- Discover the tax benefits available to both pass-through entities and C corporations.
- Learn about other tax-related factors business owners should consider before choosing a business entity.
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 – a C corporation or a pass-through entity such as a sole-proprietorship, partnership, limited liability company (LLC) or S corporation. Fiducial knows that there are many factors to consider. Proposed federal tax law changes under consideration by Congress may also affect your decision.
The corporate federal income tax is currently imposed at a flat 21% rate. Meanwhile, 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. This deduction is available to eligible pass-through entity owners that are individuals, estates and trusts.
Note: Noncorporate taxpayers with modified adjusted gross income above certain levels are subject to an additional 3.8% tax on net investment income.
Thinking of organizing a business as a C corporation instead of as a pass-through entity? This can reduce the current federal income tax on the business’s income. The corporation can still pay reasonable compensation to the shareholders. They can also 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.
Other business entity considerations
Business owners should also consider other tax-related factors. For example:
- If substantially all the business profits will be distributed to the owners, it may be preferable that the business be operated as a pass-through entity rather than as a C corporation, since 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, businesses must evaluate the impact of double taxation based on projected income levels for both the business and its owners.
- If the value of the business’s assets will likely appreciate, it is generally preferable to conduct it as a pass-through entity. This will avoid a corporate tax if the business sells the assets or the owners liquidate the business. Although businesses can avoid corporate level tax 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.
- What if the entity exists as a pass-through entity? Then the owners’ bases in their interests in the entity are stepped-up by the entity income allocated to them. That can result in less taxable gain for the owners when they sell their interests in the entity.
- If the business is expected to incur tax losses for a while, owners should consider structuring it as a pass-through entity. This way the owners can deduct the losses against their other income. Conversely, if the owners of the business have insufficient other income or the losses aren’t usable (for example, because they’re limited by the passive loss rules), it may be preferable for the business to be a C corporation, since it will be able to offset future income with the losses.
- If the owners of the business are subject to the alternative minimum tax (AMT), 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.
What comes next?
These are only some of the many factors involved in operating a business as a certain type of legal entity. Want more details about how to proceed in your situation? Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations to discuss your situation.