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Tax Implications of Business Entity Selections

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Tax season is upon us, with all its attendant anxieties, concerns, and worries. Many businesses spent the better part of 2021 simply trying to stay afloat, given the rise of multiple new strains of COVID-19, continued shutdowns and social distancing, uneven economic recovery, and so forth. Now, if you’ve been fortunate enough to make it through to this point in 2022, you’re rewarded with the not so pleasant task of fulfilling your yearly tax reporting and payment requirements. If you’re an aspiring entrepreneur, you’ve no doubt wondered about all the tax obligations that you’ll need to cope with if you move forward with your business aspirations. Tax matters will affect nearly every aspect of your business, including the actual formation of your business itself.

In this post, we will discuss a few of the critical tax implications of business entity selection. Business owners select from a fairly wide range of entities when they initiate their business. As we will discuss, this choice can have far reaching ramifications.

Passthrough Entities: Sole Proprietorships, Partnerships, LLCs

When it comes to taxation, the critical distinction is whether a business entity is classified as either a passthrough entity or a non-passthrough entity. By “passthrough entity,” we mean an entity which literally passes through all its income directly to its shareholders. The income generated by the entity is then reported on the individual tax returns of the shareholders. Consider this scenario: a passthrough entity generates $100,000 of income in a given year, and this entity has a total of 4 shareholders, and each shareholder owns an equal slice of the company (i.e. 25%). At the end of the year, each shareholder reports $25,000 on his or her tax return, as the shareholder’s proportionate share of income passes through directly. This is a very simplistic scenario, of course, but this is useful to show the basic mechanics of passthrough taxation. This doesn’t take account of adjustments, deductions, and other possible tools which can be used to lower the potential tax burden.

Which entities fall into this category? Sole proprietorships, partnerships (i.e. LLPs, general partnerships, etc.), LLCs, S corporations, and others.

Non-Passthrough Entities: C Corporations & Special Elections

In contrast with passthrough entities, non-passthrough entities are subject to double taxation, which means that income generated by a non-passthrough entity will be taxed at the entity level and then at the individual shareholder level too. When a non-passthrough entity is taxed at the entity level, it is subject to the corporate income tax, which involves a rate structure which is wholly different from the structure of the personal income tax. Then, the income will be taxed when it is distributed to shareholders in the form of dividends. These dividends will be subject to the applicable capital gain tax rate, provided that they are “qualified dividends.” Ordinary dividends will be taxed at the standard rates which apply to individuals for personal income tax.

C corporations are the only non-passthrough entity. However, other entities can elect to be taxed as a C corporation if they make the appropriate election for tax purposes. In other words, a partnership can be taxed like a C corporation provided that the partnership elects this form of taxation.

Obtain Expert Counsel Prior to Entity Selection

While there is no question that this overview should be quite useful, it’s important to note that entrepreneurs should obtain expert counsel before making a decision on entity selection. Passthrough taxation has its benefits, but non-passthrough taxation can also have its advantages too. Everything depends on the full facts of a given case. In certain cases, setting up a C corporation may be desirable because of the various deductions available to these entities. In other cases, a LLC may be the best choice. Be sure to obtain expert counsel before making a firm decision.

Contact the Trembly Law Firm for More Information

Need more information? Reach out to the Trembly Law Firm today by calling (305) 985-4582 and one of our business attorneys can assist you.

Trembly Law Firm
9700 South Dixie Hwy Penthouse 1100
Miami, Florida 33156
(305) 431-5678

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