Nov 15, 2019

Best Corporate Structure for Small Business Under Tax Reform

Leon Dutkiewicz, CPABy Leon J. Dutkiewicz Jr., CPA

MoneyLife100The federal corporate tax rate is now at a flat 21%, which has attracted a lot of attention from business owners as they consider their operating entity structure. The rate is a significant decrease from the previous top corporate rate of 35%. The top individual tax rate also decreased, from 39.6% to 37%. Many pass-through entities – which include partnerships, LLCs, sole proprietorships, and S corporations – also may benefit from a new qualified business income (QBI) deduction of up to 20%.

Yes, the above rates make the corporate structure an attractive option, but there are a number of additional factors that need to be addressed when picking an operating entity. The choices present their own tax opportunities and challenges in addressing that business’s unique needs and goals.

Question marks: Which is the right choice of entity?The above tax rates cited are just the federal rates. Most states tax C corporations, and many have corporate rates higher than their individual rates. Therefore, unless there is a reason to reinvest profits, most small businesses want to distribute the profits to the owners. There is a double taxation issue when it comes to profits in C corporations: putting state taxes aside, there is the corporate-level tax of 21% and then there is an individual tax rate of 23.8% on dividends paid.

In this regard, the S corporation may look to be a good entity choice. Still, the ultimate decision between the choice of an S or C corporation goes beyond the rates. Some C corporation benefits include the following:

  • No restrictions on the number of owners or multiple classes of stock,
  • Under certain circumstances, fringe benefits for the employee-owner can be deducted
  • There is the potential for double taxation on a sale of a business by an S corporation

One significant difference between the S corporation and other pass-through entities (partnerships, LLCs, and sole proprietorships) is how the flow-through profits are taxed. Both are subject to federal and state taxes, but for the other pass-through entities the profits are also subject to self-employment taxes.

The comparative advantages seem to stack up for the S corporation, but that choice is not for everyone. Here are a handful of reasons (not a comprehensive list) one may choose an entity that will be taxed as a partnership (this also includes LLCs taxed as partnerships):

  • Ownership of an S corporation is limited to 100 members, and some owners cannot qualify as S corporation shareholders.
  • Partnerships can have different classes of ownership; all S corporation stock must have the same economic rights.
  • Unlike partnerships, income allocation does not necessarily have to correspond with equity ownership.
  • Partners can generally increase their basis for partnership liabilities, which may allow them to deduct business flow-through losses on their individual returns. S corporation owners can only increase their basis with loans they make directly to the corporation.
  • An individual can receive a “profits interest” in a partnership for services performed with a tax consequence. This would be taxable if an individual receives an ownership share in exchange for the services.

Choice of an entity – one of the more important decisions to make right after deciding to start a business or to change an existing business structure – is not an easy selection. The decision needs to follow your particular facts and circumstances so that your ultimate choice will meet your financial and operational goals and maximize the benefits to the owners.

Leon J. Dutkiewicz Jr., CPA, is partner, practice leader of international tax services, with Citrin Cooperman in Philadelphia.

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Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of PICPA officers or members. The information contained in herein does not constitute accounting, legal, or professional advice. For professional advice, please engage or consult a qualified professional.