Law in the Marketplace: Choosing the best tax structure for your business

For the Monitor
Published: 10/21/2020 2:11:55 PM

As I wrote in my Oct. 11 column, if, because of the coronavirus pandemic or for other reasons, you’ve decided to start a new business, you need to handle two basic legal and tax procedures – namely, non-tax choice of entity and tax choice of entity. Non-tax choice of entity means choosing the right state-law entity of your business solely on legal grounds. As I wrote in the previous column, on the basis of a non-tax choice of entity, almost all new businesses in New Hampshire should be formed as single-member or multi-member LLCs. Forming a new business as a corporation is almost always a bad choice.

By contrast, tax choice of entity means choosing the best federal tax regimen for your new business purely on tax grounds. To make this choice, you must take into account, above all, federal income taxes and Social Security Taxes.

About 75% of all new LLCs are single-member LLCs whose members are individuals. The federal tax regimens available to these individuals are sole proprietorship taxation and taxation under Internal Revenue Code Subchapters C and S. The federal tax regimens available to the members of multi-member LLCs are taxation under Subchapters C, K (partnership taxation) and S.

The traditional tax choice-of-entity process is and always has always been unavoidably complex, and, for reasons discussed below, on Jan. 1, 2018, it became far more complex thanks to Internal Revenue Code section 199A. Thus, my purpose here is merely to give you the big picture of these two tax choice-of-entity procedures. But I hope my doing so will be useful to you and your tax advisers.

Traditional tax choice

of entity

For starters:

■If you will be the member of a new single-member LLC, then, if you make a traditional tax choice of entity, you generally must compare the federal income tax results for you of roughly six major federal income tax issues on the basis of, on the one hand, sole proprietorship taxation and, on the other, Subchapter S. You must also take into account the Social Security tax impact on you of these two federal tax regimens.

■ If you will be one of the members of a new multi-member LLC, then, if you and your co-members make a traditional tax choice of entity, you generally must compare the federal income tax results for you and your co-members of roughly eight major federal income tax issues on the basis of, on the one hand, Subchapter K (partnership taxation) and, on the other, Subchapter S. And you must also take into account the Social Security tax impact of these regimens on you and your co-members.

■ Using a traditional tax choice-of-entity methodology, if you are the member of a single-member LLC, you may want your LLC to be taxable as a sole proprietorship because of the simplicity of that federal tax regimen. However, if this will result in a significant Social Security Tax for you (called the “Self-Employment Tax” for members of single-member LLCs and of multi-member LLCs taxable as partnerships), you may well want your LLC to be taxable as an S corporation, since Subchapter S may save you substantial Social Security taxes every year, potentially amounting to many thousands of dollars.

■ Using a traditional tax choice-of-entity methodology, if you are the member of a multi-member LLC, you may want your LLC to be taxable as a partnership because of the unique federal income tax benefits of that federal tax regimen as compared with Subchapter S. However, if this will result in a significant Social Security Tax for you, you may well want your LLC to be taxable as an S corporation, since Subchapter S may save you substantial Social Security taxes.

Tax choice of entity

under IRC section 199A

However, because of new Internal Revenue Code section 199A, which became effective on Jan. 1, 2018, when you are forming a new business, you must do not only a traditional tax choice-of-entity procedure – i.e., the procedure described above – but also a quite separate non-traditional tax choice of entity, employing quite different rules, under section 199A. Section 199A can be, as one tax scholar has written, “overwhelmingly” complex. However, it can also provide massive annual federal income tax deductions to owners of “pass- through businesses” on their shares of the net income of their business if their business is properly structured.

These deductions can amount to 20% of net business income. Pass-through businesses consist of sole proprietorships, S corporations and entities taxable as partnership (including most multi-member LLCs).

In general, under section 199A:

■ If you file your federal tax return jointly with your spouse and if your joint taxable income is $326,600 or less, you will generally want your LLC to be taxable as a sole proprietorship if it is a single-member LLC and as a partnership if it is a multi-member LLC. If your joint taxable income exceeds the above amount, you will generally want it to be taxable as an S corporation regardless of whether it is a single-member LLC or a multi-member LLC.

■ If you file your federal tax return separately and your taxable income is $163,300 or less, you will generally want your LLC to be taxable as a sole proprietorship if it is a single-member LLC and as a partnership if it is a multi-member LLC. If your taxable income exceeds the above amount, you will generally want it to be taxable as an S corporation regardless of whether it is a single-member LLC or a multi-member LLC.

Miscellaneous

However:

■ While section 199A is normally decisive in post Jan. 1, 2018 tax choice-of-entity analyses, in some cases traditional tax choices of entity may provide you with a better tax outcome. Thus, when you’re starting a new business, you must do not only a traditional but also a section 199A tax choice of entity.

■ There is a little-known but very powerful IRS proposed regulation, called Prop. Reg. § 1.1402(a)-2, that may enable you to lawfully avoid even more Social Security taxes as a partner of a partnership than you can avoid under Subchapter S.

■ While tax choice of entity generally must focus on federal income taxes and Social Security taxes, New Hampshire state taxes, including especially the New Hampshire Interest and Dividends Tax, may also play a key role in a tax choice-of-entity analysis and may lead to a different result than the normal section 199A result.

■ Effective Jan. 1, 2018, the federal tax bill enacted in 2017 by President Trump, called the Tax Cuts and Jobs Act of 2017 (the TCJA), reduced the top federal income tax rate for entities taxable under Subchapter C from 35% to 21%, The beneficiaries of the TCJA consisted almost entirely of large public corporations and very wealthy individuals. However, in rare cases the TCJA may even benefit owners of small, closely held business who have only modest wealth but who form their businesses as C corporations.

To sum up: Making the right tax choice-of-entity choice can be difficult, and it can cost you significant professional fees. But it may also save you thousands or even tens of thousands of dollars of federal income taxes and Social Security taxes every year.

John Cunningham is a Concord tax and businesses lawyer and estate planner. He has published Drafting Limited Liability Company Operating Agreements and Maximizing Pass-Through Deductions under Internal Revenue Code Section 199A. Both are the leading books in their fields. If you have business or tax questions you’d like addressed in this column, call John at (603) 856-7172 or e-mail him at lawjmc@comcast.net.




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