10 May 2006

Which Entities Do Businesses Choose?

Usually, a tax or business advisor discusses with prospective business owners how their businesses should be organized, but occassionally it is worth noting what they actually do.

Number of U.S. Business By Form of Business

One of the first questions faced by every business owner is what form of organization the business should have, and about 19 million make the default choice, a sole proprietorship. Tax data (from 2004 for non-corporate entities, and from 2003 from corporate entities) from the IRS Statistics of Income division provides some insight into which choices are actually made by business owners, who choose to operate as some type of business entity.

The most popular form of business entity is the S corporation. There are about 3.3 million active S corporations in the United States, most of which are small business, usually with just one or two families as owners, and in the vast majority of cases with no more than ten families as owners, who make the decision because there is no entity level tax, limited liability, fairly simple tax law involved, and some ability to reduce FICA taxation.

The next most popular form of business entity is one taxed as a partnership. There are 2.5 million businesses in the United States taxed as partnerships with 15.6 million partners, an average of about six partners each.

About 402,000 are limited partnerships (i.e. those with both general and limited partners), with an average of 17 partners each, disproprtionately in the finance and insurance area, and to a lesser extent in the real estate, rental and leasing industries. About 725,000 are general partnerships (i.e. those in which all partners have unlimited liability), with an average of 3.7 partners each. About 1,270,000 are limited liability companies, with an average of 3.9 partners each. About 150,000 are some other form of entity taxes as a partnership (one suspects that limited liability partnerships and limited partner assocations would be in this category, for example), with an average of six partners each.

In finance and real estate, partnership form is typically chosen for some combination of, at least partial limited liability, lack of entity level taxation, flexibility in structuring economic relationships, and favorable tax treatment if property is distributed from the entity in kind. General partnerships are typically formed by default, through lack of careful legal counseling, rather than deliberately, a conclusion buttressed by their generally small size. Limited liability companies are typically chosen for reasons similar to those of S corporations, particularly if the businesses are passive in nature, where limited liability companies have an edge over S corporations.

There are also about 2.1 million C corporations. But, a supermajority of these corporations do not pay significant corporate level taxes.

How Many C Corporations Pay Significant Corporate Taxes?

The main reason to not form an S corporation is a desire not to pay corporate level income taxes. But, this is easily solved in a closely held business by having any would be profits distributed as a bonus to the owner-employees. In practice, most closely held C corporations "zero out" their profits each year. About 52% of C corporations file returns with no corporate level net income. Another 16% of C corporations have corporate level net income but owe no taxes due to corporate level tax credits. Thus, only 32% of C corporations pay any corporate level tax at all.

There is also sometimes an incentive to defer tax by not distributing it. While net corporate income is subject to an entity level tax, the shareholder level tax can be deferred indefinitely until dividends are distributed. In contrast, in an entity with pass through taxation, entity profits are immediately taxed at the owner's income tax rate and, in the case of active business owners of businesses taxed as partnerships, also subjected to self-employment taxes. So, for a business owner who is in an individual income tax bracket above 15%, retaining corporate earning and paying taxes on them at the corporate level can reduce current income tax expenses, and potentially defer the individual level part of the double taxation equation indefinitely. Thus, it is not surprising that many C corporations choose to pay entity level taxes up to the point where the tax rate is 15%.

About 23% of C corporations (more than two-thirds of those that pay any income tax at all) have under $6,000 of corporate level income tax, and pay less than $900 a year in corporate level income taxes, due to graduated corporate tax rates (the first $50,000 of corporate level income is taxed at the 15% tax rate), many pay less than that due to corporate level tax credits. Another 6% of C corporations, have more than $6,000 of corporate level income and do pay taxes, but have under $50,000 of corporate level income, leaving them in the 15% corporate income tax bracket.

Only 2.6% of C corporations (54,476) pay corporate level income taxes at above the 15% tax bracket. Thus, only about 0.7% of all businesses required to file an entity level tax return pay any entity level tax at more than the 15% tax bracket, and only 0.2% of all businesses pay an entity level tax at more than the 15% tax bracket.

About one in three of those corporations that do pay entity level taxes are publicly held corporations. While closely held C corporations very rarely pay significant corporate level taxes unless it is economically rational for them to do so, as explained above, publicly held corporations pay corporate level taxes because they have no other choice. A publicly held company is always taxed as a C corporation, and unlikely closely held companies, cannot easily divert all of their corporate level income to bonuses and interest payments to business owners, many of whom are not otherwise affliated with the business, and privately held medium sized businesses with a large number of equity owners (and often an ultimate goal of going public) are in same situation. Legally speaking, in the United States, your company is publicly held unless you company is not listed on the NASDAQ or any other stock exchange and:

Your company has fewer than 300 shareholders of the class of securities offered; or your company has fewer than 500 shareholders of the class of securities offered and less than $10 million in total assets for each of its last three fiscal years.

There are, at least, 13,094 publicly traded companies (pdf page 208) in the United States.

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