What Are Some Other Business Entities And What Are The Tax Consequences If These Entities Generate Income or Loss?
In addition to C corporations, S corporations, partnerships, and sole proprietorships, four other business entities are particularly common: limited liability companies (LLCs), limited liability partnerships (LLPs), limited partnerships (LPs), and professional corporations (PCs). When forming one of these entities, it is important for you to know the tax consequences if your business generates income or loss. Additionally, you should be aware of the impact (if any) on tax basis.
Impact on Specific Business Entities
Tax treatment will vary, depending on the type of business entity you select.
Limited Liability Companies (LLCs)
An LLC is a business entity created and regulated under state law. LLC laws allow companies that operate as partnerships to benefit from the limited liability characteristics of corporations. This means that LLCs give their owners, who are called members, protection from the claims of business creditors. Thus, the liability of an LLC member for business debts is limited to the value of his or her individual ownership interest in the LLC. Also, unlike limited partners in a limited partnership, all LLC members can take an active role in the operation of the business without exposing themselves to personal liability.
For federal tax purposes, the LLC can choose to be treated as a partnership or as a corporation. In general, LLCs choose to be taxed according to partnership rules to avoid the double taxation imposed on C corporations. Because the LLC entity itself does not pay federal income tax, net income is therefore taxed at a single level to the members. The LLC serves as a conduit or pass-through entity, like a partnership or S corporation. It must, therefore, issue each member an Internal Revenue Service Form K-1 at the end of each year, showing the member's proportionate share of the business's profit or loss.
An LLC with a single owner will be treated like a sole proprietorship for federal income tax purposes if it does not elect to be taxed as a corporation. However, you should be aware that some states do not recognize or permit LLCs with a single owner.
Limited Liability Partnership (LLP)
Most states allow certain professionals (such as doctors, lawyers, and accountants) to form an entity similar to the LLC. This entity is called a limited liability partnership (LLP). An LLP is a partnership organized under state statutes that give a degree of liability protection to individual partners. Partners in a general partnership are liable for all partnership obligations, including the negligence or malpractice of other partners. Once an LLP business is properly registered, however, the partners of the LLP do not have liability for the malpractice of the other partners but still remain liable for their own acts.
For federal tax purposes, an LLP follows the same entity classification rules as the LLC. That is, it can elect to be taxed as a corporation or as a partnership. Most LLPs will choose to be taxed as partnerships, however, in order to avoid the double taxation imposed on C corporations. Therefore, the entity itself does not pay federal income tax but rather passes income and losses through to the individual partners.
Limited Partnerships (LPs)
A limited partnership (LP) is defined as a partnership with one or more general partners and one or more limited partners. General partners are liable for all partnership debts and obligations. In contrast, a limited partner is only liable for the value of his or her individual ownership interest in the partnership. Although LPs are similar to LLCs and LLPs, there are a number of differences, as well. For instance, although most states forbid limited partners from participating in management decisions, LLC members are free to participate in management.
Basically, LPs are taxed as partnerships for federal tax purposes. Income and losses pass through to partners, but recognition of losses is limited by the partner's basis, the at-risk rules, and the passive activity rules. Although a general partner's share of business income is subject to self-employment tax, a limited partner's share of business income is not subject to self-employment tax unless the partner performs services for the partnership.
Professional Corporations (PCs).
PCs, or qualified personal service corporations (as they are sometimes called), are a special type of corporation composed of professionals. Under the federal tax code, a qualified personal service corporation is defined as a corporation formed under state law in which substantially all of the activities involve services in the fields of health, law, engineering, accounting, actuarial science, performing arts, or consulting.
The tax treatment will depend largely on how much of the outstanding stock is owned by employee-shareholders. Although PCs can sometimes choose to be treated as S corporations, most will choose to follow the regular C corporation rules. Like a C corporation, a PC is normally treated as a separate tax entity from its owners (employee-shareholders). However, certain PCs are not taxed at the same graduated rates that apply to C corporations. Rather, these PCs are taxed at a flat 35 percent rate on their taxable income. In practice, however, the shareholders typically receive profits as tax deductible (to the corporation) salaries, bonuses, and fringe benefits. Therefore, the shareholders usually pay income taxes on their individual returns, while the PC pays nothing. The 35 percent income tax applies only to money actually left in the corporation at the end of the tax year.
Tip: Note also that PCs are subject to the passive activity loss rules and the at-risk rules. For more information, contact an accountant or business attorney.
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