When the Cons Outweigh the Pros
Every rose has its thorn, and every entity type has its tax disadvantages. Some entity types get more positive publicity than others, but in reality, there is no one structure that will work best for everyone. The trade-offs that lower taxes for one business could increase taxes for another business. So how do you go about measuring the perks against the drawbacks? A “pros and cons” list simply won’t work here. What you need is an in-depth analysis of your specific business to see which advantages and disadvantages will impact you the most.
Go Back to the Basics
When choosing your entity type, start with the foundation: What is the purpose of that entity type? For instance, partnerships exist because they are a simple way for multiple people to do business together. Partnerships are pass-through entities, designed to pass income and losses through to the partners without incurring a corporate level entity tax. They also offer flexibility in their structure—you can set up ownership how you want and determine how decisions are made.
These can be major benefits, but the question is whether these perks best meet your business needs? Because multi-owner businesses are taxed as partnerships by default, owners sometimes don’t stop to question if there is a better structure for them. Don’t let this be you. Talk to a tax expert to make sure you understand the reasons to choose a partnership—and the reasons not to.
The Trouble with Partnerships
So where might partnerships fall short? There are four key areas to consider:
Liability. For all their perks, partnerships come with a major flaw: unlimited liability for general partners. What does this look like? The general partner controls operations, but they are also personally responsible for all debts and legal obligations. This means that if the business is sued, creditors can go after the general partner’s personal assets.
Guaranteed Payments. Owners in a partnership cannot be paid as employees. Instead they must be paid through guaranteed payments. This setup can create complications. For instance, if the partnership agreement calls for $100,000 as your guaranteed payment but the partnership has a loss, the business still has to accrue the wage and pay it at some point. Unfortunately, this can cause an unplanned bump in income in a future tax year, resulting in higher taxes and limits on things like qualified business income. Since they are not treated as employees, owners also cannot receive tax-free fringe benefits.
Self-Employment Tax. This is often the factor that scares business owners away. Guaranteed payments are subject to self-employment tax. This can make partnerships an expensive entity type, depending on the exact pass-through amount. However, this does not mean a partnership is not the right choice. Depending on other factors in your business, you can pay self-employment tax and still end up with a lower overall tax bill.
No Stock Losses. Lastly, partnerships cannot issue stock. One of the tax benefits of stock is deducting losses. Certain small business stock can be deducted as ordinary losses, but the business must be a C or S corporation for that to happen.
Tax Planning to the Rescue
When you work with a Certified Tax Planner, you can be sure that they will actually do the math. Instead of making a surface-level assessment, they dig into the details of your business and make recommendations that are tailored to you. Choosing the right entity type is an essential step, but it’s just the beginning of formulating an effective tax plan.
Professionals You Can Trust
The American Institute of Certified Tax Planners does what it takes to earn your trust. Our coursework ensures that our tax planners know how to apply current tax law to your situation, what the ripple effects are of each entity choice, and how to identify the tax strategies that will work best for you. Redirect your energy toward growing your business, and put your tax planning in the hands of an expert. Reach out to a Certified Tax Planner.
