WARNING: The following is only a very broad overview of the tax treatment of certain business entities under the Internal Revenue Code and its regulations. It is for informational purposes only and is not legal or tax advice. Do not take any action based on the following without first consulting with a qualified tax advisor.
Benefits of Disregarded Entity Tax Treatment
Disregarded entities are unique in that, although they are separate entities for legal purposes (thus affording us asset protection), they are treated as nonexistent for tax purposes. In other words, the activity of the entity is, for tax purposes only, treated as the activity of its owner(s). Because of this, income from a disregarded entity is reported on its owner(s)’ personal tax return as sole proprietorship income (if the owner is a natural person, then the income is reported on their 1040 Schedule C income tax return.) This allows disregarded entities to do certain things that no other entity can do. For example:
- Disregarded entities can hold S corporation stock, which a partnership or corporation cannot do.[1]
- A disregarded entity can own a personal residence, yet still qualify for the Internal Revenue Code §121 exemption on gain when the home is sold (the exemption amount is $250,000 a single individual or $500,000 for a married couple, as long as they’ve lived in the home two out of the last five years.)
- If a person contributed property to a disregarded entity, and then paid rent to use the property, no tax consequences are incurred; other entities would often have to consider the rent payments as income.
- Disregarded entities don’t have to file an entity level information return (such as a 1065 partnership return), which greatly reduces their maintenance costs.
Despite the many benefits of disregarded entities, they do have their limits. For example, a disregarded entity could never be used to reduce self-employment tax liability. Furthermore, although a disregarded entity may have multiple owners, it may only have one owner for tax purposes. For example, if a person named Jeff owned a single member LLC (LLC A), and then both LLC A and Jeff were members of LLC B, then LLC B would be disregarded as separate from Jeff for tax purposes because Jeff is the only underlying taxpayer. He is the only underlying taxpayer due to the fact that he’s the owner of both LLC A as well as the only other member (besides LLC A) of LLC B.[2]
Benefits of Partnership Tax Treatment
Furthermore, although an LLC may be taxed as a partnership, a C or S corporation may not. Partnership tax treatment in many instances features tax benefits superior to that of an S corporation. For example, a return of appreciated capital from an S corporation to its capital contributor will trigger a taxable event (capital gains tax must be paid to the extent the property appreciated in value). However, return of capital from a partnership to its contributor does not usually trigger a tax. Furthermore, limited partner distributions are self-employment tax free. LLC members may claim their distribution is self-employment (SE) tax-free if it complies with certain IRS proposed regulations.[3] These proposed regulations, which were never enacted but nonetheless serve as de facto tax guidelines, allow SE-free distributions if, among other things, an LLC member works for the LLC no more than 500 hours annually. For a single-member LLC that wishes to avail itself of SE tax savings, or for a multi-member LLC where each member works more than 500 hours annually for the LLC, SET savings may be realized if the LLC elects S corporation tax treatment.
Benefits of S Corporation Tax Treatment
Although partnership tax treatment is often preferred to S corporation treatment, there are situations were S corporation treatment is preferred. Such instances may include the following:
- The company only has one owner, and the owner wishes to minimize self-employment taxes. By choosing S corporation treatment for his LLC, he may pay himself a reasonable salary and then remaining profits (called S corporation dividends) are received SE tax-free.
- The company’s stockholder(s) plan to sell their stock in the future, and taxable gain upon a return of capital is not a concern. If the company’s stock appreciates, and then it is sold, the tax treatment of such a sale may be preferable to the tax treatment of a sale of an appreciated partnership interest in certain situations. (For example, sale of appreciated S corporation stock may be treated only as capital gain, while sale of an appreciated partnership interest may be treated mostly or completely as ordinary income, and thus taxed at a potentially higher rate.)
Be aware that any entity classified as an S corporation for tax purposes has its ownership restricted to the following:
- S corp stock may not be owned by a non-U.S. citizen or offshore entity.
- The S corp may have no more than 100 shareholders (though a husband and wife may be treated as one shareholder.)
- S corp stock may only be held by a natural person, an estate, a disregarded entity, certain tax-exempt organizations, or a certain trusts, such as a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT).
Benefits of C Corporation Tax Treatment
Finally, although C corporation tax treatment is usually avoided, sometimes it is used to provide certain tax benefits that can’t be obtained any other way. Such benefits include:
- The income tax rate of the 1st $50,000 of income for a C corporation is only 15%, which is lower than the tax rate of other entities. If corporate profits stay within the company and are reinvested rather than distributed to stockholders, a C corporation may be preferable (and when you’re ready, you can elect S corporation treatment in a future tax year.)
- C corporations have much greater flexibility than S corporations, disregarded entities, or partnerships when choosing their taxable year.
- C corporations may have tax-favored Employee Stock Ownership Plans (ESOPs.)
- When a C corporation is acquired by another C corporation, its losses may be used to offset the 2nd corporation’s profits.
- Certain fringe benefits for the corporation’s owner-employees are 100% deductible to the company and are not taxed on the individual.
Because of the above advantages of a C corporation, it is not uncommon to make an LLC taxed as a C corporation (hereinafter referred to as simply a C corporation) a 1% member of another LLC, or a 1% general partner of a limited partnership. The management fees it receives, along with its 1% share of company profits, may then be used to provide an ESOP plan or 100% deductible fringe benefits to its employee-owners, with the goal being that most or all of the C corporation’s profits are spent on such programs, therefore leaving no taxable income that would be subject to tax liability.
[1] See IRS PLR 0107025.
[2] See IRS Rev. Rul. 2004-77 for more information regarding when a multi-member entity is disregarded from its owner(s) for tax purposes.
[3] IRS Prop. Reg. 1.1402(a)-2.