Maybe you are considering starting a family business or preparing to transfer one you started to the next generation. You may also be learning to manage a business your great-great-grandfather started long before you were born. Whatever the case, being involved in a family business has its challenges – including tax planning– and you should prepare to face them.
Today and tomorrow, we will share a two-part series on family business tax issues. Today, we will give a refresher course on the most important tax consideration – entity choice.
Forming your family business
Let’s start at the very beginning – that’s a very good place to start. When you read, you begin with ABC. When it comes to family businesses, you should begin with...LLC or Inc.
It is important to consider not only the best option right now, but what will work best for managing, transitioning and protecting your organization for your family.
The most popular structures for a family business are limited liability companies (LLCs), S-corporations, and C-corporations. While sole proprietorships are also very common, they generally serve as a steppingstone for a more formal business arrangement, such as organizing as an LLC or incorporating.
Limited Liability Companies (LLCs)
Type of entity: Flow-through
Federal tax reporting: Form 1120S or 1065, taxes calculated on Schedule E of Form 1040
Tax rate: Marginal rate of owners, net of Qualified Business Income Deduction
Liability protection: Limited
Often professional service firms, such as law and accounting firms, or contracting companies are organized as an LLC. An LLC is a flow-through entity with the option to be taxed as either partnerships or S-corporation. Income is taxed to the owners on Schedule E of their individual tax returns. Almost any taxpayer can become a member of an LLC, including individuals, many trusts, and most other entities.
If an LLC is treated as a partnership, it can define the roles and responsibilities of its members with flexibility. Actively involved partners are subject to self-employment tax. Income to partners who do not actively participate in the business is considered passive income, avoiding the additional tax. In the context of structuring a family business, this is an important distinction because it allows for family members who are not involved in the business to hold a profits interest, shifting the income to lower tax brackets without disrupting power structures.
LLCs, however they elect to be taxed, do offer a protection from personal risk not found with sole proprietorships or general partnerships, shielding members from personal liability. This is an important consideration, since it helps to avoid exposing owners to risks of operating the business.
S-Corporations
Type of entity: Flow-through
Federal tax reporting: Form 1120S, taxes calculated on Schedule E of Form 1040
Tax rate: Marginal rate of owners, net of Qualified Business Income Deduction
Liability protection: Limited
Many manufacturers, wholesalers, and distributors companies are formed as S-corporations. S-corps are the middle ground of entity structures, the hybrid between LLCs/partnerships and traditional C-corporations.
S-corporations can originate as either an LLC or a C-corporation - once formed, qualifying entities can elect to be taxed as an S-corporation. If S status is terminated or revoked, the organization would revert to its default status, so choose wisely.
S-corporations offer less flexibility in ownership than LLCs or C-corporations, with only specific types of taxpayers being eligible. Partnerships, corporations, nonresident aliens, and many trusts are disqualified as owners.
Individual owners who provide services to the S-corporation must be paid a reasonable salary, subject to employment taxes. Family businesses should take care to follow these rules, as what might be "expected" (volunteered) help from a family member is often classified by the IRS as an employment relationship.
An advantage of S-corporations over C-corporations is the flexibility to draw earnings either tax-free distributions or reductions of basis. Should these distributions reduce a shareholder’s basis to zero, any remaining distribution would receive long-term capital gain tax treatment (still favorable to the tax treatment of most dividends).
Like an LLC, passive owners can hold S-corporation stock. If an owner does not “materially participate” (as defined by the IRS), income will not be subject to self-employment tax and losses will be limited to offsetting passive income (such as income from rental properties or other passive holdings).
C-Corporations
Type of entity: Separate taxable entity
Federal tax reporting: Form 1120
Tax rate: 21%
Liability protection: Unlimited
Similar to an S-corporation, this is a popular choice among manufacturers, wholesalers and distributors. One distinction between S- and C-corps is the level of risk protection. C-corporations are separate from their owners and offer the strongest shield of liability, making it the best structure for businesses engaged in riskier activities. They are also attractive because it is easy to raise capital (issue shares) and shares are easily transferred or sold. Additionally, the IRS imposes no limitations on who can hold shares in a C-corporation.
C-corporations have been gaining in popularity since the corporate tax rate was reduced to 21% in 2017. Also, Sec. 1202 Qualified Small Business Stock, if held for 5 years, can be sold without recognizing capital gain up to $10M/owner, making C-corporations extremely attractive for entrepreneurs who anticipate growing and selling business interests.
C-corporations are not flow-through entities and are subject to their own layer of corporate tax. Owners can draw earnings as either wages or dividends, both of which are taxable income. Rather than taking wages or dividends, shareholders may take distributions against income which has already been reported on their tax returns.
General Considerations
Businesses structured as flow-through entities have the advantage of passing their income through to their owners’ tax returns. Although individual tax rates will vary among the partners, at the overall combined family level, the outcome is generally more favorable than if the entity were taxed at corporate tax rates.
Partnerships specifically can be advantageous for several reasons, including the ability to specially allocate distributive shares and shifting the tax burden from high-bracket family members to those in lower brackets.
Taxes on income is only one consideration in selecting the right formation option. Tomorrow we will discuss how each of these common entity types is managed.