Partnership. Partnership income is taxable to the partners regardless of whether it is actually distributed or retained in the business. The partners report their distributive share of partnership income, deductions and credits on their individual income tax returns, where these items will be combined with income and losses from other sources. This income is taxed at the individual income tax rate applicable to that partner’s tax bracket. The partners may allocate their distributive share of partnership income, deductions and credits for tax purposes in the partnership agreement. As long as there is “substantial economic effect” to the allocation (as defined by tax laws and Internal Revenue Service regulations), the partnership may offer greater opportunity for tax planning than the proprietorship or corporate form of organization. By “substantial economic effect” essentially means that the allocation made in the partnership agreement may actually affect the dollar amount of the partner’s share of the partnership income or loss independently of any tax consequences. As with the proprietorship, both the amount and character of various income and deduction items are passed through to shareholders. However, certain deductions may not be permitted, certain items must be separately stated, and a partner’s ability to claim his or her share of partnership losses generally is limited to the partner’s adjusted basis in the partnership interest. (Basis is a way of measuring an individual’s investment in property.) In the case of a partnership interest it generally starts with the amount of cash or basis of property contributed for the partnership interest (or the amount paid in the case of a purchase from another partner) and is increased by later contributions and income allocated to the interest and decreased by losses allocated to the interest and distributions. Basis also can be affected by the amount of partnership debt allocated to a partner for tax purposes. These rules can be quite complex and often should be discussed with competent advisors when a partner’s tax basis is relevant. C Corporation. C corporations are legal entities and taxed separately from their owners. The C corporation’s taxable income, and tax, are determined prior to distribution of profits to shareholders. Profits which are distributed to shareholders in the form of dividends are then taxable to the shareholders. Thus both the C corporation and the shareholder are subject to tax on their respective incomes. The dividends are taxed to the shareholder as ordinary income. The attributes of capital gains, charitable contributions and other income and deduction items end at the C corporation and do not retain their character when passed to shareholders in the form of dividends. Similarly, individual shareholders do not share a corporation’s losses for tax purposes. C corporations offer some opportunity for tax planning in that dividends may be accumulated by the corporation rather than distributed to shareholders. However, Internal Revenue Service regulations limit the amount of accumulated earnings that may be retained by the corporation. An accumulated earnings tax may be imposed on excessive accumulated earnings. Because all income of the sole proprietorship, partnership, and S corporation is taxable to the owners whether or not it is distributed, these entities are not subject to the accumulated earnings tax. The C corporation also may pay a salary to owner-employees. Salaries are deductible by the corporation and thus are not included in the corporation’s taxable income. However, the Internal Revenue Service may treat excessive salaries as dividends and disallow that portion of the salary expense. S Corporation. Like a partnership, the S corporation is a conduit through which the firm’s income and deductions flow to the shareholders. Income items (including capital gains) and deductions generally retain their character when passed through to shareholders. Special reporting rules apply and the opportunity to fully claim a share of the S corporation’s losses may be limited by passive activity or other tax rules as well as by the shareholder’s tax basis in stock and in loans made by the shareholder to the S corporation. Unlike a partnership, allocations to S corporation shareholders must be in proportion to their shareholdings. Thus this form of organization may offer less attractive tax planning opportunities.
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