Restaurants may legally organize in several different forms. Most people are familiar with the Limited Liability Company (LLC) and Corporation, all legal classifications. It’s commonly misunderstood that the legal classification is automatically the tax classification, but that’s not quite true. This blog will NOT address the ideal legal entity type for restaurants; you should discuss that process with an attorney. In this blog, we’ll walk you through the ideal tax entity type for your restaurant(s) based on your goals.
Entity Tax Classifications
The entity classification on your restaurant’s tax return is not always the legal classification selected when registering the business with the state. Very frequently it’s advantageous to make an election to file as a different tax classification.
There are four common tax classifications for restaurants or restaurant groups:
- C-Corporation
- Partnership
- S-Corporation
- Sole Proprietorship
Here are the pros and cons for each tax entity type, and how to determine the best fit for you:
C-Corporation
Pros
- Owners don’t have any personal tax implications unless a dividend is issued or they’re selling/liquidating their shares.
- Issuing shares and stock is more straightforward and flexible.
- Many venture capital firms require you to be a C-corporation for tax purposes before they invest.
- Allows you to put aside an option pool of stock for key employees and strategic partners.
- C-corporations have perpetual existence, meaning they can continue to operate even if ownership changes or shareholders leave or pass away. This stability and continuity are appealing to investors, as it reduces the risk of business disruption and ensures the long-term viability of their investments.
- Gains from selling C-corporation stock of a small business can be excluded from capital gains tax if it qualifies under sec 1202 of the Internal Revenue Code.
Cons
- Subject to double taxation, once at the entity level and again at the personal level when cash is distributed to shareholders.
Best Fit
C-Corporation is usually the tax entity of choice for restaurants that follow a “start-up” model, meaning they raise money from venture capitalists or other investors so they can add many locations quickly with the goal of exiting at a high valuation. The C-corporation is preferred in this model because the only disadvantage (double-taxation) is irrelevant since all profits are being reinvested and the restaurant group is not experiencing any gains until a successful exit.
Partnership
Pros
- No double taxation (pass-through taxation)
- The owner’s share of profits (but not guaranteed payments) qualifies for the Qualified Business Income (QBI) deduction unless they are subject to the specific limitations of the QBI deduction.
- Flexible profit distributions and multiple classes of ownership (class A, class B, preferred, etc.) are allowed.
- Allows partners to carry losses (due to accelerated depreciation) in the first year of business to their personal tax returns to potentially offset other sources of income.
Cons
- The owner-operator’s (managing partner) share of business income is subject to self-employment tax.
- Owner-operator’s pay for services performed can’t be run through payroll. Instead, they need to be paid out as guaranteed payments (also subject to self-employment tax).
- The owner’s guaranteed payments reduce qualified business income for calculating the QBI deduction.
- Partners can’t file their personal tax returns without receiving a schedule K-1 from the partnership that shows their share of tax profits/losses for the year.
- All the cons above also make it difficult to grant equity to employees.
Best Fit
The partnership is ideal for restaurants with multiple partners and different classes of ownership (class A, Class B, preferred, etc.). This is the most popular tax entity of choice for multi-partner independent restaurant(s) because it offers flexibility with no tax consequences.
Partnerships can be structured to pay managing partners based on performance or profits. If done strategically, partners can legally reclassify their payments from guaranteed payments to profit distributions, thus bypassing all the disadvantages connected to guaranteed payments. This is commonly referred to as “carry” and is commonly used in private equity to mitigate taxes. Partnerships can also issue profits interests, which allows a fast-growth restaurant or restaurant group to issue sweat equity after meeting a certain distribution threshold and having advantageous tax consequences.
Partnerships are also the entity of choice for multi-member entities holding real estate for the following reasons:
- Real estate rental income is not subject to self-employment tax, so there’s no reason to put it in an S-corp.
- Partners in a partnership are not taxed on the contribution of appreciated real estate to the partnership, regardless of their ownership percentage afterward. In a C-corporation or S-corporation, they might be taxed depending on the circumstances.
- The gain on the sale of real estate will be double-taxed under a C-corporation, and the distribution of the real estate to shareholders will trigger a taxable gain to the corporation plus the shareholder will have to recognize dividend income on the FMV of the property distributed as well.
- A partnership can easily distribute real estate held by the partnership to the partners tax-free, in case they decide to liquidate the partnership.
- If one of the partners sells his/her interest, the buyer can get a step up in basis (via sec 754 election) and receive increased depreciation deductions.
Therefore, if you own the real estate for your restaurant with multiple partners, you may want to consider putting that property into a separate LLC taxed as a partnership (instead of a C-corporation or S-Corporation), and then renting it to your restaurant. See the Ideal Tax Structure for Restaurant Real Estate to learn more.
S-corporation
Pros
- No double taxation (pass-through taxation)
- The owner’s share of profits (but not salary) qualifies for the QBI deduction unless they are subject to the specific limitations of the QBI deduction.
- Allows partners to carry losses (due to accelerated depreciation) in the first year of business to their personal tax returns, potentially offsetting other sources of income.
Cons
- Multiple classes of stock from a distribution perspective are not allowed, meaning all distributions will be split based on a single ownership %. You can’t specially allocate!
- Limitations on shareholders:
- Must be US Citizens/permanent residents.
- <100 shareholders
- Corporations, partnerships, and certain trusts can’t be shareholders.
- You must pay owner-operators a reasonable salary through payroll. This salary is subject to payroll tax and reduces qualified business income, reducing the QBI deduction.
- Limitations on shareholders:
Best Fit
Historically, the S-corporation was the most favorable tax entity type for any single or multi-member small business corporation or LLC that didn’t have multiple classes of stock, foreign shareholders, or more than 100 shareholders. However, that all changed when the QBI deduction was introduced in 2017 as part of the Tax Cuts and Jobs Act (TCJA). Therefore, to determine whether a partnership/sole proprietor or S-corporation is more beneficial, it’s best to input projected figures into a QBI entity selection calculator to see if the savings on self-employment tax surpass the reduction in the QBI deduction resulting from paying a reasonable salary to owner-operators.
Sole-Proprietorship/Schedule C
Pros
- No double taxation (pass-through taxation)
- The owner’s share of profits AND earned income qualifies for the QBI deduction, unless they are subject to the specific limitations of the QBI deduction.
- Allows owner to carry losses (due to accelerated depreciation) in the first year of business to their personal tax returns to potentially offset other sources of income.
- There’s no additional tax return filing requirement. The owner simply reports the business income on Schedule C on their personal tax return.
Cons
- All earnings are subject to self-employment tax.
- Schedule C filers have shown a higher probability of getting audited in the past, although that is slowly changing.
Best Fit
This is usually the most ideal tax entity type for a single-owner restaurant or restaurant group. As mentioned above, the S-corporation used to be the entity of choice for single-owner restaurants, however the QBI deduction has changed that. The reduction in admin costs (due to filing a single return) and the maximized QBI deduction usually result in the lowest taxes. We still recommend inputting projected figures into a QBI entity selection calculator to see if the savings on self-employment tax (in an S-corporation) surpass the reduction in the QBI deduction due to paying a reasonable salary to owner-operators.
State Tax Consequences
The Pros and Cons above only consider federal income tax implications. Every state and local jurisdiction has its own set of tax rules for each entity type, which has a major impact. For instance, NYC and DC do not recognize pass-through entities, meaning they double tax S-corporations, Partnerships, and Sole Proprietorships/Sch C businesses at a high-income tax rate. This tax is deductible, and in DC, a credit can be claimed for residents but not non-residents. Other states, like MD, offer an election that allows S-corporations and Partnerships (but not Sch C taxpayers) to pay and deduct state income tax at the entity level while allowing partners/shareholders to claim a credit on their personal tax returns for these taxes paid by the businesses. This is very advantageous to S-corporations and Partnerships in MD, and could be why you select an S-corporation over a Sch C for a single-owner business.
When assessing the ideal entity type for your restaurant, you must consider state income tax implications.
Operators in NYC and DC face a unique set of local taxes that impact the tax savings or cost of filing as an S-corporation or Partnership. Check out Maximizing Tax Savings for Your NYC Bar or Restaurant and Maximize Tax Savings For Your DC Bar or Restaurant for the ideal tax structure of a restaurant or bar in NYC and DC respectively.
Conclusion
As you can see, you need to consider many variables when determining the ideal tax entity type for your restaurant(s). There is no rule of thumb because it is highly contextual and situational. Therefore, we recommend working with a professional to ensure you have chosen the ideal tax entity type based on your goals and priorities. Please contact us if you need help determining your ideal tax entity type.
Written by Raffi Yousfian, CPA
