Important Tax Considerations in Starting a Business

08/02/2021

Major tax considerations in forming a business primarily surround whether or not the business owner wants items of income, loss, credit and deduction (“tax items”) taxed at the entity level or at the owner level. An entrepreneur should also be concerned about how to insulate the business from incurring back taxes, interest and penalties as a result of an Internal Revenue Service (“IRS” or “Service”) examination, which can be accomplished implementing proper record keeping upon formation. The discussion in this section will be limited to five major types of business entities: partnerships, C corporations, S corporations, and disregarded entities.

Obtaining an EIN: Upon formation, a partnership or corporation should obtain an Employer Identification Number (“EIN”). An EIN can most often be obtained online by going to the IRS website (www.irs. gov). In order to obtain an EIN, a Form SS-4 must be completed. The SS-4 is generally retained by the taxpayer, but in some cases, the IRS will require the taxpayer to submit the form by fax or mail to the IRS. Those circumstances are beyond the discussion in this section. A disregarded entity does not need to obtain an EIN, unless a bank account in the name of the business is needed. An EIN is required in order to file tax returns and make certain elections with the IRS, such as a disregarded entity election and S corporation election.

Partnerships: Partnerships are commonly referred to as “pass through” entities because items of income, loss, credit, and deduction flow through the entity to the partner and are taxed at the partner level. Partnerships include such entities as a limited liability company (“LLC”), general partnership, and limited partnership. It should be noted that if a partnership has one partner, the IRS will by default categorize it as a “disregarded entity,” which will be discussed later. An entity classified as a disregarded entity by default can file an election with the IRS to be treated as a partnership for tax purposes. This election is made by filing Form 8832 (Entity Classification Election). It should also be noted that a limited liability company with one member or multiple members can also elect to be taxed as a C corporation by filing the same Form 8832 and electing to be treated as an “association taxable as a corporation.” A limited liability company can also elect to be treated as an S corporation by filing a Form 2553 (Election by a Small Business Corporation).2 The taxation of C corporations and S corporations will be discussed later in detail.

Partnership tax items are reported on the partner’s income tax return. The partnership files an annual Form 1065 (U.S. Return of Partnership Income). Although the partnership files a return, it does not pay tax at the partnership level. The tax is calculated and paid by each respective partner who receives a Schedule K-1 for Form 1065 (Partner’s Share of Income, Deductions, Credits, etc.) from the partnership, which allocates each respective partner’s portion of income, loss, deduction and credit. This allocation is normally based on each partner’s respective percentage member interest in the partnership. Thus, for 50/50 partners, the allocation of tax items would also be 50/50. The Internal Revenue Code (“IRC”) permits partners to make allocations not in conformity with the partner’s percentage member interests in the form of a “special allocation.” However, there are very strict tests in the IRC applicable to special allocations and a tax professional should be consulted.

Disregarded Entities: As mentioned earlier, partnerships that have one member are classified by default as a disregarded entity. In the case of a limited liability company with one member, the LLC is commonly referred to as a “single member limited liability company” or “SMLLC,” which is also considered a disregarded entity. Again, a disregarded entity can file a Form 8832 and elect to be classified as a partnership for tax purposes. Unlike a partnership that files a partnership return (Form 1065), a disregarded entity does not have any requirement to file a return. Instead, the tax items are reported and paid by the single owner on his, her, or its tax return.

C Corporations: C corporations pay tax at the entity level and the shareholders receive dividends, which are taxed to them at special dividends rates.3 Unlike partnerships in which gain recognition occurs at the partner level, C corporations recognize gain at the entity level. This means that items of income, loss, credit and deduction are calculated at the entity level and tax is paid at the entity level by filing a corporation tax return (Generally, Form 1120 – U.S. Corporation Income Tax Return). The corporation pays tax at graduated corporate income tax rates. It is commonly stated that corporations have “double taxation,” meaning that income is taxed twice: Once at the corporate level by the filing of the corporate income tax return, and again at the shareholder level when the income is distributed to the shareholder in the form of a dividend.4

S Corporations: An entity treated as a C corporation can elect to be treated as a small business corporation (also known as a Subchapter S Corporation) by filing Form 2553 within two months and 15 days of the beginning of the tax year in which the election is to take effect. In the case of a newly formed corporation, the tax year would normally begin on the date of formation. If that deadline has passed, the IRS permits late election relief subject to meeting certain conditions. A tax professional should be consulted before requesting late election relief from the Service. S corporations are also considered pass-through entities, but aspects of this treatment are different from the treatment of partnerships. S corporations avoid the “double taxation” inherent in C corporation. Although corporate income, loss, deduction and credit is determined at the entity level, the tax on the corporate income is paid at the shareholder level. Tax items are passed through to the shareholder through the Schedule K-1 for Form 1120-S (Shareholder’s Share of Income, Deductions, Credits, etc.).

Other Tax Considerations: Beyond the scope of this section are other tax-related considerations in forming a business, which are quarterly payments of estimated taxes, required withholding related to payroll taxes, choosing a method of accounting, choosing a tax year for the business, self-employment taxes, and the Additional Medicare Tax as added by the Affordable Care Act (“ACA”). A tax professional should be consulted on these areas.

IRS Examinations: An entrepreneur should be meticulous about keeping adequate books and records of expenses incurred during the formation of a business, as well as after formation during operations. If the business is audited, the IRS will request varying levels of “substantiation,” which include, but is not limited to, books and records, receipts, invoices, cancelled checks, bank statements, and credit card statements. An entrepreneur may make a significant capital outlay prior to opening a business, and any documents that support the expenses incurred in making the capital outlay should be retained. It is the opinion of the author that records substantiating business expenses should be retained indefinitely in hard copy or electronic form. Take the example of an entrepreneur who pays for substantial tenant improvements to a retail space in Year 1, and in Year 10 the business owner abandons the space and the improvements. If there is an IRS examination for Year 10, the business owner will need to substantiate the actual existence of the improvements and the cost basis of the improvements. If the business owner has discarded the records, it will be difficult to establish that the improvements in fact existed, let alone the cost basis. If an entrepreneur is vigilant about keeping good books, records, and substantiation of expenses at the outset of the business formation and thereafter, the process of an IRS examination will be less painful.

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