What Business Entity Type Makes the Most Sense for My Business?
Adapted from a BDO Article
When you’re starting a new venture, one of the most important decisions you make is which type of tax entity is best for your business.
Oftentimes, founders must choose between C corporation, S corporation, or partnership. Each has its own advantages and disadvantages that must be evaluated in terms of how the entity’s tax and legal characteristics align with the goals of the business and its investors.
At Weiss, our tax professionals work with clients to consider the tax and legal implications when making this choice. We help analyze available cash, income projections, losses, rate of return on investment, and the time horizon for ownership exit. We also help existing businesses evaluate their choice of entity, which could be acutely important in light of new tax proposals being floated by the new administration.
Here are a few considerations:
Effective tax rate on earnings
The rate at which businesses pay tax on their earnings impacts after-tax cash flow and return on investment. Further, whether the business distributes or reinvests its available cash affects enterprise value.
Corporations pay tax on their earnings at the corporate level at a 21% rate, and earnings distributed as dividends are subject to tax again at the shareholder level. This double taxation amounts to an overall effective tax rate on distributed earnings of around 40%, as opposed to a single 21% rate on earnings that are reinvested in the business. President Biden’s tax proposals would increase the corporate tax rate to 28%, which would increase the overall rate on distributed earnings to 45%—or even higher for individuals that would, under his tax plan, be subject to ordinary income tax rates on dividends.
Passthrough entities (S corporations and partnerships), on the other hand, do not pay entity level tax. Instead, their earnings are reported by and taxed at the rates of their owners, regardless of whether the earnings are distributed. For individual owners, this means a top marginal tax rate of 37% on passthrough earnings, or 29.6% if the qualified business income deduction applies. President Biden’s plan would increase an individual owner’s top rate to 39.6% and phase out the qualified business income deduction at income levels exceeding $400,000.
Although, based on the difference in tax rates, C corporations that reinvest their earnings may be able to generate greater after-tax cash flow than a passthrough entity, the analysis should not end there. A C corporation shareholder may pay more tax upon disposing of its investment than a passthrough owner, especially in cases where no viable tax planning strategy exists (see “Exit Strategies,” below). In addition, C corporations that do not pay dividends may be subject to the accumulated earnings tax and the personal holding company tax.
The amount of tax owed on exit plays a very important role in the choice of entity decision. Due to the difference in the build-up of tax basis in investments in C corporations versus investments in passthrough entities, C corporation shareholders will generally have a larger gain on the disposition of their investment than passthrough entity owners. The tax on disposition will depend on the owners’ tax rates and the amount of ordinary income recapture, among other factors.
There are certain exit strategies that may be used to defer the tax on gains from dispositions of investments. These strategies include:
- Reinvesting the gains in qualified opportunity zones or qualified opportunity funds;
- Selling the shares of a C corporation to an employee stock ownership plan; and
- Transferring the investment through estate planning. Note that under President Biden’s tax proposals, the tax basis step-up of property at death would be limited.
In addition, non-corporate shareholders may be permitted to exclude part or all of the gain from the sale or exchange of “qualified small business stock” (QSBS) of C corporations that has been held for at least five years. The overall gain exclusion per issuer is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the disposed shares. Each partner in a partnership and each shareholder in an S corporation is entitled to their own $10 million limitation on dispositions of QSBS by the partnership or the S corporation.
Changes to entity classification
Converting from one type of entity to another requires thoughtful consideration, analysis, and planning, and certain entity types may provide more flexibility than others for changing entity status. Converting to a different type of entity may trigger immediate tax consequences, which must be measured relative to any potential future tax benefits. Examples of possible tax consequences include taxable liquidations, tax on built-in gains, gain on liabilities in excess of tax basis, deferred revenue recognition, and changes in accounting methods.
Other tax considerations
The following are among the many other tax issues to consider when choosing your corporate structure, the tax treatment for which can vary by entity type:
- International tax rules, such as taxation of controlled foreign corporations, foreign tax credit limitations, and consequences of repatriation tax deferral;
- Deductibility of upfront net operating losses;
- Self-employment taxes (note that the social security base would increase under President Biden’s tax proposals);
- State income taxes, which vary by state;
- Estate and inheritance tax consequences for individual owners and their families; and
- Tax reporting requirements, which in certain cases can be less onerous for C corporations as opposed to passthrough entities.
While the choice of entity is often a tax-driven decision, there are also many non-tax factors to consider, such as:
- Liability protection for owners and management;
- Flexibility for making day-to-day management decisions and for binding the organization;
- Access to capital;
- Transferability of ownership interests; and
- Available exit strategies and succession planning.
For more information on this, or for help choosing or changing your tax entity, contact your Weiss tax professional at your convenience.
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