This is an overview of how U.S. federal income tax laws impact different types of for-profit business entities. These tax rules apply to startup companies that are U.S. corporations, partnerships, and limited liability companies. The tax rules that apply to trusts, tax-exempt organizations, banks, insurance companies, and other specialized industries are not addressed.
The first decision a founder must make is what type of business entity to form (corporation, partnership, limited liability company). This determines the legal structure of your business. This choice of entity leads to the second decision, the federal tax classification of the business. This post walks you through the choice of entity considerations, then explores the tax classifications available to each entity type.
1. Choice of Business Entity
The first step when forming a business is to decide what type of entity is the best form for the business. This decision depends on your business goals, timeline, structure, liability, management, and tax considerations. Non-tax factors are usually the primary considerations because in some instances a business can choose how it is treated for tax purposes.
Businesses are generally formed under state law, and can be corporations, partnerships (which come in several flavors), and LLCs (also in several flavors). For tax purposes, a business is treated as a disregarded entity, C-corporation, S-corporation, or a partnership.
The state law classification of a business is not always the same as the federal tax classification of a business. For example, a LLC can elect to be taxed as a partnership or as a corporation. The tax classification of a business is important because the tax rules that apply to a disregarded entity, C-corporation, S-corporation, and partnership are quite different.
a. Disregarded Entity
A "disregarded entity" is a business entity with a single owner that is generally ignored for tax purposes, even though it's a separate legal entity for state law purposes. The owner of the disregarded entity is considered to own the assets (and be subject to the liabilities) of the disregarded entity for tax purposes and reports the entity's income and expenses on its own income tax return. In other words, a disregarded entity is treated, for tax purposes, like a sole proprietorship, branch, or division of the owner.
The advantages of a disregarded entity for a startup business are that the structure is simple with minimal administrative costs. But the owner of the disregarded entity must pay self-employment tax on any net earnings, and this structure is only available if there is only one founder or owner.
b. C-Corporation
All corporations other than S-corporations are C-corporations. C-corporations are the most common corporate form and generally are subject to two levels of tax on their income: first at the entity level when earned, then at the shareholder level when distributed. The burden of two levels of tax is currently somewhat reduced by the 21% corporate income tax rate that took effect in 2018, but this low corporate tax rate is likely to change with tax reform measures.
Most publicly traded companies are required to be taxed as C-corporations. However, for smaller and non-publicly traded companies, the decision to be taxed as a C-corporation should be carefully considered because an entity that is taxed as a partnership (for example, an LLC) may be a more appropriate entity for a startup company.
If a C-corporation becomes desirable later on, it is very easy to convert from a partnership or LLC to a C-corporation, but beware that it is extraordinarily difficult to do the reverse (meaning, convert from a C-corporation to a partnership or LLC). However, if a startup company wants to immediately raise venture capital and potentially go public, the startup company may want to start out as a C-corporation. Venture capital investors generally prefer C-corporations because of the ability to structure equity ownership and have multiple classes of stock.
c. S-Corporation
An S-corporation is a pass-through entity for tax purposes, which means it generally does not pay an entity level tax. The S-corporation's profits and losses instead generally pass-through to its shareholders, who include their respective share of those items on their income tax returns (whether or not the income is distributed).
S-corporations are less common than C-corporations because of the substantial limitations on the availability of the S-corporation election. An S-corporation can have only one class of stock, no more than 100 stockholders, and, with certain limited exceptions, can only be owned by US individuals (citizens or residents). In addition, only an eligible US entity can make the election (generally a US C-corporation or other US business entity eligible to elect C-corporation tax status).
S-corporations are useful for individual entrepreneurs because not all profits are subject to the self-employment tax. However, a startup company should carefully consider the significant limitations placed on the number, types, and residency of stockholders that can own an interest in an S-corporation. In many cases, a partnership or LLC may be a better choice for a startup company that desires pass-through taxation for its owners.
d. Partnerships
Like an S-corporation, a business entity taxed as a partnership is a pass-through entity for tax purposes, which means it does not pay an entity level tax. The partnership's profits and losses are instead computed and allocated among the partners annually and pass-through to the partners, which include their respective share of those items on their income tax returns (whether or not distributed). Partners are generally subject to self-employment tax on income allocated to them.
Unlike an S-corporation, a partnership does not have any restrictions on the number (other than the requirement that a partnership have two or more owners), type or residency of its owners. Therefore, a startup that desires pass-through taxation often chooses partnership tax status. However, partnership agreements can be complicated and outside investors may not interested in a startup company that is taxed as a partnership because it can complicate their tax filings.
e. Limited Liability Company (LLC)
Even though an LLC is a recognized type of business entity formed under state corporate law, LLCs do not have their own federal income tax regime. For tax purposes, an LLC is classified as a disregarded entity, C-corporation, S-corporation, or partnership. A single-member LLC is treated as a disregarded entity and a multiple-member LLC is treated as a partnership for tax purposes unless the LLC elects C- or S-corporation tax status. LLC members are generally subject to self-employment tax on income allocated to them.
LLCs often choose to be treated as a partnership for tax purposes, which means that the LLC does not pay an entity level tax. The advantages of using an LLC that is taxed as a partnership are that there is a single level of tax at the owner level, a flexible allocation of income and loss, and no restrictions on the number (other than the requirement that an LLC have two or more members), type or residency of its owners as there are with an S-corporation.
However, LLC operating agreements can be complicated and outside investors may not be interested in investing in a startup company that is taxed as a partnership because it can complicate their tax filings.
2. Choice of Tax Classification
The state law classification of a business is not always the same as the federal tax classification of a business. Under the "check the box" Treasury regulations, a business entity is classified either as a "per se" C-corporation or as an entity eligible to choose its tax classification (an "eligible entity").
a. Per Se C-Corporation
Under the "check the box" Treasury regulations, certain entities are automatically classified as per se C-corporations and cannot make an election to be treated as a disregarded entity or partnership for tax purposes. A corporation incorporated under state law is a per se C-corporation for tax purposes. However, a per se C-corporation that meets the requirements for the S-corporation election can elect S-corporation status on formation.
b. Eligible Entities
An eligible entity (any business entity not treated as a per se C-corporation) generally chooses its tax classification. Partnerships and LLCs organized under state law are eligible entities under the check the box regulations.
The check the box regulations have two default rules for eligible entities: (1) An eligible entity with a single owner is automatically classified as a disregarded entity unless it elects C-corporation tax status; and (2) An eligible entity with multiple members is automatically classified as a partnership unless it elects C-corporation tax status.
An eligible entity only needs to make a formal check the box election on IRS Form 8832 if it desires C-corporation tax status instead of its default tax status.
To avoid potential adverse tax consequences, an eligible entity should file a check the box election within 75 days of its formation. If an eligible entity elects C-corporation tax status after formation, it generally cannot make an election to change its tax classification to partnership or disregarded entity tax status for five years unless there is a significant ownership change (more than 50%) and the IRS permit it. This limitation on changing elective tax classification does not apply if the election to be taxed as a C-corporation is made by a newly formed eligible entity and is effective on the date of formation.
c. Tax Classification of a Partnership
A partnership organized under state law is automatically classified as a partnership for tax purposes unless it elects C-corporation tax status or is treated as a "publicly traded partnership." It is not common for a partnership to elect C-corporation tax status, or for a partnership to be publicly traded.
Technically, under the Treasury Regulations, a partnership meeting the requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status), but it is not that common in practice. An S-corporation election is typically made by a corporation or an LLC.
d. Tax Classification of a Single-Member LLC
Under the default classification rules, a single-member LLC is treated as a disregarded entity for tax purposes unless it elects C-corporation tax status. A single-member LLC meeting the requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status). If a single-member LLC (treated as a disregarded entity for tax purposes) adds another member, the LLC automatically converts to a partnership for tax purposes.
e. Tax Classification of a Multiple-Member LLC
Under the default classification rules, a multiple-member LLC is treated as a partnership for tax purposes unless it elects C-corporation tax status. A multiple-member LLC meeting the requirements for the S-corporation election can elect S-corporation tax status on formation (or after formation if it elected C-corporation tax status). If a multiple-member LLC (treated as a partnership for tax purposes) reduces its membership to a single member, the LLC automatically converts to a disregarded entity for tax purposes.
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