GENERAL BACKGROUND

The United States (US) taxes business entities based on how they are classified for income tax purposes. There are distinct differences in the tax treatment of flow through entities compared to corporations.

This article will provide a brief overview of the different US tax implications applicable to flow through entities and to corporations. This is especially important for International businesses who are expanding or looking to expand to the US.

The recent “Made In America Tax Plan” of the Biden Administration is another important factor to consider and how this proposed tax reform could affect your current or future US structure. This tax plan proposes corporate reforms to stimulate economic growth in the US post-COVID and one of the key provisions of the plan applicable to this article includes raising the U.S. corporate rate to 28% from 21% and imposing minimum taxes on both foreign incomes as well as the domestic earnings that corporations report to shareholders, all of which are expected to hike corporate America’s tax bill.

INTRODUCTION

Businesses in the US can choose from five basic legal structures of which a quick summary is provided below:

  1. Sole proprietorship
  2. Partnership
  3. S Corporation
  4. C Corporation
  5. Limited Liability Company (LLC)

The above list can then be further categorized as follows – 

  1. Pass-Through Entities:
    1. Sole proprietorship
    2. Partnership
    3. S Corporation
  2. C Corporation
  3. LLC, which is a legal entity only, and is taxed as one of the four options above

Businesses in the US are either taxed as pass-through (or flow-through) entities or as corporations. Unlike C-Corporations, flow through entities are not subject to the corporate income tax or any other entity-level tax. Instead, their owners or members include their allocated shares of profits in taxable income under the individual income tax. 

From a federal tax standpoint, the Internal Revenue Service (IRS) treats an LLC as an eligible entity under the “check-the-box” rules, and therefore, the LLC has the flexibility to be classified as either a partnership, an association taxable as a corporation, or a disregarded entity. 

FEDERAL TAXATION OF FLOW THROUGH ENTITIES

  1. Sole Proprietorship —
    A sole proprietorship is not treated as an entity separate from its owner for federal income tax purposes and the income earned by the sole proprietorship is simply included on its owner’s individual income tax return along with his or her other items of income and deduction. The income of a sole proprietorship is therefore taxed at its owner’s individual marginal income tax rates.
  2. Partnership —
    While a partnership is treated as an entity separate from its owners for some tax purposes, it is not treated as a separate tax-paying entity. The partnership’s items of income, gain, loss, deduction, and credit are passed through to its owners and included on their income tax returns for the year that includes or ends with the end of the partnership’s taxable year.
  3. S Corporation —
    A S corporation is generally not subject to any corporate-level taxes. Its income, gain, loss, deduction, and credit pass through to its shareholders and are reported by them on their individual income tax returns.  An S corporation may, however, be subject to corporate-level taxes if it was originally formed as a C corporation and converted to S status after its initial taxable year. It’s also important to note that S Corporations aren’t allowed to have non-US citizen shareholders.

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FEDERAL TAXATION OF CORPORATIONS

Entities classified as corporations that do not elect to be taxed as “S corporations” are considered “C corporations.” The term “C corporation” refers to Subchapter C of the Internal Revenue Code, which governs the taxation of a C corporation. 

Under Subchapter C of the Code, a corporation is treated as a separate taxable entity. Thus, income generated by the corporate business is taxed twice. The income is taxed once earned by the corporation and again when distributed to the shareholders. C corporations are therefore taxed quite differently than a pass-through entity

STATE TAXATION 

The state income tax consequences of the selection of an entity must also be considered. As a general rule, sole proprietorships and partnerships are exempt from state-level income taxes just as they are from federal income taxes. Some states, however, impose entity-level taxes on sole proprietorships and partnerships. Similarly, some states impose a separate, entity-level tax on LLCs.

C corporations are generally subject to a separate entity-level state income tax. The treatment of S corporations varies greatly from state to state. Some states follow the federal tax treatment of S corporations, while others tax S corporations as regular corporations. Moreover, some states that recognize the federal S election may still impose a corporate-level tax (if, for example, the corporation has non-resident shareholders).

POSSIBLE TAX REFORM SHIFTING MINDSETS (ONCE AGAIN)

The proposed reforms of President Biden regarding the increase of the corporation tax rate could once again reshape the way businesses and individuals analyse entity choices in the US and abroad. It’s however advisable to not jump to any conclusions as of yet and avoid the looking for advice from the tax specialist called Google. This could lead to premature decision made on your US structure that could have negative tax implications in the long run. 

Irrespective of the possible increase in corporate tax rates, there is always opportunity for tax planning, and one should be cognizant of this when looking at a structure. There’s no one shoe that fits all answers. 

CONSIDERATION OF WHICH US BUSINESS ENTITY TO ESTABLISH

When considering what US business entity is best for a given circumstance, the two most common entities that impact Australian businesses and Australian families investing in the US are C corporations and LLCs.

The choice of entity should always be driven by the commercial objectives of a client. The commercial objectives are therefore looked at first and this could be then structured in the most tax efficient manner. Which could be either by using a flow through entity or corporation. 

At Asena Advisors we make sure that your specific needs are catered for and that our recommendations on choosing a structure is family/business specific. Choosing between a flow through or corporations will therefore depend on the client’s needs and optimizing long term growth for the client.

Shaun Eastman

Peter Harper