In my last post, I covered the different types of business entities you can choose in forming a Pennsylvania business, including each entity’s different ownership model, liability, and taxation. In this article, I focus on tax differences in forming your business in Pennsylvania, Delaware, and New Jersey.
“Check-the-box” regulations were adopted in 1996. Before then, partnerships and limited liability companies had to be carefully constructed to avoid taxation as an association subject to corporate income taxes. The IRS would carefully interpret indicators in the filings such as the degree of limited liability of partners and members, the duration of the entity, transferability of interests and the scope of centralized management to conclude whether an entity more closely resembled a partnership or a corporation for income tax purposes.
Such analysis became inconsequential with the adoption of check-the-box regulations. Since then, entity determination for federal income tax purposes is governed by a series of default rules that look to state law. These rules include:
- Entities formed as corporations are always taxed as corporations.
- Entities formed as partnerships or limited liability companies with more than one member default to partnership taxation
- Single member limited liability companies default to disregarded status.
Entities that default to partnership taxation or entity status can elect to “check-the-box” and be taxed as corporations. Should an entity do so, if eligible, it can then elect S corporation status.
Subchapter C of the Internal Revenue Code (“IRC”) establishes the taxation arrangement of many corporations. Corporations taxed according to subchapter C are referred to as “C corporations.” Under the provisions of subchapter C, corporations pay taxes at the entity level and stockholders are subject to taxation on their dividends. Consequently, it is frequently said that corporate income is subject to “double taxation.”
Not all corporations are subject to double taxation, however. Although business owners who want to be publicly traded and publicly owned usually select a C corporation as the best form of business for them, the IRC permits business owners to avoid double taxation if they elect to conduct business and pay taxes as an S corporation. The requirements a corporation must meet to qualify for S corporation status are discussed in the following section; note, however, that an entity that cannot qualify for taxation as an S corporation is automatically taxed as a C corporation.
Subchapter S of the IRC establishes the criteria an entity must meet to be taxable as an S corporation. Instead of being taxed at the corporate level, an S corporation’s items of income, gain and loss flow through to individual stockholders.
To obtain S corporation status, an election that has been signed by all stockholders must be filed with the IRS by the 15th day of the 3rd month of the corporation’s taxable year. Exceptions to this deadline may be allowed if a corporation’s late election was for reasonable cause. Unless a corporation stops meeting the requirements, the S corporation election remains in place for subsequent taxable years.
An S corporation is able to have a maximum of 100 allowable shareholders. Generally, allowable shareholders are individuals, qualified trusts and decedent’s estates. Non-resident aliens and entities such as corporations, partnerships, or LLCs are not allowable stockholders, although a subsidiary that is a qualified subchapter S subsidiary can have another S corporation as the sole stockholder.
There are limitations on S corporation stock. For example, an S corporation can only have one class of stock. Voting and non-voting stock are permissible, but only if both types of stock have the same economic rights.
In Pennsylvania, Delaware and New Jersey state income taxation follows federal tax law. For example, an entity that is taxable as a corporation for federal income taxation purposes is also taxable as a corporation for state income taxation.
Entities pay state taxes in the jurisdictions in which they conduct business even if they were incorporated elsewhere. If, for example, a corporation is formed in New Jersey, operates headquarters in Pennsylvania, and only conducts business in Pennsylvania and Delaware, then that corporation will be subject to taxation in Pennsylvania and Delaware.
Domestic and foreign corporations pay Pennsylvania’s corporate net income tax, which is mainly levied on federal taxable income but with a few modifications. The 2014 corporate net income tax rate is 9.99%. Certain deductions available for federal income tax purposes are excluded, such as net operating loss deductions.
All corporations doing business or operating fiscal offices in Pennsylvania are subject to the corporate loans tax. Each dollar of certificates, bonds, and other evidences of indebtedness is taxed at a rate of 4 mills (0.004%).
The capital stock and foreign franchise tax is imposed on domestic and foreign corporations, respectively. It is imposed on an entity’s capital stock value, which is derived by the application of a formula. However, it is subject to a phase out and will no longer be levied in Pennsylvania after 2015.
For the privilege of existing under New Jersey law, New Jersey’s Corporation Business Tax (“CBT”) Act imposes a franchise tax on domestic corporations regardless of where the corporation’s business is actually conducted. The same tax law applies to foreign corporations with a filing obligation in Jersey.
The corporate income tax rates are based on New Jersey gross receipts, with minimum taxes at each level:
- Corporations with an entire net income of $50,000 or less are taxed on their adjusted entire net income at 6.5%
- Net incomes over $50,000 and less than $100,000 are taxed at 7.5%
- For corporations with an entire net income greater than $100,000 the tax rate is 9%
Delaware’s corporate income tax applies only to corporations actually conducting business in Delaware and is not levied on entities incorporated in Delaware but doing business elsewhere. For corporations deriving income in Delaware, a rate 8.7% applies to the entity’s entire net income derived from operations carried on any property located in Delaware and is based on the federal income tax with certain adjustments.
Delaware’s franchise tax is imposed at a flat rate of $75 per each 5,000 shares and maxes out at $180,000 per year. However, corporations that have a high number of shares paired with a relatively low value of assets have the option of calculating their franchise tax based on stock’s assumed par value of capital. This alternative can often significantly reduce the amount payable.
In Pennsylvania, a corporation that is taxable as an S corporation for federal tax income purposes is automatically taxable as an S corporation for Pennsylvania income tax purposes. If a corporation was previously taxed as a C corporation, however, its built-in gains may be subject to the corporate net income tax of 9.99% on those gains.
In New Jersey, entities that have elected S corporation status for federal tax purposes must also make an S corporation election for state income tax purposes. Without the additional election the entity will be taxed as a C corporation and is subject to New Jersey’s Corporate Business Tax.
Once a corporation meets the requirements for and has filed as an S corporation, it may still be subject to the CBT if it has income that, for federal purposes, is taxable at a corporate level. More often than not, this occurs when an S corporation has previously been taxed as a C corporation before making an election under IRC Subchapter S.
A Delaware corporation that is taxable as an S corporation for federal tax purposes is automatically taxed as an S corporation for Delaware state income tax purposes. For as long as the corporation remains eligible for federal S corporation status it also remains eligible for state income tax purposes.
Delaware S corporations are required to withhold Delaware income tax on amounts distributed to shareholders that are not Delaware residents. Delaware income tax ranges from 2.2% to 6.6%, where taxable income over $60,000 is subject to the maximum rate.
Items of income, gain and loss flow through to individual members or partners and are subject to Pennsylvania’s income tax. The income is taxed in proportion to respective ownership interests unless otherwise specified in the partnership agreement or limited liability company agreement.
Partnerships are not subject to the Pennsylvania Capital Stock tax. However, until the tax is discontinued after 2015, Limited Liability Companies are subject to capital stock tax.
Like Pennsylvania, items of income, gain and loss flow through to individual members or partners and are subject to the state’s income tax. The income is taxed in proportion to respective ownership interests unless otherwise specified in the partnership agreement or limited liability company agreement.
Partnerships, LLPs and LLCs that derive income from New Jersey sources pay an annual fee of $150 per partner/member, although this fee is capped at $250,000.
Items of income, gain and loss flow through to individual members or partners and are subject to Delaware’s income tax. The income is taxed in proportion to respective ownership interests unless otherwise specified in the partnership agreement or limited liability company agreement. There is no requirement for a partnership or multi-member LLC to withhold taxes on members or partners that are not residents of Delaware. There is, however, an annual franchise tax of $250.
Disregarded entities are a business entity that is separate from its owner but which elects to be disregarded as separate from the business owner for federal tax purposes. Pennsylvania, New Jersey and Delaware adhere to the IRC’s taxation method of disregarded entities, meaning that items of income, gain and loss are taxed as items of income, gain and loss of the member of the entity. In Delaware, disregarded entities pay a yearly $250 franchise tax. New Jersey’s $150/member annual partnership fee is levied on the member of a disregarded entity. Pennsylvanian disregarded entities have been subject to Pennsylvania’s Capital Stock Tax but will no longer pay the tax once it is eliminated in 2016.
Although this guide provides a useful outline on income taxes and business taxation in general, it focuses mainly on comparisons among Pennsylvania, Delaware and New Jersey laws. There are many other taxes that must be considered when choosing an entity. Certain taxes apply to one type of entity but not another and may affect your business. Langsam Stevens Silver & Hollaender LLP will be happy to assist you in specific matters and to find the entity type that best suits your needs.