Currently the most popular forms of ownership for small and medium businesses is in the form of Limited Liability Companies (LLCs) or through S Corporations. These entities are relatively simple to set up and provide protection for assets of the owners of the businesses. They also only feature one layer of taxation, as the profits and losses are directly taxed on the owner’s tax returns, rather than on the business level, also known as pass-through taxation.
The benefits of this generally relate to owners taking profits out of the business, as the pass-through taxation eliminates the double taxation of dividends on both the business and shareholder level. For example, any dividend that say Apple pays to you as a shareholder will have been taxed twice; first via a corporate level income tax and then again to you as the individual shareholder. This double taxation can make the effective rates of taxation on profit upwards of 60% in some cases.
Despite their popularity, many business owners are still unfamiliar with the taxation of these structures, particularly on their personal returns. Below are some basic “ABCs” to better help owners understand taxation of these entities
A is for Assignment of Profit and Loss. As mentioned above, the business income or loss is reported, or assigned, to the individual that owns the entity. Contrary to popular belief, the amount distributed to the shareholders does not represent the taxable amount onto the shareholders return, but rather the full amount of the profit the business earned. Often, the business profit can be reinvested in the business or used to pay down debt, which leads to an increase in basis.
B is for Basis. Basis represents, on a general level, what “skin in the game” the owners have in the business. Any investments into the business, such as initial capital, loans into the business from owners, and retained profits increase the basis in the business. Any distribution of profits or losses can decrease the basis in the business.
C is for Convenience of Distributions. In a typical C Corporation structure, distributing money to the shareholders can be a difficult process. Typically the board will need to pass a resolution to approve the dividend, the dividends must be paid to the shareholders in an equal amount to their ownership rights, the dividends in certain cases must have withholding on them, and additional information returns are required to be filed with the government. Additionally, as mentioned above, the taxpayer will pay tax on these dividends again, which represent profit previously taxed. In a pass-through structure, the owners can just cut themselves a check directly to represent the distribution they wish to make, and may distribute as much or as little profit as they would like and the business can sustain.
Often business owners can get confused and frustrated seeing a profit on their tax return for which they only received a certain amount in distributions, and often wonder why the company isn’t paying the tax itself. While this anger is understandable, owners should also consider all the benefits that they will get in the future and in the past with the pass-through taxation, and make sure they understand precisely what is happening with the taxation of their business.
Edward McWilliams, CPA
Partner
Ed is a Partner in the firm’s tax and business advisory practice focusing on providing services to middle market private companies across different industries as well as to early stage startups. Ed has over a decade of experience providing tax and business consulting services to these companies of different sizes and across different industries, bringing a broad and diverse knowledge base and strategic solutions to the many complex issues that businesses face.