Taxation of Business Income and Loss
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 relates to the tax considerations on how income and losses are taxed in various business forms.
A partnership or LLC is not a separate tax-paying entity. Each partner or member is separately and individually taxable on his share of partnership or LLC profits, losses, deductions, and credits. Each partner or member reports his share of each tax item, and each item retains the same character it had when it was earned or incurred by the partnership or LLC. Under this pass-through tax regime, the members and partners avoid the double tax imposed on corporate income and the losses incurred by the business may offset income the partner or member has from other sources.
A C corporation is a separate, tax-paying entity. Its income and profits are taxed at the corporate level when earned, and these amounts are subject to a second tax when they are distributed to the shareholders as dividends. At the corporate level, dividends are taxed as ordinary income, at the shareholder level dividends are taxed under the capital gains rates. Dividends were previously taxed to the individual shareholders at ordinary income tax rates. Tax advisors then devised plans in which to avoid the ordinary income tax rate in preference for the lower capital gains tax rate by devising techniques referred to as “bail outs.” A “bailout” is a distribution of earnings in a transaction such as a redemption of stock, that qualifies as a “sale or exchange,” enabling the shareholder to recover all or part of her stock basis and to benefit from preferential capital gains treatment on any realized gains. In some cases, such as where the shareholder has died and the basis of her stock has been stepped up to its date of death value, the bailout may be accomplished tax free. Congress responded to these techniques with anti-bailout provisions to ensure that distributions resembling dividends would be taxed as ordinary income. When dividends and capital gains are taxed at the same preferential rate, the traditional incentive for a bailout almost disappears. But if capital gains are taxed at much lower rates than dividends, a bailout becomes a viable strategy to reduce the double tax on C corporations and their shareholders. Currently, dividends and long-term capital gains rates mirror one another, diminishing any type of motivation for bailouts.
Taxation of an S corporation is similar to the treatment of a partnership and LLC. An S corporation is not a taxable entity; it serves as a conduit through which its income and losses passes through to shareholders. Each shareholder reports his share of each tax item on his tax return, and these items retain the same character they had when they were earned or incurred by the S corporation. Although a partnership is never treated as a taxable entity, an S corporation may be taxable if it once operated as a C corporation. Corporate-level taxation may result if excessive passive-type income is generated by corporation assets or if the corporation disposes of assets that had built-in gains when the S election was made.
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.
McGrath & Spielberger, PLLC provides legal services in Florida, Georgia, North Carolina, Ohio, South Carolina, and Tennessee, as well as in some Federal courts. The Firm offers full scale representation, as well as limited scope services, as appropriate for the situation. Please be advised that the content on this website is not legal advice, but rather informational, and no attorney-client relationship is formed without the express agreement of this law firm. Thank you.