Podcast Summary: "Entity Selection" | How Tax Works

Release Date: June 10, 2024
Host: Matthew Foreman, Co-Chair of Falcon Rappaport & Berkman’s Taxation Practice Group

Introduction to Entity Selection

In the inaugural episode of "How Tax Works," host Matthew Foreman delves into entity selection, emphasizing its critical importance for business owners. Foreman asserts that choosing the right business entity stands as one of the most significant decisions entrepreneurs make, influencing both legal protections and tax obligations.

"Entity selection is perhaps the most important decision a business owner will make."
— Matt Foreman [00:00]

Balancing Legal and Tax Considerations

Foreman outlines the fundamental tension between legal and tax considerations when selecting a business entity.

• Legal Considerations (Corporate Perspective): Focus on maximizing liability protection.
• Tax Considerations: Aim to minimize tax burdens.

He highlights that these objectives often pull in opposite directions, requiring a strategic balance to achieve optimal results.

"From a corporate perspective, you want as much protection as possible, but from a tax perspective, you actually want to lower your taxes."
— Matt Foreman [00:02]

Understanding C Corporations

Foreman begins with an in-depth analysis of C Corporations, detailing their characteristics and tax implications:

• Characteristics:

  • Limited liability
  • Free transferability of ownership
  • Centralized management
  • Perpetual existence

• Tax Implications:

  • Subject to a flat 21% federal corporate tax rate.
  • Additional state taxes ranging from 4% to 8%.
  • Distributions taxed at the shareholder level, potentially up to 23.8% when including capital gains rates.

"C Corporations... have limited liability, free transferability of ownership, centralized management, continuity of life."
— Matt Foreman [00:05]

Partnerships and Unincorporated Entities

Foreman contrasts C Corporations with Partnerships and Unincorporated Entities like LLCs:

• Characteristics:

  • Typically offer limited liability (especially LLCs).
  • Managed by owners or designated managers.
  • Flexibility in ownership and operational structures.

• Tax Implications:

  • Pass-Through Taxation: Income taxed at the individual owner level, potentially reaching up to 37% plus state taxes.
  • Payroll Taxes: Owners may owe payroll taxes on distributions unless specific exceptions apply (e.g., limited partners).

"Any partnership or LLCs... owners cannot receive W2s and the distributions are generally subject to payroll taxes."
— Matt Foreman [00:30]

S Corporations: A Middle Ground

While not extensively detailed in the transcript, Foreman touches upon S Corporations, highlighting their similarity to partnerships in terms of pass-through taxation, but with distinct requirements:

• Limitations:
  • Restricted to 100 shareholders.
  • Only U.S. citizens or residents can be shareholders.
  • Must adhere to having only one class of stock.

"S Corporations... no tax at the end level, but New York City ignores the S election and imposes an 8.85% tax on S Corporation income."
— Matt Foreman [00:45]

Tax Strategies and Considerations

Foreman emphasizes the importance of aligning entity choice with tax strategies:

• C Corporations may be advantageous for businesses that plan to reinvest earnings rather than distribute them, potentially lowering overall tax burdens.

  "For some businesses, being a C corporation can actually lower your taxes."
  — Matt Foreman [00:15]

• Pass-Through Entities like partnerships and LLCs are beneficial when businesses intend to distribute most of their income, despite higher individual tax rates.

  "Pass throughs... if you're going to distribute all or the vast majority, you're going to have lower overall taxes."
  — Matt Foreman [00:35]

Foreign Ownership and Cross-Border Implications

The episode also explores the complexities of foreign ownership in U.S. business entities:

• C Corporations are generally more accommodating, as they allow foreign shareholders.
• S Corporations and LLCs present challenges, including potential double taxation and qualification issues due to differing international perceptions of entity types.

"Foreign individuals, they can own partnerships... but foreign owners cannot hold shares in S Corporations."
— Matt Foreman [01:00]

Qualified Small Business Stock (Section 1202)

Foreman briefly covers Section 1202, which offers tax exclusions for gains on qualified small business stock, outlining its stringent qualifications:

• Must be an active business (not passive investments).
• Holding period of at least five years.
• Asset and investment thresholds must be met.

He warns of the complexities and narrow criteria, advising entrepreneurs to consult knowledgeable tax advisors when considering this option.

"Section 1202... has some very, very finicky rules and it exists somewhat on an island because it really doesn't."
— Matt Foreman [01:20]

State and Local Tax (SALT) Considerations

A significant portion of the episode is dedicated to State and Local Tax (SALT) implications:

• General Corporation Tax (GCT) and Unincorporated Business Tax (UBT):
  • New York City imposes an 8.85% GCT on C Corporations and an approximate 4% UBT on pass-through entities.
  • These taxes apply irrespective of the federal entity classification, complicating the tax landscape for businesses operating in or having clients from high-tax jurisdictions.

"New York City's... imposing a general corporation tax and a unincorporated business tax that can significantly impact your overall tax liability."
— Matt Foreman [01:40]

Foreman underscores the necessity of considering local tax rules alongside federal regulations to avoid unexpected tax burdens.

Strategic Entity Selection

Concluding the episode, Foreman advises business owners to:

1. Assess Long-Term Goals: Understand where the business aims to be in 1, 5, or 15 years.
2. Consult Tax Advisors: Engage with professionals to navigate the intricate tax implications of each entity type.
3. Consider Flexibility and Compliance: Be aware of the rules and potential pitfalls, especially when dealing with S Corporations and foreign ownership.

"Think about the long term and what you're trying to accomplish...it's really important."
— Matt Foreman [01:55]

Final Thoughts

Matt Foreman wraps up by reiterating the complexity of entity selection and its profound impact on a business's financial health. He encourages listeners to approach this decision with careful consideration and professional guidance to navigate the labyrinthine world of tax law effectively.

"Hope you learned something, hope you enjoy it... talk to you again in two weeks."
— Matt Foreman [02:00]

Key Takeaways:

• Entity choice significantly affects both legal protections and tax obligations.
• C Corporations offer lower tax rates on retained earnings but face double taxation on distributions.
• Pass-through entities like LLCs and Partnerships provide tax efficiencies for distributions but entail higher individual tax rates and potential payroll taxes.
• S Corporations present a middle ground but come with stringent ownership and operational restrictions.
• Foreign ownership introduces additional layers of complexity, often necessitating careful tax planning to avoid double taxation.
• State and Local Taxes can override federal tax advantages, making local tax law a crucial component of entity selection.

For personalized advice, always consult a qualified tax professional to navigate the specific needs and circumstances of your business.