The Unexamined Entity
It’s a commonly-told story among tax planners: A client forms a business without deeply examining which entity type is actually the best for their tax bill. Fortunately, this is also a prime opportunity for you to be the hero. As tax planners, we know that no good tax strategy can be built on assumptions. A business owner may have heard that “S corporations are best” because they avoid double taxation or that “C corporations are worth it” because of the qualified small business stock tax break. The reality is that each business’ tax situation is unique, and your job is to ask the probing questions that will help them identify the best entity type for their needs.
The Partnership Dilemma
A situation you may run into with inexperienced entrepreneurs is the “surprise partnership.” Two (or more) business partners launch a small company, and when tax season rolls around, they are surprised to find that the IRS is taxing them as a partnership. In fact, they may not even understand how a partnership functions—what its perks and limitations are. So they come to you to figure out if this is actually the best structure for their business.
Unlike a C corporation or S corporation, you do not need to file an official election to be considered a partnership. If a business has two or more owners, it is automatically deemed a partnership in the eyes of the IRS. Now this might be a blessing in disguise. With your expertise, you can help clients leverage the unique qualities of a partnership to optimize their tax savings. To do so, knowing the main tax advantages of partnerships is essential.
What Makes a Partnership “Special”
The good news for your client is that partnerships have tax advantages that do not exist in any other entity type. Say, for instance, a business owner has real property that they are hoping to transfer to their business. Under a partnership, they can typically contribute that property to the business tax-free. The same is often true for distributions—you can take value out of the business without triggering a tax.
The main benefit to highlight for your clients is special allocations. Special allocations provide an opportunity to customize how profits, losses, and deductions are distributed. The major perk here is that distributions do not have to match the ownership percentages. Partners can have 50/50 ownership of the business and yet split the profits and losses 25% and 75% or 0% and 100%. Of course, these allocations are subject to rules to prevent partners from simply evading taxes. But if your client passes the test, they can customize their distributions to create the most benefits for each partner.
Ask the Right Questions
When deciding which entity type to recommend to a client, it can help to get back to basics. Why does that entity type exist? What is its core purpose? Partnerships are intended to be an efficient way for two or more people to go into business together. As pass-through entities, they are more flexible than a corporation. Partners receive distributions of income and losses and have the opportunity to structure ownership in a way that works for them. Business owners who would benefit most from this flexibility and avoiding that corporate level tax should consider a partnership.
Whether the move is to convert to a partnership or pivot away from one, you can best serve your clients by challenging their assumptions and digging into what best meets their business needs.
Amplify Your Expertise
The American Institute of Certified Tax Planners can help you offer the highest level of service to your clients. Our trainings not only introduce you to effective tax strategies—they also take you beneath the surface to better customize your approach to each client. With us, you can move beyond compliance to proactive tax planning, and build a business that sustains itself year-round.
Begin your journey today by signing up to become a Certified Tax Planner.
