Are you thinking about starting a company or changing your business structure? If that’s the case, you’ll need to decide whether a C corporation or a pass-through entity (sole proprietorship, partnership, limited liability company (LLC), or S corporation) is ideal for you. There are several factors to evaluate when choosing an entity type, and potential federal tax code changes now under consideration by Congress may have an impact on your selection.
The corporate federal income tax rate is now set at a flat 21 percent, while individual federal income tax rates start at 10 percent and rise to 37 percent. The qualifying business income (QBI) deduction, which is available to eligible pass-through company owners such as individuals, estates, and trusts, may help offset the difference in rates.
Noncorporate taxpayers with modified adjusted gross income over specific thresholds must pay an extra 3.8 percent tax on net investment income.
The current federal income tax on a business’s income may be reduced by forming it as a C corporation rather than a pass-through entity. The company can still pay reasonable compensation to its shareholders as well as interest on their loans. Individually, that revenue will be taxed at a higher rate, but the overall rate on the corporation’s income will be lower than if the business is structured as a pass-through entity.
Other factors to consider when choosing an entity type
Other tax-related variables should be taken into account as well. Here are some examples:
• If the company’s earnings will be distributed to the owners, it may be advantageous to operate as a pass-through entity rather than a C corporation, since dividend payments from the corporation would be taxable to the shareholders (double taxation). On the other hand, owners of pass-through organizations will only be taxed on business income once—at the personal level. The effect of double taxation must be assessed based on expected income levels for both the company and its owners.
• If the value of the company’s assets is projected to increase, it’s usually better to run it as a pass-through entity to avoid paying corporate taxes if the assets are sold or the company is dissolved. Although the buyer may insist on a lower price since the tax basis of appreciated company assets cannot be stepped up to match the purchase price, the buyer will avoid corporate-level tax if the corporation’s shares, rather than its assets, are sold. Consequently, the buyer’s post-purchase depreciation and amortization deductions may be significantly reduced.
• If the business is a pass-through, the owners’ bases in the entity are stepped up by the entity income that is allocated to them. When the owners’ interests in the business are sold, this might result in a lower taxable gain for them.
• If the company is projected to have tax losses for a long time, consider forming it as a pass-through entity so that the owners may deduct the losses from their other income. If the owners of the business don’t have enough other income or the losses aren’t useable (for example, because they’re restricted by the passive loss rules), it could be better to form a C corporation, which will be able to offset future income with losses.
• If the business’s owners are subject to the alternative minimum tax (AMT), forming a C corporation may be a better choice since corporations are not subject to the AMT. The AMT rate is 26% or 28% for affected individuals.