The Difference Between Tax Status and Legal Form of a Business or Nonprofit

iStock_000005953904Small.jpgI just read a report by the Small Business Administation that includes a wealth of statistics and other information about small businesses in the United States. As useful as the report is, it contains a mistake that, although commonly made, one would not expect from the SBA. The last item in the report asks the question, “What legal form are small businesses?” That’s a good question, but the SBA didn’t answer it. Instead, it answered another question, “What is the tax status of small businesses?” Even though the two questions are related, they are nonetheless distinct, and answering the second question does not answer the first.

Legal Form of a Business or Nonprofit

As we’ve discussed before, businesses are commonly organized according to one of a handful of legal forms: sole proprietorships, general partnerships, corporations, and limited liability companies. There are a few others used less frequently, including limited partnerships, limited liability partnerships, and professional corporations. Tax exempt organizations are commonly organized as nonprofit corporations, but they can also be organized as unincorporated associations, charitable trusts, and sometimes limited liability companies.

The legal form of a business or tax exempt organization is primarily related to two fundamental attributes: who controls the organization, and who is liable for the organization’s obligations. For example, if a business is structured as a general partnership, the partners collectively control the business and the partners are individually liable for the obligations of the partnership. In contrast, if a business is structured as a corporation, it is probably controlled by a board of directors, elected by the shareholders and acting through the officers. As long as things are done properly, neither the shareholders, the directors, nor the officers are liable for the corporation’s obligations.

Tax Categories

Although selecting the legal form of an organization determines the attributes of control and liability, it does not determine how much income tax the organization must pay. That is determined by the particular subchapter of Chapter 1 of Subtitle A of Title 26 of the United States Code (also known as the Internal Revenue Code) that applies to a particular business or nonprofit.  There are four common possibilities: Subchapter C (the default provisions for corporations), Subchapter S (which is an alternative to Subchapter C that can be elected by small business corporations that meet the eligibility criteria), Subchapter K (for partnerships), and Subchapter F (for tax exempt organizations). There is actually a fifth possibility because some types of legal forms that have a single owner, such as sole proprietorships, are disregarded for income tax purposes, with their income reported on the owner’s income tax return. Those businesses or nonprofit organizations are known as, appropriately enough, “disregarded entities.”

A common source of confusion is that there is not a one-to-one correspondence between the type of entity and the tax status, and you may have noticed that there is no tax status called “LLC.”  Depending on the number of members in the LLC and some other factors, LLCs may be taxed as disregarded entities, as partnerships under Subchapter K, as corporations under Subchapter C, or as small business corporations under Subchapter S.  In fact, most forms of organization have more than one choice for tax category, as shown in the chart below.  (We’ve indicated that a sole proprietorship is taxed as a disregarded entity, which is technically not correct because there’s no entity to disregard.  But for practical purposes a sole proprietorship is the treated the same way as a disregarded entity owned by an individual.)  Even nonprofit corporations have more than one possibility; while most nonprofit corporations are organized with the intent of qualifying for Subchapter F (exempt organizations), if a nonprofit corporation fails to meet the criteria for tax exemption, it will be subject to taxation under Subchapter C.

Legal Form Tax Status Table cropped

Now you won’t make the same mistake that the SBA made.

[Note:  The above table was corrected on May 7, 2015 to include all the possibilities for the tax status of partnerships.]

If you intend to start a business or tax exempt organization, we think you should hire a law firm, whether it’s ours or another, to help you with it. You may be tempted to do it yourself, but the money you spend to determine the best choices for legal form, tax status, and a myriad of details related to management and organization can result in a tremendous payback on down the line.