Many tax attorneys and tax advisors—including me—tout the tax benefits of using an S-corporation, LLC, or partnership. While the Tax Cuts and Jobs Act has made C-corporations more tax-efficient than they used to be, “pass-through” entities such as S-corporations, LLCs and partnership still typically provide a lower overall tax burden than C-corporations.
In the U.S. tax system, there are two types of “pass-through” entities: S-corporations, which are regular corporations that have elected to be taxed under Subchapter S of the Internal Revenue Code, and partnerships, which (for tax purposes) includes general partnerships, limited partnerships, limited liability partnerships, and most limited liability companies (or LLCs).
S-corporations and partnerships achieve tax efficiency by passing their tax obligations through to their owners. For example, assume that Company X is an S-corporation. Company X is owned by Jane, Juan, Estella and Joe, each of whom has a 25% interest. If Company X has $100,000 in taxable income for 2018, it will not pay federal income tax—instead, Jane, Juan, Estella and Joe will each report $25,000 on their personal income tax returns. Jane, Juan, Estella and Joe will have to report the income on their personal returns even if Company X does not distribute any money to them. Their tax obligations will not increase if Company X makes a shareholder distribution, and it will not decrease if Company X keeps all of the money.
What would happen if Company X was a C-corporation? In that case, Company X would report the entire $100,000 on its corporate income tax return and would pay the tax itself. Jane, Juan, Estella and Joe would not be responsible for reporting any income or paying any tax unless they actually receive a shareholder distribution from Company X. But, if Company X makes a shareholder distribution, it will come with a second level of tax—Jane, Juan, Estella and Joe will have to pay tax (typically 15%) on any shareholder distribution they actually receive. This infamous “double taxation”—where Company X pays tax on its income, and its shareholders pay tax again if that income is distributed to them—typically makes C-corporations less tax efficient and desirable than S-corporations or companies taxed as partnerships.
But, the cost of double-taxation comes with the benefit of security for Jane, Juan, Estella and Joe. If they are shareholders of a C-corporation, they can rest assured that they will not have to pay tax on money unless they actually receive it. They can also rest easy that if Company X is audited by the IRS, their personal tax returns are not likely to be impacted. If Company X is a C-corporation and the IRS determines that its taxable income was really $200,000, Company X must foot the added tax bill. But if Company X is taxed as an S-corporation or partnership, the extra tax liability will flow through directly to Jane, Juan, Estella, and Joe, who must file amended tax returns and report the extra unreported income.
The bottom line is that an investor—particularly a passive investor who is not in a position to control the company’s distributions and tax reporting—should be aware of these issues when deciding whether to invest in a C-corporation versus a pass-through entity such as an S-corporation, partnership, or LLC.
In some cases, the benefits of a C-corporation—They are easier to form, No shareholder limit and foreign shareholders are allowed, Easier to raise funding due to investors not liable for the C-corporation’s mistakes—outweigh the additional tax burden of double taxation.
This is a general overview of some of the pitfalls of S-Corporations, LLCs & Partnerships and should not be confused with legal advice. If you’d like to talk with Jonathan about this matter, or a business, tax or estate planning matter, please contact him at email@example.com