Yesterday, we explored your options for entity choice in forming your family business and the general tax issues of each structure. Today, we will dig into each of these a little deeper and explore the applicable accounting and tax elections, income and loss treatments, and limitations and flexibility each offers.
Managing and operating your family business
Family dynamics, sibling rivalry, and even holiday squabbles aside, operating a family business requires trade skills, industry knowledge, and tax and strategic planning to make the most of available capital. Let us look at some of the tax advantages and disadvantages to operating a business, depending on its entity type.
LLCs and partnerships are one of the most attractive structures for closely held or family businesses because of their flexibility.
- Taxation: Income and deductions can be specially allocated to the partners. These strategies must be carefully planned and executed, as the rules governing special allocations in partnerships are complex and heavily audited by the IRS.
- Losses: Losses are limited to members outside basis, or the tax basis of contributions, partnership debt and previously taxed income. Any excess is suspended and carried forward to future tax years. Cash distributions also offset outside basis, with excess being treated as either long- or short-term capital gains.
- Accounting method: Many partnerships elect to use the cash method of accounting for tax purposes, with special rules applying to those owned by corporations.
- Deductions: Partnerships can also elect in or out of provisions to accelerate or defer deductions, such as bonus and §179 depreciation expense. These options provide flexibility in determining taxable income in a given year, allowing for advantageous tax and cash flow planning.
- Fiscal Year: There are limitations on tax elections available to LLCs and partnerships, as they generally must maintain the same fiscal (tax) year as a majority of their owners, most often limiting them to calendar years.
- Transfers: Transfers of partnership interests must be carefully executed to avoid triggering taxable events within the partnership or to other partners. However, when taxable transfers do occur, the partnership structure can allow faster recovery of tax basis adjustments for purchasing partners when compared to the other entity choices.
S-corporations offer some of the flexibility of partnerships with some of the ease of ownership and liability protection of corporations.
- Accounting Methods: Many of the same accounting method and depreciation elections are available to S-corporations, however a key difference lies in the fact that special allocations cannot be made, and tax items are allocated to shareholders on a per share per day ownership basis.
- Ownership: S-corporations are limited to issuing one class of stock to up to 100 shareholders, and those shareholders are limited to specific types of taxpayers. Generally, nonresident aliens, certain trusts, partnerships and corporations cannot own S-corporation stock. This means in the case of a family business, careful planning is required to take advantage of minimizing tax on transfers of ownership, and often limits S-corporations to a calendar year end.
- Fiscal Year: As a general rule, an S-corp will use the calendar to dictate its fiscal year. However, an S-corp may apply to use a fiscal year that coincides with the tax year used by shareholders holding more than 50% of the corporation’s stock.
- Transfers: Transfers of ownership do not have tax consequences to the corporation, and sales or gifts of minority interests within families often qualify for valuation discounts to minimize transfer taxes (similar to partnerships).
- Distributions: As with other flow-through entities, S-corporations allow owners to take tax-free distributions against contributed capital and previously taxed income, eliminating the second layer of taxation which exists on dividends paid out by traditional corporations. As distributions are taken, they offset a shareholder’s basis in his stock. Once a distribution reduces stock basis to zero, the remainder is usually taxed as a long-term capital gain, again more favorable than dividend treatment.
- Losses: As in partnerships, without basis a shareholder cannot claim any losses from an S-corporation; instead, these amounts accumulate and carry forward until basis is restored either by S-corporation income or capital contributions. Losses from S-corporations can be further limited, and again are not specially-allocable to specific owners who could benefit from them. However, partners are generally able to include liabilities of the business when calculating their basis; this is not the case for S-corporations. For many startup businesses with early tax losses, the basis limitations will favor choosing a partnership over an S-corporation.
C-corporations, as we outlined yesterday, are separate from their owners and thus offer a strong shield of liability.
- Fiscal Year: C-Corps are unique in that it allows for the business to easily elect a fiscal year, without restrictions based on the owners. This may be advantageous for businesses with a cyclical revenue stream, such as contractors who are busiest over summer or manufacturers with particularly busy times of year.
- Ownership: C-corporations also have no restrictions on ownership, meaning any taxpayer can hold stock. Shares are easily transferred or sold, and do not trigger any taxable event for the C-corporation or its other owners. C-corporations can also issue multiple classes of stock, meaning a family can issue non-voting shares to members not actively involved in the business.
- Taxation: Since C-corporations are separate legal entities from their owners, they are subject to their only layer of tax. No items flow through to the personal returns of owners – for most family businesses, this requires cash to be drawn from a C-corporation as either wages or dividends, both of which are subject to additional taxes. However, tax filings for owners of a C-corporation are generally more straightforward when compared to flow-through owners who need to deal with K-1 reporting.
- Exit planning: C-corporations can be subject to double-taxation on operating profits and potentially on proceeds from the sale of the business. Possible long-term scenarios should be thoroughly modeled to identify undesired back-end tax results. In addition to this analysis, the likelihood of achieving a IRC Sec. 1202 exclusion (a provision which can exclude 100% of the gain on the sale of C-corporation stock) should be evaluated.
- Accounting method: C-corporations are subject to the same $25M gross receipt threshold as partnerships and S-corporations when it comes to electing to be cash basis taxpayers. They are also able to elect in or out of additional depreciation deductions, providing a little wiggle room when it comes to cash flow planning at the corporate level.
As you can see, each formation option has advantages and disadvantages, and selecting the right one for your family business is not as obvious as you might hope. While we have covered the basics here, there are many layers of complex rules at play. If you are considering starting or are preparing to take over a family business, let your M&S Tax Advisor help make all the best decisions.