There are three conditions that can characterize the way a business operates: (1) it earns a profit, and then gives that profit to its owners; (2) it earns a profit, and then retains a portion of it; (3) it loses money. How does it matter whether a business is classified as a partnership or a corporation under each of these three conditions?
A corporation that earns a profit is taxed on the income that it is earned. The rate is 15% for taxable income that is not over $50,000; 25% for taxable income that is not over $75,000; 34% for income that is not over $100,000; 39% for taxable income that is not over $335,000; 34% for taxable income that is not over $10,000,000; 35% for taxable income that is not over $15,000,000; 38% for taxable income that is not over $18,333,333; and 35% for taxable income beyond $18,333,333.
The 39% and 38% tax rates are called “bubble rates” because they are created to take away the advantages of the lower 15% and 25% taxable income rates. For example, imagine a corporation earns $400,000. The tax is straightforward to calculate: $500,000 x 0.34= $170,000. The reason why it is straightforward to calculate and matches what you would intuitively expect is due to the presence of that 39% rate included. The first $50,000 is taxed at 15% creating $7,500 in government tax obligations, the next $25,000 is taxed at 25% for $6,250, the next $25,000 taxed at 34% for $8,500, the next $235,000 taxed at 39% for $91,650, and then the final $165,000 taxed at 34% for $56,100. Together, $7,500+$6,250+$8,500+$91,650+$56,100=$170,000. The benefits of the lowered 15% and 25% rates are effectively wiped out by the 39% tax rate that occurs between $100,000 and $335,000.
After paying this tax, the corporation can do one of two things: pay out some of the remaining profits as dividends, or retain profits for future reinvestment. If it pays out a dividend, there is another tax on the act of transferring money from a corporation to a shareholder (i.e. the dividend tax).
The dividend tax is tied to a shareholder’s personal income tax rate. If the shareholder is treated as a taxpayer in the 10% or 15% tax bracket, then the dividend tax is 0%. If the shareholder is in the 25%, 28%, 33%, or 35% tax bracket, the dividend tax is 15%. For taxpayers in the 39.6% tax bracket, the dividend tax is 20%. And the Net Investment Income Tax of 3.8% affects those whose “net investment income from interest, dividends, annuities, royalties, rents, and gains not generated in active trade or business or modified adjusted gross income in excess of $200,000 ($250,000 for married filing jointly; $125,000 for married but filing separately).”
If the corporation retains some of its taxable income, then the tax is temporarily deferred. If it is reinvested into a new project, then the cycle repeats itself the next year (paying corporate taxes on the income generated, and then an additional tax on the dividend paid). The deferral of taxes on income retained by the corporation could theoretically extend forever–though if a shareholder sells his common stock, he may in reality pay taxes on the retained earnings when it comes time to pay the capital gains tax–this makes the assumption that a company retaining $1,000,000 in earnings is trading at a valuation of $1,000,000 higher than if that money were not retained.
If a corporation is not making money, the expenses may be deducted against the income generated by the business. The amount of the loss can be carried back three years, and then carried forward five years. This area of corporate tax law is highly fact specific and requires different factors to be measured against other, and you can find the specifics at 26 U.S. Code § 1212.
With a partnership that earns a profit, it doesn’t matter whether the profit is paid out to the partners or retained within the partnership. The profit is taxed only once–the signature hallmark of the partnership structure that is different from a corporation. Once the tax is paid, even if the money remains within the partnership, it is not taxed. If it is later distributed to the partners, there is no additional tax.
The assumption under the tax code is that the profits correlate to the ownership. If there are three partners–and one owns 60%, and the others own 20%, the default assumption is that the distributive shares correspond accordingly. If the partnership earns $100,000 in a year, the assumption is that the partner with 60% of the ownership has a distributive share claim on 60% of it–and must pay taxes on $60,000 of the partnership’s income. The other partners are responsible for $20,000 as their 20% interest indicates.
But these default rules can be overruled by a partnership agreement. It is the ownership allocation under the partnership agreement that is controlling–the preceding paragraph refers to the presumption that is created in the absence of a partnership agreement or a partnership agreement that is somehow silent on the allocation of ownership. It can be altered–say, if one partner has extra-management duties for the partnership that are manifested in a higher ownership percentage of the partnership. However, this arrangement requires that the partners specifically follow the formalities and substance of the “special allocation” component of the tax code.
If the partnership loses money, then the losses can be deducted against other income (the rules are more stringent for a partner that only has a passive interest in the partnership).
From a taxation perspective, a general partnership is superior to the corporation firm in cases where the profits are distributed or the business loses money. The amount of deductions when a partnership loses money does not have as stringent time or amount controls as the corporation firm, and benefits enormously from the single taxation in the event that profits are turned over to owners. The double taxation of the corporation firm can easily turn $1 of profit at the corporation level into $0.51 after paying federal corporation taxes and dividend taxes for those shareholders in a high tax bracket. The corporation form, however, may provide a benefit when earnings are retained–the retained earnings in a corporation defer taxes indefinitely, while the taxes on retained earnings in a partnership must be paid immediately. The tax consequences of a partnership are generally preferable to those of a corporation. However, corporation advantages such as limited liability, ease of ownership transfer, and financing versatility may explain why the owners may choose the corporation form over that of a partnership.
Notice: This article, which I believe may be of interest to readers, is for general information and entertainment purposes only. It only reflects my best understanding of the topic at hand and should not be relied upon as legal or investment advice.