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Pass-through and disregarded business entities: a tax advantage Alaskans should know about.

Every business--regardless of the size, the number of employees, or the industry--is subject to state and federal tax. For this reason, all business owners at some point will ask the same question: how can my business pay less in taxes? Surprisingly, the answer may be as simple as using Alaska residency as part of their tax planning strategy.

Alaska, after all, is one of only two states in the Union that offer both no income and no state sales tax to its residents. Additionally, Alaska's overall tax burden ranks among the lowest in the country at about 7 to 7.5 percent annually. These tax advantages, which generally benefit the individual taxpayer, can also be used to benefit businesses as well.

Pass-Through Entities

Consider the tax implications of the four main types of business entities: corporations (which can be taxed as either C corporations or, under certain circumstances, S corporations), sole proprietorships, partnerships, and limited liability companies (LLCs). For both federal and state income tax purposes, the C corporation is a separate entity from its shareholders, the owners of the corporation. As a result, the profits of a C corporation are subject to double taxation: first at the corporate level when income is earned and again at the individual shareholder level when profits are distributed or stock is sold. In contrast, S corporations, sole proprietorships, partnerships, and LLCs are not automatically treated as separate entities for federal or state income tax purposes. The profits realized by any of these four types of entities can pass to the individual owners without first being taxed at the corporate level. Thus these entities, commonly referred to as "pass-through entities," offer the advantage of avoiding the double taxation that applies to C corporations. This tax advantage is even more valuable to Alaska resident business owners who can also escape owner-level income tax.

It is relatively easy to form a pass-through entity. If a company operates as a partnership, sole proprietorship, or LLC, the default is to treat that company as a pass-through entity. A domestic LLC with more than one owner can, however, ignore the default and elect to be treated as a corporation. In contrast, the owners of an S corporation must affirmatively elect pass-through status. Fortunately, the election process is relatively simple.

Accounting for the income of a pass-through entity is not as simple. The owner of a pass-through entity must prepare and file a separate income tax return despite the fact that business income will be reported on the individual owners' tax return.

Disregarded Entities

Just as corporations are owned by shareholders, LLCs are owned by members. A multi-member LLC is, as discussed above, a pass-through entity unless it elects to be treated as a corporation. If the entity is a single-member LLC, however, the default is to treat the entity as disregarded.

Disregarded entities are in some respects very similar to pass-through entities. Both types of entities are pass-through entities insofar as they are not themselves subject to federal and, in Alaska, state entity-level income tax. The Alaska resident owner of a pass-through or disregarded entity can avoid owner-level income tax. Both types of entities can be formed easily with the use of the applicable election or default tax treatment. Finally, and perhaps most importantly, both entities provide liability protection to their owners. If, for example, a pass-through or disregarded entity is sued, the owners are not personally liable for any liabilities of the entity. Despite these similarities, however, several distinctive characteristics have enabled disregarded entities to grow in popularity among business owners.

As a disregarded entity, for instance, the assets and income of the entity are treated as the assets and income of the member. The member essentially owns every item that is purchased, sold, or acquired by the entity. Additionally, unlike owners of pass-through entities, the sole member of a disregarded entity generally is not required to file a separate tax form. The income tax consequences related to the operation of a disregarded entity are accounted for on the tax return of the owner.

Conclusion

With increased pressure to cut costs and improve efficiency, business owners are constantly searching for simple ways to save money. Many business owners have found the tax advantages provided by pass-through and disregarded entities to be the perfect solution. This is certainly true in Alaska, where over 70 percent of the new or newly registered businesses in 2014 claimed pass-through or disregarded status. This statewide popularity is arguably due to the added benefit pass-through and disregarded entities provide Alaska resident business owners.

Disclaimer: This article is limited in scope and in detail. Please consult a professional before choosing a business entity.

Andrea N. Canfield is an attorney with Stoel Rives LLP whose practice focuses on counseling Alaska-based clients in general commercial transactions and mergers and acquisitions. Contact her at andrea.canfield@stoel.com.
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Title Annotation:Legal Speak
Comment:Pass-through and disregarded business entities: a tax advantage Alaskans should know about.(Legal Speak)
Author:Canfield, Andrea N.
Publication:Alaska Business Monthly
Geographic Code:1U9AK
Date:Jun 1, 2015
Words:810
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