Are you planning to launch a business or thinking about changing your business entity? If so, you need to determine which entity will work best for you. Business structure types include a C corporation or a pass-through entity such as a sole-proprietorship, partnership, limited liability company (LLC) or S corporation. There are many factors to consider and proposal for federal tax law changes by Congress may affect your decision.
The corporate federal income tax is currently imposed at a flat 21% rate, while the current individual federal income tax rates begin at 10% and go up to 37%. The difference in rates can be mitigated by the qualified business income (QBI) deduction that’s available to eligible pass-through entity owners that are individuals, estates and trusts.
Note that non-corporate taxpayers with modified adjusted gross income above certain levels are subject to an additional 3.8% tax on net investment income.
Organizing a business as a C corporation instead of as a pass-through entity can reduce the current federal income tax on the business’s income. The corporation can still pay reasonable compensation to the shareholders and pay interest on loans from the shareholders. That income will be taxed at higher individual rates, but the overall rate on the corporation’s income can be lower than if the business was operated as a pass-through entity.
For selecting the best business structure, other tax-related factors should also be considered. For example:
Will all the business profits will be distributed to the owners? If yes, it may be preferable that the business be operated as a pass-through entity rather than as a C corporation. This is because the shareholders will be taxed on dividend distributions from the corporation (double taxation). In contrast, owners of a pass-through entity will only be taxed once, at the personal level, on business income. However, the impact of double taxation must be evaluated based on projected income levels for both the business and its owners.
Are the value of your business’s assets likely to appreciate? If so, it’s generally preferable to conduct it as a pass-through entity. This setup will help you avoid a corporate tax if the assets are sold or the business is under liquidation. Although corporate level tax will be avoided if the corporation’s shares, rather than its assets, are sold, the buyer may insist on a lower price because the tax basis of appreciated business assets cannot be stepped up to reflect the purchase price. That can result in much lower post-purchase depreciation and amortization deductions for the buyer.
If the entity is a pass-through entity, the owners’ bases in their interests in the entity are stepped-up by the entity income that’s allocated to them. That can result in less taxable gain for the owners when their interests in the entity are sold.
If the business expected to incur tax losses for a while? If so, consider structuring it as a pass-through entity so the owners can deduct the losses against their other income.
Conversely, owners of the business may have insufficient other income or the losses aren’t usable. For example, because of the limitations due to the passive loss rules. In this situation, it may be preferable for the business to be a C corporation. This is because it’ll be able to offset future income with the losses.
Are the owners of the business are subject to the alternative minimum tax (AMT)? If so, it may be preferable to organize as a C corporation, since corporations aren’t subject to the AMT. Affected individuals are subject to the AMT at 26% or 28% rates.
These are only some of the many factors that involve in operating a business as a certain business structure type. For details about how to proceed in your situation, consult with us.