entity separate from its owners. S corporations are taxed under the rules set forth in subchapter S of the federal income tax law. Internal Revenue Code Sections 1361-1379. All other corporations are C corporations. Internal Revenue Code Section 1361.
Most C corporations pay tax on their income at graduated rates going as high as 39 percent. Internal Revenue Code Section 11.
A personal service corporation is a C corporation for which the performance of services is substantially all of its business and employees, former employees or their heirs own substantially all of its stock. Internal Revenue Code Section 448(d)(2). Personal service corporations pay tax at a flat rate of 35 percent. Internal Revenue Code Section 11.
In California, C corporations pay a franchise tax rate of 8.84 percent, with a minimum tax of $800 ($500 for new corporations starting a new business with receipts under $1 million). They also pay tax on income not subject to franchise tax at 7.6 percent. Revenue and Taxation Code Sections 23151, 23153 and 21501. Financial corporations' tax rates are 2 percent higher. Revenue and Taxation Code Sections 23181 and 23186.
Corporations that have only one class of stock and are owned by 75 or fewer individuals, each of whom is not a nonresident alien, are eligible to make an election to be an S corporation. Internal Revenue Code Section 1361. S corporations generally are not subject to federal taxation, although there are some exceptions. Internal Revenue Code Section 1363. An S corporation's taxable income is passed through to its shareholders and taxed on the shareholder level. Internal Revenue Code Section 1366.
A corporation that is an S corporation for federal tax purposes can elect to be treated as a C corporation for California tax purposes. Revenue and Taxation Code Section 23801. California generally follows the pass-through rules of subchapter S, although there are exceptions. Revenue and Taxation Code Section 23800.
In California, S corporations also pay franchise tax and tax on income not subject to franchise tax at a rate of 1.5 percent, with a minimum tax of $800. Revenue and Taxation Code Sections 23802 and 23153. Financial corporations' tax rates are 2 percent higher. Revenue and Taxation Code Section 23181.
Entities taxed as partnerships are taxed under subchapter K of the federal income tax law. Internal Revenue Code Sections 701-777. Partnerships generally are not subject to federal taxation. Internal Revenue Code Section 701. Partners are taxable on their distributive share of partnership income. Internal Revenue Code Section 702.
California generally follows the pass-through rules of subchapter K. Revenue and Taxation Code Section 17851. In California, limited partnerships, LLCs and LLPs are subject to an $800 franchise tax. Revenue and Taxation Code Sections 17935, 17941, 17946 and 23153. Additionally, LLCs are subject to a fee based on their total income, with graduated fees going as high as $11,790. Revenue and Taxation Code Section 17942.
Sole proprietorships and entities with one owner that would otherwise be treated as partnerships are disregarded as entities separate from their owners, who are taxed directly. 26 C.F.R. Sections 301.7701-2(c) and 3(b).
The primary advantage of C corporations over pass-through entities are that C corporations generally are allowed to establish medical plans, life insurance plans, deferred compensation plans, pension plans and other employee benefit plans on terms more favorable than those allowed in the case of pass-through entities or sole proprietors.
The primary advantage of pass-through entities over C corporations is that pass-through entities avoid the double taxation resulting from a C corporation being taxed on its profits and then its shareholders being taxed on distributions of profits and on gains from sales or other dispositions of stock.
Since the various forms of organization have different business consequences and tax costs in different circumstances, selecting the proper vehicle for the owners' and business's entrance, growth and exit strategies can result in substantially lower costs over the life of the business. Advance planning will be well worth the effort.
Stephen M. Loeb is a tax attorney in Los Angeles.
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