The traditional C Corporation makes up less than 25% of our client base.  There may be good reasons for the C Corporation, but the majority of our clients operate their businesses in a flow through entity as either a partnership or as an S-Corporation.  In both cases, the incidence of taxation rests with the owners of the entity where the activity is reported to the Government on the K-1 information return.

There are reasons one may choose one flow through type over the other.  Partnerships allow for great flexibility as the underlying principle of the partnership agreement is that it must have “substantial economic effect”.  In other words, the deal between the partners must make sense and cannot be a device to avoid taxation. Partners can be any type of entity, from individuals, corporations or even other partnerships.  Entry and exit in and out of a partnership can be done in tax-deferred methods that can minimize personal taxation.  The division of items of income, expense gain or loss are dictated primarily by the partnership agreement as long as they make economic sense.

S Corporations are much more formal.  The division of items of income, expense gain or loss are done strictly on a per share per day basis.  Ownership is limited to American citizens, resident aliens or qualifying trusts.  The number of shareholders is limited to 100, although that can be a larger number based on family attribution rules.  Transfer of assets out of an S-Corporation will result in a taxable event.  The difference between fair market value and the corporation’s basis will trigger gain or loss at the corporate level that is then reported on the individual K-1.

In order to take a loss from either type of flow through entity you must have basis in the entity or, in the case of a partnership, be at risk for a loss. Basis is created by a direct investment in the entity, either in the form of a capital investment or a direct loan.  Profits will increase your basis and losses and distributions will decrease your basis.  Partners that personally guarantee a loan will be considered “at risk” and can use that to take a loss on their personal return, but this will reduce their basis in that particular loan and that can create taxable income when the loan is repaid.  Loans guaranteed by real estate, but not personally guaranteed are called qualified non-recourse debt and can create basis in real estate partnerships.  The same tax danger exists when that debt is repaid or the entity sold with the debt is still outstanding.

Partners cannot be employees of their partnership.  If they are actively employed in the conduct of a business, then the income earned will be subject to self-employment tax.  However, this activity will not be subject to the net investment income tax.  S-Corporation owners working in their business will be considered employees and must be paid a reasonable compensation.  This is done to avoid the temptation of taking out all the S-Corporations’ earnings in distributions that are not subject to self-employment tax or the net investment income tax.  What is considered a “reasonable” compensation is a facts and circumstances test and the IRS will be looking at S-Corporation owners paying an unreasonably low wage to themselves.

Partnerships and S-Corporations have a great deal of similarities and are not subject to a corporate level tax.  Partnerships offer a greater degree of flexibility, however, someone used to a regular paycheck and the withholding that goes along with it can get frustrated.  S-Corporations are great for active businesses as you can both receive wages and distributions that have differing tax consequences, but the S-Corporation is much less flexible in its operation. 

Most real estate entities we see are set up as partnerships.  To the extent the real estate partnership is tied to a related operating entity, the income will not be subject to the net investment income tax.  Operating entities can go either as an S-Corporation or as a partnership, depending on how sophisticated your agreements may be, how you are financing the entity and the types of owners involved.  Deciding how you want to set up your business can be a daunting task and, as always, your Dermody, Burke & Brown tax professional can walk you through the pros and cons of your entity choice.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.