Growing up on my family’s farm, we used a number of methods to water our crops. The most prevalent was to flood irrigate the fields. On a few fields, however, we used a pressurized sprinkler system, and it fell to me and my siblings to move the sprinkler pipe.
As many young men would, I considered the task arduous and unnecessary. Why continually move the sprinkler pipe when we could just as easily flood irrigate these fields as we did others? My father’s response was that while flood irrigating may appear to be the “easy” way, it did not provide the even and managed coverage that the sprinkler system did.
At their origins, many farms and ranches can be traced back to a small family endeavor generally undertaken without any formal structure. Similar to flood irrigation, these unstructured endeavors can get the job done.
The farm operates reasonably well; however, in the process, high areas get dry and low areas get oversaturated. Entity formation, like the sprinkler system, can provide the structure and tools to better manage the operation and provide better quality and higher yield.
A number of choices exist when selecting the type of entity. For income tax purposes, the most common entity forms include partnerships, regular “C” corporations, “S” corporations, and partnerships/limited liability companies. Each form has unique tax and nontax advantages.
While this article will focus on the tax considerations, the nontax considerations should be weighed just as heavily in making a final determination. The overall goal in selecting business form is determining the structure that will meet the nontax objectives while maximizing current and future tax benefits.
C corporations
A corporate entity is completely separate and distinct from its shareholders. Corporations are created under state law and have specific formalities which vary depending on the state of incorporation.
For federal income tax purposes, all items of income, loss and deductions are computed at the entity level. The corporation is required to pay its federal and, where applicable, state income tax based on those amounts.
Losses generated by the corporation can only be utilized to offset taxable income of the corporation from the previous two-year period (a five-year carryback is available for farmers) or the following 20-year period.
One of the largest potential drawbacks of a corporation is the double taxation of corporate earnings. While the corporation is required to pay income tax based on its earnings, shareholders must recognize and pay tax on dividend payments received from the corporation.
Corporations also face unfavorable tax treatment for distributions of appreciated property. Property distributions from a corporation must be made at fair market value.
Therefore, to the extent the property has increased in value (land is a prime example), the corporation must recognize income and pay income tax on the appreciation prior to the distribution. Add to this the double taxation described above, and it becomes prohibitive to transfer appreciated property out of corporations.
S corporations
From a legal standpoint, a regular C corporation and an S corporation are the same. For tax purposes, an eligible C corporation can elect to be treated as an S corporation by filing an election with the IRS. To make the election, the corporation must meet the following requirements:
1. It must be a domestic corporation.
2. It must have fewer than 100 shareholders (some exceptions exist for family-owned businesses).
3. All shareholders must be individuals, estates or qualified trusts.
4. There can only be one class of stock.
5. There cannot be a nonresident alien shareholder.
An S corporation is generally referred to as a flow-through entity. Unlike a C corporation, which pays tax at the entity level, an S corporation passes through its items of income, loss and deduction to the shareholders on a pro-rata basis.
The shareholders are required to include these amounts in the calculation of their taxable income and pay the applicable income tax. To the extent the S corporation generates a loss, the shareholders may be able to reduce their taxable income by their share of the loss. Generally, the S corporation will not pay any tax at the corporate level.
An advantage of S corporations over C corporations is that generally there is no double taxation of corporate earnings. While the shareholders are required to pay tax on their pro-rata share of earnings as described above, distributions from the S corporation (similar to dividends from a C corporation) are generally not taxable to the shareholders.
While there is generally no double taxation for S corporations, distributions of property are, as with regular C corporations, required to be made at fair market value. Therefore, as with C corporations, to the extent an S corporation distributes property that has increased in value, the increase in value is considered income on which the shareholders are required to pay tax.
Due to this requirement, it is generally recommended that assets which are likely to increase in value over time (i.e. land) not be placed in an S corporation.
Partnerships/limited liability companies
For federal income tax purposes, partnership is the default classification for a number of legal entities. Historically, partnerships were limited to general partnerships and limited partnerships. Limited liability companies became prevalent as states enacted statutes for their formation.
A limited liability company is somewhat a combination of a corporation and a partnership. They are structured to resemble a corporation for legal and owner liability purposes, yet resemble partnerships for federal income tax purposes.
Partnerships, like S corporations, are referred to as flow-through entities. As with S corporations, the items of income, loss and deduction of the partnership are passed through to the partners/members.
One distinction, however, is that the items of income, loss and deduction do not have to be passed through pro-rata from a partnership. Partnerships provide additional flexibility and can allow for special allocations of tax benefits to specific partners.
Another advantage of partnerships over S corporations is the lack of “eligibility” requirements which restrict the number and type of owners.
Also, distributions made from a partnership are not required to be made at fair market value. This makes partnership the ideal holding entity for appreciating assets (i.e. land), as the assets generally can be distributed out of the partnership without any adverse income tax consequences.
Check-the-box regulations
An important tool available when selecting entity type is the check-the-box regulations. Often there is a disconnect between the type of entity ultimately chosen for nontax reasons and the desired type of entity for tax reasons. In these circumstances the regulations may provide the ability to utilize the chosen entity form while electing, for tax purposes only, to be treated as a different entity type.
For example, a limited liability company may elect, for income tax purposes, to be treated as an S corporation even though it will remain a limited liability company for all other purposes.
There are many considerations to be taken into account when determining entity formation and structure. This article is not intended to be a comprehensive list of what should be considered, merely a few high-level considerations. As with any major business decision, advice from legal and tax advisers should be received when determining entity formation and structure.
Just like moving sprinkler pipe, completing an analysis of possible entity structures and putting the structure in place can be an arduous task. But the results and benefits of the structure, as with the measured and evenly watered crop, will more than compensate for the additional effort. PD
Paul Campbell
Tax Officer
Jones Simkins, PC
pcampbell@jones-simkins.com
