Choice Of Entity

<div class="Section1"><br /> <br /> For many pass-through business owners, the choice of entity decision may be strongly impacted by whether the business intends to distribute most of its income to the owners each year (as many small businesses do). Regardless of the form the distribution takes, the double tax structure (discussed in Q Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8581">8581</a>) that arises in the C corporation context will often result in a C corporation generating a higher effective tax rate, depending upon the business owner&rsquo;s income tax bracket.<br /> <br /> If a C corporation does not distribute most of its income, the accumulated earnings tax and personal holding company tax must be considered. Both taxes are designed to prevent a C corporation from stockpiling earnings within the corporate structure in order to avoid tax at the individual level. The 20 percent&nbsp;accumulated&nbsp;earnings&nbsp;tax applies when the corporation accumulates earnings beyond the reasonable business needs of the corporation. The 20 percent personal holding company tax can also become important for closely held corporations that derive more than 60 percent of adjusted gross income from passive investments (such as dividends, interest and rent).<br /> <p class="PA">Businesses that would most likely benefit from C corporation structure after enactment of the 2017 tax reform legislation generally include capital-intensive businesses, such as a manufacturing company that has a legitimate business reason for leaving large amounts invested within the corporation (e.g., for purchasing and maintaining equipment).</p><br /> <br /> </div><br />

<p>Beyond the pure tax aspects, small business clients should be advised that tax laws have a tendency to change even when they are characterized as permanent. If the small business converts to C corporation status, problems can result if it turns out that the conversion was ill-advised or the rules change in the future. For example, once an S corporation converts to C corporation status, it cannot convert back to an S corporation for five years.<br /> <br /> Further, if the owner does decide to convert back to an S corporation in the future, taxes on built-in gains may apply and issues surrounding accumulated earnings and profits arise.<br /> <p class="PA">Accounting issues can arise if the pass-through entity is required to change its accounting method as a result of the conversion. Under the new legislation, any accounting adjustments under IRC Section 481(a) that are required because of the conversion of an &ldquo;eligible terminated S corporation&rdquo; (such as changing from the cash to accrual method of accounting) must be taken into account ratably during the six tax years beginning with the year of the change. Eligible terminated S corporations are basically S corporations that convert within two years of the passage of the tax legislation, where the ownership structure remains the same. See <em>2023 Tax Facts on Individual and Small Business</em>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9045">9045</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a more in-depth discussion of small business accounting issues post-reform.</p></p><br />

<div class="Section1"><br /> <br /> Under the 2017 tax reform legislation, C corporations are now subject to a flat 21 percent income tax rate at the entity level and pass-through business income is taxed at the individual level, where a maximum 37 percent rate now applies. While this seems simple on the surface, the true calculus post- tax reform is not nearly so straightforward.<br /> <br /> C corporation income must eventually be distributed by the corporation to its owners, where it is then taxed a second time, at the individual level. The rate of tax on corporate distributions depends on how the distribution is classified. If the income is salary, the maximum 37 percent ordinary income tax rate may apply, but the corporation may deduct the payment. If the distribution comes in the form of dividends, a maximum long-term capital gains rate of 23.8 percent (including net investment income tax) may apply and no deduction is permitted. This structure makes dividend distribution more appealing, but even the effective tax rate on dividends creeps up to 39.8 percent when the double tax is factored in. If a sale of the C corporation is contemplated, the double tax issue arises once again.<br /> <br /> Pass-through entities may be entitled to all or part of a new 20 percent deduction for qualified business income. The availability of this deduction depends upon the business&rsquo; annual income and the type of business in which the entity is engaged. Specified service trades or businesses (SSTBs, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>) can only take advantage of the full deduction if income is less than the annual threshold levels plus $50,000 ($100,000 for joint returns).&nbsp; The applicable threshold levels for 2025 are $394,600 and $197,300 and for 2024 are $383,900 and $191,950.<br /> <br /> Further, when the pass-through entity&rsquo;s income exceeds the thresholds (regardless of business type), the 20 percent deduction is capped at the greater of (1) 50 percent of W-2 wage income or (2) the sum of 25 percent of the W-2 wages of the business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all &ldquo;qualified property&rdquo; (basically, depreciable business property).<br /> <br /> Additionally, state-level taxes on corporate and pass-through (individual) income should also be included in the choice of entity analysis. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a discussion of the impact of the accumulated earnings tax and personal holding company tax on the choice of entity analysis. Some special considerations that can arise in the case of S corporations are discussed at Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> Sole proprietors and S corporations with only a single shareholder may wish to examine their choice of entity decisions to more fully take advantage of the Section 199A deduction for QBI. Generally, reasonable compensation paid by an S corporation to its shareholder is included in the W-2 wage limit and excluded from QBI.<a href="#_ftn1" name="_ftnref1">¹</a> A sole proprietor is not subject to similar requirements (the Section 199A proposed regulations clarified that the reasonable compensation rule applies only in the S corporation context).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the business’ income for the year exceeds the relevant threshold levels, these rules would maximize the QBI deduction if the business was organized as an S corporation. If income fell below the relevant thresholds, the sole proprietor would obtain the larger QBI deduction, as illustrated in the examples below.<br /> <blockquote><em>Example 1</em>: A sole proprietorship and S corporation with one shareholder each generate $500,000 in QBI for the year, and neither business has any qualified property. The S corporation shareholder pays himself reasonable compensation for the year of $100,000. The sole proprietor is not required to pay himself a wage. Both businesses are subject to the W-2 and UBIA limitations because their income exceeds the relevant threshold levels. The S corporation’s QBI deduction for the year is limited based on the statute’s W-2 limitation, so is limited to $50,000 (50 percent of W-2 wages, i.e., the shareholder’s reasonable compensation). The sole proprietor’s QBI deduction (also phased out) is zero, because wages and UBIA both equaled zero.<br /> <br /> <em>Example 2:</em> If each business described in the example above instead earned $100,000 (i.e., below the income thresholds), the W-2 wage and UBIA limitations would not apply. Assume the S corporation shareholder paid himself $40,000 in reasonable compensation for the year. The sole proprietor’s QBI deduction is $20,000 (simply 20 percent of $100,000). The S corporation shareholder must reduce his QBI for the year by the amount of reasonable compensation ($40,000) before calculating the deduction. Thus, his QBI deduction for the year is only $12,000.</blockquote><br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 199A(c)(4)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  Prop. Treas. Reg. § 1.199A-3(b)(2)(ii)(H).<br /> <br /> </div>