Are you starting a business or considering changing your business’s legal structure? If so, you have a number of choices to make.
Should you operate as a C corporation or as a pass-through entity such as a partnership, limited liability company (LLC) or S corporation? The tax consequences of forming any given entity are a key consideration.
Tax treatment basics
Currently, the corporate federal income tax is a flat 21% rate and individual federal income tax rates begin at 10% and go up to 37%. With a pass-through entity, income the business passes through to the owners is taxed at individual rates, which currently range from 10% to 37%. So, the overall rate, if you choose to organize as a C corporation, may be lower than if you operate the business as a pass-through entity.
But the difference in rates can be alleviated by the qualified business income (QBI) deduction, which is available to eligible pass-through entity owners who are individuals, and some estates and trusts.
The QBI deduction will expire Dec 31, 2025, unless Congress acts to extend it. The 21% corporate rate is permanent, but Congress could still change it by passing new legislation.
More to consider
There are other tax-related factors to take into account.
Will most of the business profits be distributed to the owners?
If so, it may be preferable to operate as a pass-through entity because C corporation shareholders will be taxed on dividend distributions from the corporation, resulting in double taxation. Owners of a pass-through entity will be taxed only once on business income, at the personal level.
Does the business own assets that are likely to appreciate?
It may be better to operate as a pass-through entity because the owner’s basis is stepped up by an owner’s interest in the entity if that is the case. That can result in less taxable gain for the owner when his or her interests in the entity are sold.
Is the business expected to incur tax losses for a while?
Under those circumstances you may want to structure it as a pass-through entity, so that you can deduct the losses against other income. Conversely, if you have insufficient other income or the losses are not usable (for example, because they’re limited by the passive loss rules), it may be preferable to organize as a C corporation, because it will be able to offset future income with the losses.
Is the business owner subject to the alternative minimum tax (AMT)?
That could mean it is better to organize as a C corporation, because only the very largest corporations are subject to corporate AMT. Meanwhile, AMT rates on individuals are 26% or 28%.
Contemplate the issues
Clearly, many factors are involved in determining which entity type is best for your business. This covers only a few of them.
This column is for information only and is not intended as advice. Taxes are complicated and errors can be costly in both time and money to remedy. Consider getting experienced professional help with all tax matters.
Norm Grill, CPA, (N.Grill@GRILL1.com) is managing partner of Grill & Partners, LLC (www.GRILL1.com), certified public accountants and consultants to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien, 203 254-3880.
