Paul M. Yenerall

Article Summary:

Businesses often overlook that the business entity they choose affects the federal income taxation of employee retirement and benefit plans.

Choosing a Business Entity - Tax Considerations

Businesses often overlook the fact that being a corporation, partnership, limited liability company (LLC) or limited liability partnership affects the federal income taxation of employee retirement and benefit plans. Disregarding the taxability or deductibility of these benefits can create a significant extra tax liability, either for the entity or its owners.

The differences in the federal income taxation of employee benefit plans relate to whether the individual covered under the plan is considered to be "self-employed." Employees who have no ownership in the entity are all treated the same. Individuals considered self-employed are in many instances subject to different tax rules. An individual is self-employed if he or she is a sole proprietor, partner, or 2% or more shareholder of an S corporation or of an LLC taxed as an S corporation. Shareholders of a C corporation or of an LLC taxed as a C corporation are not treated as self-employed, regardless of the amount of their ownership.

Here are some ways sole proprietors, partnership, S corporations and LLCs taxed as S corporations may incur extra federal income tax liability from employee retirement and benefit plans:

  • Contributions to qualified retirement plans are not deductible to the extent that they create a net operating loss.
  • Group term life insurance premiums paid for self-employed individuals are not deductible by the entity and are included in gross federal taxable income of the self-employed individual. The self-employed individual is not entitled to take a portion of this expense as a business deduction or a personal itemized deduction.
  • Employer-provided disability insurance for self-employed individuals is not deductible. If disability occurs, however, the self-employed individual pays no income tax on the proceeds.
  • Self-employed individuals cannot participate in cafeteria plans and qualified transportation fringe benefit plans.

The taxability and deductibility of employee benefit plans should generally not be the deciding factor in selecting a form of entity, but business owners should understand that these factors may affect the business's and their personal bottom lines in significant ways.

Paul Yenerall, an attorney at Eckert Seamans Cherin & Mellottt, advises businesses on employee benefits and tax law matters. He assists domestic and international employers and individuals on the design and implementation of qualified retirement plans, stock option and stock appreciation right plans, and other nonqualified incentive and deferred compensation arrangements. www.escm.com

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