Tax Considerations When Choosing a Type of Entity for Your Business
If you own investment property or a small business in your own name, you should consider transferring it to an entity wholly owned by you. This generally will protect you from some kinds of liabilities that can arise from ownership of the transferred assets. It will not protect you from your own negligent acts or misconduct, even if those acts were done on behalf of the entity, and it will not protect you from liabilities that you have personally guaranteed. Otherwise, generally only the entity will be liable for its debts and obligations, including liabilities incurred by people on its behalf or when acting for it.
Entity Taxed Personally
The first choice you need to make is whether the income from the new entity will be taxed to you personally as owner or to the entity itself. For most investment property and some businesses, it is advantageous to have the revenue and deductions “pass through” to your personal income tax return. If you use a “pass through” entity, the owner pays taxes personally on the income, which means there is significant pressure to distribute all of the available cash to the owner. If that is done, you have the benefit personally of the deductions and, although you personally will pay taxes on the income, the income will be only taxed once.
Entity Taxed Separately
For some businesses that need to accumulate capital, it is usually advantageous to have the entity taxed separately. If the entity needs to accumulate capital (for example, if the business uses significant machinery which must be purchased and replaced or if the business needs to keep extensive inventory on hand), a corporation (not electing to be taxed as an S corporation), which is taxed separately, is usually the choice.
The owner can still take cash out of the corporation by paying himself a salary, which will not be taxed at the corporate level but will be taxable to the owner, so there will be a “double tax” only on cash distributed as dividends.
“Pass Through” Entity Options
If you choose to form a “pass through” entity, the usual choices are corporations electing to be taxed under Subchapter S of the Internal Revenue Code (S Corporations), limited liability companies, and limited partnerships. An S corporation is a regular corporation or a limited liability company that makes a special election with the IRS. (You cannot tell whether a corporation is an S corporation by looking at the public records of the Arizona Corporation Commission).
There are restrictions on who can be a shareholder of an S corporation, and all shares of stock in an S corporation must be treated exactly the same. If, for example, you have foreign owners in your entity or you want to repay investors before distributing cash to the “sweat equity” owners, you cannot use an S corporation and would use a limited liability company (taxed as a partnership) or a limited partnership. There are no significant differences in Arizona between limited partnerships and limited liability companies, so a limited liability company is usually chosen (that is not true in all states).
There are other considerations. An entity primarily rendering services performed by its owners may be able to save some employment taxes if it is taxed as an S corporation (this advantage is not currently available to entities taxed as partnerships). An entity formed solely to own property should be a “pass through” entity (usually a limited liability company or a limited partnership), since the primary objective will be to realize profit on sale and avoid a double tax on the profit. (However, there can be significant tax liabilities to entities taxed as partnerships, but not to S corporations, if the property is foreclosed or sold at a short sale.)
Always Get Tax Advice
Because there are significant tax ramifications to forming an entity, you should always get tax advice first. Putting assets in an entity may also affect your estate planning, and you should be sure your actions are consistent with your estate plan.
For More Information
If you have questions about these or any other business issues, please contact one of the attorneys below: