The choice of entity type is among the most important decisions facing taxpayers when starting a business or investment activity. The choice of tax entity generally includes a C corporation, S corporation, or partnership, each having 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.
Existing businesses should also evaluate their choice of entity—especially now, in light of President Biden’s proposals to increase the tax burden on corporations and high-wealth individuals. Depending on the circumstances, it may make sense to consider converting an existing entity to a different type of tax entity or structure in order for businesses and their owners to better manage their overall tax obligations. An analysis should be performed to determine the amount of any immediate tax cost that would be incurred upon changing entity classification compared to the future tax benefits of conversion.
Choice of entity decisions needs to take into account many tax and legal considerations based on the taxpayer’s specific facts and circumstances, as well as business and investment goals. Taxpayers should keep in mind that current tax proposals would raise tax rates and make other changes to the federal income tax system for corporations and high-wealth individuals. These proposals should be monitored, and their potential effects should be considered when evaluating the short and long-term benefits of a particular entity choice.
Tax Considerations When Choosing an Entity
There any many tax considerations that play into the choice of entity decision, some of which are discussed below. All of the considerations should be analyzed together with other important factors, such as whether investors intend to distribute or reinvest available cash, income projections including whether the business anticipates upfront losses, the expected rate of return on investment, and the time horizon for the exit, and available exit strategies.
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.
C 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 pass-through 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 pass-through entity, the analysis should not end there. A C corporation shareholder may pay more tax upon disposing of its investment than a pass-through 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 the tax basis in investments in C corporations versus investments in pass-through entities, C corporation shareholders will generally have a larger gain on the disposition of their investment than pass-through entity owners. The tax on disposition will depend on the owners’ tax rates and the amount of ordinary income recaptured, 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 have 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 limitations 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 an entity, 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.
Please contact our AZ Tax Team regarding any questions you might have concerning your choice of entity questions.