Tax Reform and Choice of Business Entity
Choice of entity—how an entrepreneur decides to conduct the business—is a key decision with critical tax and non-tax implications. In the coming months, the White House is expected to release a detailed tax reform plan which, among other things, may include a significant reduction in corporate tax rates. If the anticipated changes are adopted, should entrepreneurs be more willing to organize their business as a C-Corporation, rather than an entity that is taxed on a pass-through basis?
While making significant decisions in advance of potential tax legislation is generally risky business, it isn’t too early to consider what impact those changes might have on an entrepreneur’s choice of entity.
Earnings of a C-Corporation are subject to federal income tax when earned, and again when such income is distributed to its shareholders. This double layer of taxation can lead to an effective tax rate of up to 54 percent for stockholders of a C-Corporation. For this reason, many entrepreneurs currently elect to organize as a “pass-through” entity, such as an LLC or S-Corporation, where income is not subject to an entity level tax, thereby avoiding the double layer of tax. Instead, earnings are essentially “passed-through” to the equity owners, who then pay tax on their share of income based on their personal tax rates (up to a maximum of 39.6 percent).
Two proposed changes to the tax code, if adopted, will result in significant reductions to the effective tax rate on earnings of stockholders of a C-Corporation. First, the corporate tax rate may be reduced from the current rate of 35 percent to between 15 and 20 percent. Second, the proposals are expected to eliminate the net investment tax of 3.8 percent, which currently applies to dividends and sales of stock of a C-Corporation. If these proposals are adopted, the tax on corporate earnings distributed to stockholders would be reduced to an effective rate as low as 32 percent.
Even with the anticipated reduction in corporate tax rates, there will continue to be significant reasons why business owners would choose to form their business as a pass-through entity, rather than a C-Corporation:
Reduction in pass-through tax rates: Under current proposals, tax reform is also likely to include a reduced tax rate for earnings attributable to pass-through entities, with proposals ranging from a rate of 15 to 25 percent. If the reduction in taxation on pass-through entities is adopted, business owners will continue to enjoy a lower effective tax rate with respect to earnings from pass-through entities.
Higher sale price upon exit. Holders of equity interests in both a C-Corporation and a pass-through entity are generally taxable at capital gains rates on a sale of their equity. However, purchasers of a business generally are willing to pay a higher sale price through transactions structured as an asset sale, as a buyer will receive a step-up in the basis of the acquired assets, thereby reducing its future taxable income. If a transaction is structured as an asset sale, owners of a C-Corporation will be subject to two layers of tax on any resulting gains, while owners of a pass-through entity will often incur little to no additional tax costs.
Ability to deduct losses. Entrepreneurs who make a significant capital investment in a pass-through entity which they actively manage are generally able to take a deduction against other income for losses incurred by the company. Additionally, passive investors in these entities are also able to take a deduction for any losses, but only to the extent of any gains from other passive investments. These tax benefits are not available to individuals and entities that invest in a C-Corporation.
Increased flexibility. Owners of an LLC taxed as a partnership have greater flexibility with respect to their assets and operations. For example, if a second line of business is developed within the company, it is much more efficient to spin-out or sell those assets than it would be if an entity is structured as a C-Corporation.
On the other hand, there will also be significant reasons why a business might choose to be structured as a C-Corporation, rather than as a pass-through entity:
Tax incentives: Certain tax incentives are available only to holders of stock of a C-Corporation. For example, Section 1202 of the tax code allows certain stockholders to exclude 100 percent of any gain from the sale of qualified small business stock, provided that certain conditions are met. These tax incentives may not be available to holders of interests in pass-through entities.
Investor restrictions: Certain investors may be unwilling or unable to invest directly into a pass-through entity. Stockholders of an S-Corporation are limited to U.S. individuals, and may not include either foreign investors or most U.S. entities (such as another C-Corporation). A limited liability company also presents certain potentially adverse tax consequences for investors who are either tax-exempt investors, or are foreign persons—including any venture capital fund that has these categories of investors in the fund.
Simplicity: C-Corporations are generally easier to administer. All tax reports are filed at the entity level, and shareholders are not obligated to file any information on their personal tax returns with respect to the earnings of the C-Corporation. Additionally, employees of a C-Corporation who also hold an equity interest are treated as W-2 employees, whereas all income allocated to employee-members of a limited liability company will be subject to self-employment taxes.
If the current administration is successful in implementing sweeping revisions to the tax code, these changes may significantly impact the choice of entity decision faced by entrepreneurs. However, until further details emerge, it is not clear whether the changes will result in enhanced benefits for owners of a C-Corporation over owners of a pass-through entity. Ultimately business owners will need to carefully consider the costs and benefits of each structure to ensure a proper entity selection.