When a new business begins, or an existing business acquires another business or a significant asset (such as real estate), entity selection is often a topic of discussion. When evaluating the right entity type, it is important to understand the income tax rates that are involved. C corporations are subject to a 21% federal income tax rate under the 2017 Tax Act (“Act”). Individuals are subject to a progressive federal income tax rate structure, with a top rate of 37%. Higher-income taxpayers are subject to a 3.8% tax on net investment income (certain income from passive sources) (“NIIT”).
Forming a so-called “disregarded entity” (usually, a single owner LLC) is an easy way to segregate liabilities from a state law perspective while keeping the status quo from an income tax perspective. Disregarded entities are ignored for federal income tax purposes (and in many states, for state income tax purposes as well). Disregarded entities are commonly employed at lower levels of an organization’s structure, for example, a multi-owner real estate partnership may own several disregarded LLCs, one for each property.
A C corporation must be a state law corporation or an LLC that has made an election to be treated as a corporation for income tax purposes. C corporations are subject to a “double tax” regime because they pay income tax at the corporate level and the shareholders pay income tax on dividends when distributions are made from the corporation. For those entities that do not anticipate distributing dividends, the overall tax paid by a C corporation (21%) may be lower than that paid by the owners of a passthrough entity who are in a higher tax bracket. Further, C corporation owners do not experience “phantom” income, and thus do not pay tax on taxable income retained by the entity. However, C corporations are subject to rules that may impose additional tax if the corporation retains earnings beyond that which are needed for operations and capital expenditures. Thus, C corporations may not necessarily avoid the dividends tax by hoarding cash. Under current law, the top individual income tax rate on qualifying dividends is 23.8%. Therefore, even assuming full distribution of all C corporation profits as dividends, the maximum combined federal tax rate is 39.8%. This maximum of 39.8% rate may still be lower than a comparable passthrough entity in certain cases (see discussion below).
C corporations have other advantages. For example, they are not subject to the Act’s new limits on state tax deductions. Also, if the corporation has or will have foreign owners or tax-exempt investors, the C Corporation structure generally serves as a “blocker” allowing foreign owners to pay US tax only on dividends and sell stock without paying US income tax. Tax-exempt owners may avoid taxes on unrelated business taxable income.
Finally, stock in certain small C corporations may qualify as so-called 1202 stock which allows the owner to escape federal income tax (in whole or in part) on a sale. Qualifying for 1202 stock requires, among others, that the corporation not have more than $50 million in aggregate gross assets before and immediately after the issuance of stock, and the stock is “originally issued” from the corporation. Generally, the maximum amount that a taxpayer may exclude from taxable income is the greater of $10 million or 10 times the taxpayer’s adjusted gross basis in the stock.
Passthrough Entities (S Corporations and Partnerships)
Passthrough entities are not subject to the double tax regime, and thus may be advantageous for businesses that regularly distribute profits. Under the Act, certain business activities allow the passthrough owners a 20% deduction of “qualifying business income.” Thus, for those owners in such businesses who materially participate in the business, the top rate in such cases is 29.6% (top individual rate of 37% less a 20% deduction and no 3.8% NIIT). If the NIIT applies, then the top rate is 33.4%. However, if the owners do not qualify for the deduction and are subject to the NIIT, then the top rate is 40.8% (which is 1% higher than the maximum rate on C corporations that distribute dividends).
Partnerships v. S Corporations
Assuming a decision is made to employ a passthrough entity, a further inquiry is whether to use a partnership or an S Corporation. In general, partnerships (usually LLCs) provide much greater flexibility on ownership structure (such as special allocations, preferred returns, and like structures). S corporations are less flexible due to a single stock class requirement and they are subject to restrictive ownership requirements (generally, only US individuals and certain trusts). In addition, distributing appreciated assets from a C or S corporation usually results in gain recognition and thus, income tax on distribution. On the other hand, partnerships may frequently distribute appreciated assets tax free.
Partnerships are also advantageous on exit. For example, a buyer of a partnership interest may obtain a basis increase in the partnership interest and a corresponding basis increase for the partnership’s assets. This basis adjustment is also available upon the death of an owner. S corporations do not enjoy this treatment, and this results in a disconnect between stock basis and inside asset basis (thereby increasing the potential for higher income tax on the S corporation’s appreciated assets).
An S corporation may be a good choice for personal service businesses like physician practices (but any real estate should be kept separate). Structured properly, an owner of an S Corporation may minimize employment taxes via the payment of a W–2 wage and the distribution of profits. Shareholder profits in S corporations are not subject to employment taxes, whereas an owner of a partnership who materially participates in the business will be subject to self-employment tax on the owner’s entire distributive share, including salary.