BUSINESS ENTITIES, GENERAL INFO, & PLANNING©
BUSINESS ENTITIES OVERVIEW CONTINUED:
Capital Gains Problems with Corporations
When either C, S or PSC corporations own appreciating capital assets, the appreciation accrues on the books of the corporation only, not to the shareholders. When a C or PSC corporation sells appreciated assets, it must pay capital gains taxes at the corporate level. If the remaining gain is ever passed out to the shareholders they have to pay capital gains taxes again on their distribution. This is the same double taxation problem that exists for profit distributions. If an S corporation sells appreciated assets the gain must be passed out to the shareholders and they must pay the tax. There is no option. If the shareholders of either a C, PSC, or S corporation wish to transfer appreciated assets out of the corporation to themselves, they must pay capital gains taxes on the imputed gain even though the assets are not actually sold. And finally, all three corporate types restrict or at least complicate the chance for capital gains deferral strategies using private annuities or charitable remainder trusts.
Another problem occurs when S corp stock is inherited or purchased. Although an S shareholder receives a step up in basis when the S stock is acquired through inheritance or purchase, that basis applies only to the stock itself (called "outside" basis). There is no adjustment to the basis of the assets in the corporation (called "inside" basis). Upon the sale of appreciated assets in the S corp, the new shareholder is immediately responsible for the capital gains tax even though his stock purchase/inheritance represents the appreciated value of the assets. The new shareholder must wait until liquidation or sale of his stock before receiving an offsetting deduction for the difference between the inside and outside bases. Moreover, the deduction at the time of disposition of the stock is a capital loss, which is subject to limitations on deductibility if the shareholder does not have current offsetting capital gains.
Partnerships, LLCs, and trusts can distribute appreciated property to shareholders, members, or beneficiaries generally without triggering gain at the entity level or income to the recipients. But, a corporation cannot convert to any one of these other entities without negative tax consequences when the corporation has appreciated property.
Which Entity Should You Use?
This question can only be answered by the specifics of your situation. The following summaries are written to help you narrow the list to a final choice.
We suggest that you only consider the C and PSC corporate classifications after thorough consulting with a professional tax counselor. The big advantage to C and PSC corporations has been the availability of tax deductible employee benefits for both the owners (shareholders) as well as regular employees. But that benefit is generally outweighed by the double taxation of profits, and the fact that Congress is gradually making tax advantaged benefits available to other business entities and the self-employed. You may be able to minimize or even eliminate the double taxation by paying the profits out as salaries or benefits, but that will require a careful analysis by your tax counselor. If you plan to take your business public (register and publicly sell stock in your business), you must use a C corporation. If you rule out the C or PSC corporation, the LLC, taxed as a partnership, is probably the best alternative for you.
We suggest that in most cases you eliminate the S corporation from consideration, unless you have been advised differently by your tax or legal counsel. A limited liability company will usually be a better choice. However, if you place a high emphasis on reducing self employment or FICA taxes then an S corporation should be discussed with your tax advisor. S corporations have the ability to characterize some of your income as "unearned" and therefore not subject to self employment or FICA taxes. (This strategy loses effectiveness if the business earnings significantly exceed the FICA wage base, $70,000+.)
If your primary concern is achieving limited liability, and especially if there is more than one owner in the business, you should seriously consider an LLC. Various non-corporate employee benefits programs are available, including pension plans, though ESOPs only apply to S and C corporations. Also, health and life insurance deductibility for owners of the LLC is limited compared to a C corporation. LLCs often have tax advantages compared to corporations when the entity is taxed as a partnership (the usual arrangement). Partnership tax classification is a better arrangement than the pass thru tax status of S corporations, due to the LLCs ability to allocate income, deductions and losses to the owners in any proportion.
Whatever entity you choose, make sure you work closely with a tax advisor who is knowledgeable of your entity choice.
Further Interest?
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