The Tax Implications of Allocations of Income or Loss Items in a Business
When you decide to start a business venture, there are a myriad of things to consider. We regularly assist small business owners, especially start-up businesses, walking them through the steps that need to be taken in order to make the business official and legal. There are many ways a business can be organized and there are both non-tax and tax factors as well as state and local statutory requirements that need to be taken into consideration when embarking on this exciting journey of starting a business.
I previously wrote an article regarding the non-tax factors that should be considered when starting a business. This article is one of a series of articles that focuses on the tax implications of certain business activities and things you should consider when choosing your business entity. The most prominent federal tax considerations in choosing a business entity include:
- Capital Contributions
- Ownership Restrictions
- Business Income and Loss
- Allocations of Income or Loss
- Basis Limitations and the Deductibility of Losses
- Employment Tax Considerations
- Tax Rates on Ordinary Income
This article addresses how income and losses are allocated in the different types of businesses.
The owners of a partnership or LLC may establish their shares of each partnership or LLC item through provisions in their partnership or operating agreement. An allocation provided for in the agreement is respected for tax purposes unless under the tests contained in the Internal Revenue Code Regulations determine that it lacks substantial economic effect. If you have your operating or partnership agreement carefully drafted by a professional the agreements will ordinarily satisfy these tests making most allocations of partnership or LLC tax items valid.
Investors in a C corporation can create some flexibility for allocating income and capital appreciation among themselves by issuing different classes of common and preferred stock as well as sophisticated debt instruments.
Little flexibility is available to S corporations as an S corporation is permitted to have only one class of common stock. Although voting rights may differ, preferred stock cannot be used to create different interests in corporate capital and income. Some differences in the cash flow allocated among S corporation shareholders can be effected if a portion of their capital is provided as loans rather than as capital contributions. Because of the use of sophisticated hybrid securities may be characterized as a prohibited second class of stock, their use is precluded.
A pass-through tax regime such as a partnership, LLC, or S corporation permits losses to pass through to the owners who devote their time and energy to the business. The ability of passive investors to deduct losses is often delayed by several Internal Revenue Code provisions designed to curtail tax shelters. A C corporation is not able to pass through start-up losses to its shareholders, but corporations may deduct losses against their taxable income and carry any excess back or forward as net operating losses. For start-up companies that raise capital from outside investors, these tax rules are among several factors that may weigh in favor of a C corporation. Although start-up losses do not pass through as they are realized, most taxable investors would be unable to deduct them currently in any event. The losses may be used more efficiently as carryforwards to shelter income earned during the early years of a C corporation’s profitability.
For a complete analysis of the tax implications of C Corporations, Partnerships, and S Corporations click here for the Joint Committee on Taxation’s publication entitled “Choice of Business Entity: Present Law and Data Relating to C Corporations, Partnerships, and S Corporations.”
Attorney Angel Oliver / McGrath and Spielberger, PLLC assists clients with all sorts of tax matters, both federal and state (including but not limited to North Carolina and South Carolina). Click here to contact Ms. Oliver about your tax matter.
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