Forming a New Business Entity | Basic Tax and Liability Considerations.
While business entities can generally be used for different purposes, whether to hold real estate property, run a family business, hold financial assets, or engage in an active business, not all types of business entities receive the same tax treatment from the Internal Revenue Service (“IRS”) and not all types of entities offer the same level of liability insulation from potential creditors. This is why choice of entity and tax treatment are amongst the most important considerations when forming a new business entity.
A corporation is generally taxed at the entity level, meaning that the corporation will have to file and pay tax on any income generated during the year at the current federal corporate tax of 21%, in addition to any applicable state income tax. Besides being taxed at the corporate entity level, when a corporation decides to pay a dividend to its shareholders, that dividend will be taxed as ordinary income to the shareholders. Qualified dividends that meet certain requirements can be taxed to the shareholders at lower capital gain rates. With regards to liability protection, a corporation normally shields its shareholders from personal liability and from creditors’ claims for the corporation’s debts and obligations.
At the other spectrum of the tax treatment are business entities organized as partnerships. A partnership is generally a business entity formed by two or more partners that will be taxed at the partner level, meaning that the income generated by the partnership is passed through to the partners, who will be responsible for reporting and paying taxes on their personal tax returns. Nowadays, there are different type of partnerships. In a general partnership, each partner is considered a general partner and will be personally liable for all the debts of the partnership.
Other variations of partnerships provide partners with liability protection. In a limited partnership there will be at least one general partner who will be exposed to personal liability for the partnership’s debts, and one or more limited partners who will not be personally liable for the partnership’s debts and obligations. In a limited liability partnership, all partners will generally be isolated from personal liability for the debts of the business. Partnerships, limited partnerships, and limited liability partnerships are all passthrough entities, whereby the income and losses will be passed through as tax items directly to the partners.
The most popular type of business entity is the limited liability company. A limited liability company is a hybrid business entity organized under state law, combining the best attributes of corporations and partnerships. On one hand, members of a limited liability company will be protected from being personally liable for the debts and obligations of the business, just like shareholders of a corporation. On the other hand, a limited liability company does not have to file and pay taxes, because is generally treated as a pass-through tax entity by the IRS and any profits or losses from the business will be taxed directly to the members, like partners of a partnership.
In addition to the tax classification of entities just mentioned, the IRS allows certain variations of business entities to choose different treatment for tax purposes. For example, a so-called S corporation can elect to be treated as a partnership, and a limited liability company can also elect to be taxed as a corporation.
Finally, it is important to point out that the Tax Cuts and Jobs Act added a 20% deduction (i.e., the Qualified Business Income (“QBI”) deduction), for certain passthrough entities, resulting in an effective offset of the top bracket for individual taxpayers. However, while the QBI deduction may work as an incentive for certain business owners to take advantage of the passthrough taxation and the 20% deduction, as explained in our QBI Deduction Alert, the IRS has recently closed the loophole on the use of segregated structures by specified service trade or businesses to take advantage of the 20% deduction.
 The Tax Cuts and Jobs Act of 2017 changed the corporate tax rate from a top bracket of 35% to a fixed rate of 21%.
 Generally, corporations with only one class of shares, less than 100 individual shareholders, all of whom are Us residents for tax purposes.