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. There are many factors to consider and proposed federal tax law changes being considered by Congress may affect your decision.
The C-corporate federal income tax is currently imposed at a flat 21% rate, while the current individual federal income tax rates begin at 10% and go up to 37%. In Massachusetts, there is a flat tax on individuals of 5% while C-corporate rate is 8%. The difference in rates can be mitigated by the qualified business income (QBI) deduction that’s available to eligible pass-through entity owners that are individuals, estates and trusts.
Other tax-related factors should also be considered. 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.
- States carry a tax the entities differently that you must be wary of. As mentioned above, Massachusetts taxes a C-Corporations income an additional 3%, not to mention the potential double taxation.
- If the value of the business’s assets is likely to appreciate, it’s generally preferable to conduct it as a pass-through entity to avoid a corporate tax if the assets are sold or the business is liquidated. Although corporate level tax will be avoided 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.
- If the entity is a pass-through entity, the owners’ bases in their interests in the entity are stepped-up by the entity income that’s allocated to them. That can result in less taxable gain for the owners when their interests in the entity are sold.
- Bulit In Gains Tax (or BIG) is a form of double taxation upon sale that can still affect an S-Corporation if the planning is not done properly.
- If the business is expected to incur tax losses for a while, consideration should be given to structuring it as a pass-through entity so 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’ll 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.
These are only some of the many factors involved in operating a business as a certain type of legal entity. It is extremely important to consider what works best for your business and look at all of the factors. For details about how to proceed in your situation, consult with us at 508-888-2000.