MODCPA Information Series

Business Entities

Understanding Different Forms of Organization for Your Business

Business Advice From CPAs

Selecting the appropriate form of organization for your business is important for operating efficiency as well as tax savings. Which form of entity should you choose? In deciding about the form of entity, you should be aware of the tax and non-tax issues involved. Often, the non-tax considerations of a form of entity may outweigh the tax savings. The operational characteristics of the various forms of entity are governed by the general state laws, federal and state laws and the agreements made between the owners. Certified Public Accountants can help you understand how different forms of entities you structure may impact your business's bottom line.

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. Before applying any information to your business situation, you should seek the expert assistance of not only a CPA to provide competent, professional business advice but you may need the assistance of a legal expert as well.

If you are considering starting a business, consult a CPA before selecting a form of entity. A CPA has a broad business background and expertise in dealing with the tax and non-tax matters that confront business owners.

Tax considerations for Proprietorship, Partnership and Limited Partnership
TAX CONSIDERATIONS	PROPRIETORSHIP	PARTNERSHIP	LIMITED PARTNERSHIP
Alternative Minimum Tax (AMT): Like the passive loss rules, AMT is an attempt to close tax loopholes by not allowing deduction for items such as accelerated depreciation, oil and gas preferences, some itemized deductions, and applying a flat rate of tax.	Individuals are subject to AMT.	Pass-through AMT items to partners.	Pass-through AMT items to partners.
Retirement Plans	Deduction for payments to Keogh Plan or SEP.	Deduction for payments to Keogh Plan or SEP.	Deduction for payments to Keogh Plan or SEP.
Tax YearsBusiness Purpose Fiscal years are available to pass-through entities and PSCs if they can prove that at least 25 percent of gross receipts are received in the last two months of the proposed fiscal year.	Must use tax year of proprietor, i.e. calendar year.	Generally must use tax year of partners or make tax Section 444 election for September 30, October 31, or November 30 year-end.	Generally must use tax year of partners or make tax Section 444 election for September 30, October 31, or November 30 year-end.
Other tax considerations	Not required to maintain formal books and records.	Can have special allocations of income (loss).^{(1, 2)}
Taxability of Income/Pass-Through Entities: Pass-through entities are not subject to income tax at the entity level. Rather, the owner or owners report items of income or loss on their individual income tax returns, resulting in a single level of taxation.	Self-employment income of the individual	Pass-through	Pass-through
Compensation and Payroll Taxes: Wage income is earned by employees. They have Social Security and Medicare taxes (FICA) withheld and the employer pays a matching amount along with unemployment taxes. Employees also have federal and state income taxes withheld. Self-employment income is earned on all of the net business income of the self-employed individual who pays both the employer's and the employee's share of Social Security and Medicare taxes.	Self-employment earnings, pay FICA and income tax in quarterly estimated tax payments.	General Partners: Self-employment earnings pay FICA and income tax in quarterly estimated tax payments.	General Partners: Self-employment earnings pay FICA and income tax in quarterly estimated tax payments. Limited Partners: Quarterly estimated tax payments on share of partnership income.
Fringe Benefits: Health insurance Life insurance premiums	Limited.Not deductable.	Limited.Not deductable.	Same as partnership
Losses are passed through to the owner not to exceed investment (tax basis).	Pass-through	Pass-through	Pass-through subject to passive loss limitations.
Passive Activity Rules: Passive activities are businesses in which the taxpayer does not materially participate, or rental activities which are passive by definition. Passive losses may not offset active or portfolio income if an entity is subject to the passive loss rules.	Subject to passive loss rules at owner level.	Subject to passive loss rules at owner level.	Subject to passive loss rules at owner level.

Tax considerations for S Corporation, C Corporation and Limited Liability
TAX CONSIDERATIONS	S CORPORATION	C CORPORATION	LIMITED LIABILITY(LLC)⁽³⁾
Alternative Minimum Tax (AMT): Like the passive loss rules, AMT is an attempt to close tax loopholes by not allowing deduction for items such as accelerated depreciation, oil and gas preferences, some itemized deductions, and applying a flat rate of tax.	Pass-through AMT items to shareholders.	Subject to AMT with required inclusion of Adjusted Current Earnings (ACE), which adds back tax-exempt earnings such as tax exempt interest, deferred installment sale income and insurance proceeds.	Same as partnership
Retirement Plans	Payments are deductible if nondiscriminatory plan is at same percentage rate as employees. Loans from retirement plan to shareholder/ employee are prohibited.	Payments are deductible if nondiscriminatory plan is at same percentage rate as employees.	Same as partnership
Tax YearsBusiness Purpose Fiscal years are available to pass-through entities and PSCs if they can prove that at least 25 percent of gross receipts are received in the last two months of the proposed fiscal year.	Generally must use tax year of shareholders or make Section 444 election.	May elect any fiscal year unless classified as Personal Service Corporation (see description in box).	Same as partnership
Other tax considerations	Not subject to accumulated earnings tax. Number of shareholders limited. Corporate dividend received deduction is lost. S Corp election can be inadvertently terminated. Income shifted to shareholder's state of residence. Avoid personal holding company tax. Avoid flat tax on personal service corporations. Not recognized by all states.	Risk of accumulated earnings tax.May be subject to personal holding company (PHC) tax.	Personal Service Corporation is a company whose principal activity is providing services in the field of health, law, engineering, architecture, accounting, actuary, science, performing arts, consulting. If these personal services are provided substantially by employers, owners, the company is considered to be a PSC and subject to certain rules and regulations.
Taxability of Income/Pass-Through Entities: Pass-through entities are not subject to income tax at the entity level. Rather, the owner or owners report items of income or loss on their individual income tax returns, resulting in a single level of taxation.	Shareholders have elected to be taxed as a pass-through entity.⁽¹⁾ The election can be changed from S Corp to C Corp and C Corp to S Corp.⁽¹⁾	Income tax is levied at the entity level and again at the shareholder level when retained earnings are distributed as dividends or in liquidation.	Generally pass-through if IRS requirements for partner tax status.
Compensation and Payroll Taxes: Wage income is earned by employees. They have Social Security and Medicare taxes (FICA) withheld and the employer pays a matching amount along with unemployment taxes. Employees also have federal and state income taxes withheld. Self-employment income is earned on all of the net business income of the self-employed individual who pays both the employer's and the employee's share of Social Security and Medicare taxes.	Wage Income Paid to Owner-Employees: Income and FICA and unemployment taxes withheld. Quarterly estimated tax payments may need to be paid on corporate income since it is taxable at shareholder level.	Wage Income Paid to Owner-Employees: Income and FICA taxes withheld. Quarterly estimated tax payments on dividends received from the corporation.	Same as limited partners.
Fringe Benefits: ×Health insurance ×Life insurance premiums	Limited.Not deductable.	Deductible to corporation. Not taxable to shareholder/employee up to $50,000 of life insurance.	Same as partnership.Not Deductable.
Losses are passed through to the owner not to exceed investment (tax basis).	Generally same as limited partner.	Loss is deducted against past or future income on the corporation's tax return.⁽¹⁾	Same as limited partner.
Passive Activity Rules: Passive activities are businesses in which the taxpayer does not materially participate, or rental activities which are passive by definition. Passive losses may not offset active or portfolio income if an entity is subject to the passive loss rules.	Subject to passive loss rules at shareholder level.	Not subject to passive loss rules unless PSC. Passive losses may only offset active income (not portfolio income) of closely held corporations.	Same as partnership.

Non-Tax considerations for Limited Partnership and Limited Liability
NON-TAX CONSIDERATIONS	LIMITED PARTNERSHIP	LIMITED LIABILITY
General Decription	A partnership where at least one party is General Partner and the other partners are Limited Partners.	Hybrid form business entity combining limit liability of a corporation and taxed as a partnership.
Organizational Structure	Governed by a limited partnership agreement filed with a state.	Organized under state law. Governed by Article of Organization, operating agreement and agreement of the members.
Owners	General Partners/Limited Partners	Members
Liability of owners	General Partner: Unlimited liability; limited to the investment in the partnership.	Investor's liability generally limited (similar to a corporation).
Continuity of life	Terminates upon change of partners.⁽²⁾	Have a stated definite life.
Transferability of interests	Transferable subject to partners' approval.⁽²⁾	Transferable subject to membership agreement.
Management and administration	Must have a general partner(s) who control(s) management and limited partners who cannot manage.	Typically controlled by an operating agreement.
Capitalization	Sources of capital expand by virtue of number of partners involved.	Generally same as partnership

Non-Tax considerations for Propietorship, Partnership and Corporation
NON-TAX CONSIDERATIONS	PROPRIETORSHIP	PARTNERSHIP	CORPORATION
General Description	Self-employed person.	More than one person or entity (i.e. another partnership or corporation) in business together.	An entity organized by law to act as a single person although owned by one or more persons/entities.
Organizational Structure	No formal organization nor documents required.	Generally governed by a partnership agreement.	Corporation charter issued by a state. Governed by Articles of Incorporation, bylaws and agreement of the shareholder(s).
Owners	Owner/Propietor	Partners	Shareholders
Liability of owners	Unlimited liability	Unlimited liability	Liability limited to assets in the corporation.
Continuity of life	Finite life, ceases upon death of proprietor.	Terminates upon change of partners.⁽²⁾	Indefinite life.
Transferability of interests	Assets can be sold but the entity ceases upon sale.	Transferable subject to partner's approval.⁽²⁾	Freely transferable by sale of stock.⁽²⁾
Management and administration	Single owner, characterized by simplicity, flexibility and control.	Not required to use centralized management.⁽²⁾	Centralized management, board of directors, and corporate officers must comply with corporate legal requirements.
Capitalization	Limited to owners' assets and loans.	Sources of capital expand by virtue of number of partners involved.	Generally same as partnership

With some exceptions/restrictions.
Subject to agreement.
LLC, Similar to LLPs (Limited Liability Partnerships) are available in many states. LLPs are general partnerships with a partial or full liability shield depending upon the state. Consult your CPA for further details.

AICPA

The CPA. Never Underestimate The Value.

Communications Division
American Institute of Certified Public Accountants
1211 Avenue of the Americas
New York, NY 10036-8775

Michael J. O'Doherty & Associates
373 Baltimore Pike
Springfield PA, 19064
(610) 604-4700 / Fax (610) 544-9525
Email MODCPA