When starting a new business, a contractor has various choices of entities to establish. They are as follows:
The net income from this activity is included in the individual’s annual personal income tax returns. Any profits are subject to both income tax and self employment tax. This is the least favorable choice of entity since it affords no liability protection and thus the owner’s personal assets are exposed to potential creditors.
C Corporations offer several key tax advantages for lower taxable income levels: a 15% Federal tax rate on the first $50,000 of taxable income and 25% on the next $25,000 of taxable income. The main issue for C Corporations is double taxation since the only way to get after tax money out of the corporation is through dividends or compensations, thus producing a second level of tax.
Many small and medium-sized contractors typically choose to become S Corporations for their primary operating entity. Some construction companies decide to start as C Corporations and eventually convert into S Corporations and could therefore be subject to the Federal built in gains tax on appreciated assets. Thus the contractor will be subject to double taxation on any deferred income earned but not yet taxed while a C Corporations through the date of conversion. Another potential pitfall is that stockholder dividends must be taken in proportion to stockholder dividends must be taken in proportion to stockholder ownership or else a second class of stock deemed to be created and the S Election could be automatically revoked.
Limited Liability Company
The LLC is a common entity selection because it offers owners significant flexibility and has fewer regulations regarding structure and ownership. There is also flexibility regarding the allocation of profits and losses to the various LLC members, which is ideal when members have varying amounts of involvement or investment.
For real estate investments, an LLC is frequently the preferred option. An LLC allows for members to allocate profits and losses as they deem necessary in the operating agreement. Disproportionate distributions are allowed to the members without impairing the status of the LLC.
LLC’s are also preferred for business activities related to real estate rental activities. In an LLC, the underlying debt used to purchase the property increases an owner’s basis to take losses, which is not the case with a C or S Corporation. The net investment income tax of 3.8% recently implemented in the new tax act is generally not applicable due to the self-rental rules and real estate professional status, both of which are common among contractors. Self-rental refers to the renting of a property to an entity in which the owner of the property materially participates. The self-rental rules provide that an activity which is otherwise passive is deemed non-passive as a result of the self-rental, and therefore, not subject to the net investment income tax.
Some of our clients partner up with another contractor to perform a single contact. The LLC is the entity of choice to perform the contract since it does not expose our client’s assets, other than the investment in the joint venture, to joint venture creditors.
ARTICLES INCLUDED HEREIN DO NOT CONSTITUTE AN OPINION AND ARE NOT INTENDED OR WRITTEN TO BE USED, AND THEY CAN NOT BE USED, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER. This publication is designed to present matters of general interest relating to accounting, taxation and business management. Articles were written by the tax department of Castellano, Korenberg & Co., CPA’s, P.C. Please consult your CK & CO adviser before taking any specific actions.
© 2015 Castellano, Korenberg & Co., CPA’s, P.C.