Choice of Entity – Income Tax Issues

Partnership (Partnerships and LLCs not electing to be treated as Corporations)

Advantages:

• One level of tax (pass through) — earnings increase basis and generally may be distributed tax-free.
• Flexibility as to ownership and allocations of the economic benefits of the business.
• Property can generally be contributed and distributed without triggering gain.
• Refinancing proceeds may be distributed tax-free because partner’s tax basis in partnership interest includes share of partnership debt.
• Purchasers and estates who acquire partnership interests can obtain basis step-up of partnership assets.
• Acquirer of partnership business can obtain step-up of assets.
• Partners may deduct partnership losses against other income, subject to passive activity loss limitations and other requirements.
• Employees can be awarded partnership profits interests without triggering tax.

Disadvantages:

• Insolvency and bankruptcy exceptions to debt discharge income are tested at partner level.
• Except for limited partners and certain non-active LLC members, partnership active business income (not investment income) allocable to individuals is subject to self-employment tax.
• Partnership cannot merge tax-free with public company.
• Pennsylvania capital stock/franchise tax applies to LLCs but not partnerships. Distributions to LLC owners who materially participate in the business are deductible from income for purposes of calculating this tax.

S Corporations

Advantages:

• One level of tax (pass through) — earnings increase basis and generally may be distributed tax-free.
• Acquirer of S corporation business can obtain basis step-up of assets.
• Corporation can merge tax-free with public company.
• Shareholders may deduct S corporation losses against other income, subject to passive activity loss limitations and other requirements.
• Insolvency and bankruptcy exceptions to debt discharge income are tested at entity level.

Disadvantages:

• Limitations on ownership — shareholders must be individual U.S. citizens or residents, estates, certain trusts, an ESOP or other tax-exempt entity, and only 100 shareholders are permitted. (All family members count as just 1 shareholder for purposes of 100 shareholder limit.).
• Single class of stock requirement (but can have voting and non-voting).
• S corporation cannot distribute refinancing proceeds in excess of shareholders’ basis in stock without triggering tax.
• Purchaser/estate cannot obtain step-up in inside basis of assets unless entire corporation is acquired.
• Distribution of appreciated property triggers taxable gain.
• Pennsylvania capital stock/franchise tax applies to corporations.

C Corporation

Advantages:

• Corporation can merge tax-free with public company.
• Flexibility as to ownership and classes of stock.
• Net operating losses may be carried forward up to 20 years for federal tax purposes.

Disadvantages:

• Two levels of tax — dividends are taxable to shareholders; shareholder basis is not increased by undistributed corporate earnings; acquirer cannot obtain step-up in basis of corporate assets.
• Distribution of appreciated property by corporation triggers taxable gain at corporate level and taxable dividend income to shareholders.
• Shareholders cannot deduct losses of C corporation.
• Closely held C corporation may be subject to accumulated earnings tax on retained earnings in excess of business needs or personal holding company tax if corporation earns mostly passive investment income.
• Corporate deductions for compensation expense paid to shareholders may be disallowed if compensation paid is unreasonably high.
• No preferential rate for capital gains. Corporate-level capital gains taxed at same rates as ordinary income.
• Pennsylvania corporate income tax rate (9.9%) is more than three times greater than personal income tax rates that apply to pass through entities (3.1%).