Choice Of Entity And The Small Business

<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 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 (see Q Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8960">8960</a> and Q Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8961">8961</a>). 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 accumulated earnings 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 /> <br /> 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).<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 /> <br /> 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&nbsp;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. <em>&lt;em&gt;See&lt;/em&gt;</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9044">9044</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9058">9058</a> for a more in-depth discussion of small business accounting issues post-reform.</p><br />

<div class="Section1"><br /> <br /> Under the 2017 tax reform legislation, C corporations are now subject to a flat 21&nbsp;percent income tax rate at the entity level and pass-through business income is taxed at the individual level, where a maximum 37&nbsp;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. If the income is salary, the maximum 37&nbsp;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&nbsp;percent (including net investment income tax) may apply and no deduction is permitted.&nbsp;This structure makes dividend distribution more appealing, but even the effective tax rate on dividends creeps up to 39.8&nbsp;percent when the double tax is factored in. If a sale of the C&nbsp;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&nbsp;percent deduction for qualified business income.&nbsp;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 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 (married filing jointly) or $197,300 (single filers) and for 2024 are $383,900 (married filing jointly) or $191,950 (single filers).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> Further, when the pass-through entity&rsquo;s income exceeds the thresholds (regardless of business type), the 20&nbsp;percent deduction is capped at the greater of (1) 50&nbsp;percent of W-2 wage income or (2) the sum of 25&nbsp;percent of the W-2 wages of the business plus 2.5&nbsp;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. <em><em>See</em></em> 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 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 class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; Rev. Proc. 2023-34.<br /> <br /> </div></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&nbsp;199A deduction for QBI (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8931">8931</a>). 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&nbsp;199A proposed regulations make clear that the reasonable compensation rule applies only in the S corporation context).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the business&rsquo; 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 /> <p style="padding-left: 40px;"><em>Example</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.&nbsp;The S corporation shareholder pays himself reasonable compensation for the year of $100,000.&nbsp;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.&nbsp;The S corporation&rsquo;s QBI deduction for the year is limited based on the statute&rsquo;s W-2 limitation, so is limited to $50,000 (50&nbsp;percent of W-2 wages, i.e., the shareholder&rsquo;s reasonable compensation).&nbsp;The sole proprietor&rsquo;s QBI deduction (also phased out) is zero, because wages and UBIA both equaled zero.</p><br /> <p style="padding-left: 40px;"><em>Example:</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.&nbsp;The sole proprietor&rsquo;s QBI deduction is $20,000 (simply 20&nbsp;percent of $100,000).&nbsp;The S corporation shareholder must reduce his QBI for the year by the amount of reasonable compensation ($40,000) before calculating the deduction.&nbsp;Thus, his QBI deduction for the year is only $12,000.</p><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;199A(c)(4)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Prop.&nbsp;Treas. Reg. &sect;&nbsp;1.199A-3(b)(2)(ii)(H).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Entities that are taxed under the rules governing pass-through taxation are generally entitled to a 20&nbsp;percent deduction for qualified business income (QBI, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8931">8931</a>).&nbsp;This deduction is equal to the sum of:<br /> <p style="padding-left: 40px;">(a)&nbsp; the lesser of the combined QBI amount for the tax year or an amount equal to 20&nbsp;percent of the excess of the taxpayer&rsquo;s taxable income over any net capital gain and cooperative dividends, plus</p><br /> <p style="padding-left: 40px;">(b)&nbsp; the lesser of 20&nbsp;percent of qualified cooperative dividends or taxable income (reduced by net capital gain).<a href="#_ftn1" name="_ftnref1">¹</a></p><br /> The sum discussed above may not exceed the taxpayer&rsquo;s taxable income for the tax year (reduced by net capital gain). Further, the 20&nbsp;percent deduction with respect to qualified cooperative dividends is limited to taxable income (reduced by net capital gain).<br /> <br /> The deductible amount for each qualified trade or business is the lesser of:<br /> <p style="padding-left: 40px;">(a)&nbsp; 20&nbsp;percent of the QBI with respect to the trade or business or</p><br /> <p style="padding-left: 40px;">(b)&nbsp; the greater of (x) 50&nbsp;percent of W-2 wage income or (y) the sum of 25&nbsp;percent of the W-2 wages of the business plus 2.5&nbsp;percent of the unadjusted basis, immediately after acquisition, of all qualified property (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8931">8931</a>).<a href="#_ftn2" name="_ftnref2">²</a></p><br /> <br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong>&nbsp;The regulations (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>) provide guidance on how UBIA should be calculated in the case of a like-kind exchange or involuntary conversion.&nbsp;The regulations follow the Section&nbsp;168 regulations in providing that property acquired in a like-kind exchange, or by conversion, is treated as MACRS property, so that the depreciation period is determined using the date the relinquished property was first placed into service unless an exception applies.&nbsp;The exception applies if the taxpayer elected&nbsp;<em>not</em>&nbsp;to apply&nbsp;Treasury Regulation&nbsp;&sect;&nbsp;1.168(i)-6. As a result, most property acquired in a like-kind exchange or involuntary conversion under the new rules will have two relevant placed in service dates. For calculating UBIA, the relevant date is the date the taxpayer places the property into service. For calculating its depreciable period, the relevant date is the date the taxpayer placed the original, relinquished property into service.<br /> <br /> <hr><br /> <br /> Concurrently with the proposed regulations, the IRS released Notice 2018-64, which contains a proposed revenue procedure with guidance for calculating W-2 wages for purposes of the Section 199A deduction for qualified business income. The guidance provides three methods for calculating W-2 wages, including the &ldquo;unmodified box method&rdquo;, the &ldquo;modified Box 1 method&rdquo;, and the &ldquo;tracking wages method.&rdquo; The guidance further specifies that wages calculated under these methods are only taken into account in determining the W-2 wage limitations if properly allocable to QBI under Proposed Treasury Regulation &sect; 1.199A-2(g).<br /> <br /> The unmodified box method involves taking the lesser of (1) the total of Box 1 entries for all W-2 forms or (2) the total of Box 5 entries for all W-2 forms (in either case, those that were&nbsp;filed with the SSA by the taxpayer for the year). Under the modified Box 1 method, the taxpayer subtracts from its total Box 1 entries amounts that are not wages for federal income tax withholding purposes, and then adds back the total of Box 12 entries for certain employees.&nbsp;The tracking wages method requires the taxpayer to actually track employees&rsquo; wages, and (1) total the wages subject to income tax withholding and (2) subtract the total of all Box 12 entries of certain employees. <em><em>See</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.<br /> <br /> If the taxable income is below the applicable threshold levels (in 2025) $394,600 (married filing jointly) or $197,300 (married filing separate returns or single filers), the deduction is simply 20 percent.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> If the taxable income exceeds the relevant threshold amount, but not by more than $50,000 ($100,000 for joint returns), and the amount determined under (b), above, is less than the amount under (a), above, then the deductible amount is determined without regard to the calculation required under (b). However, the deductible amount allowed under (a) is reduced by the amount that bears the same ratio to the &ldquo;excess amount&rdquo; as (1) the amount by which taxable income exceeds the threshold amount bears to (2) $50,000 ($100,000 for joint returns).<br /> <br /> The &ldquo;excess amount&rdquo; means the excess of the amount determined under (a), above, over the amount determined under (b), above, without regard to the reduction described immediately above.<br /> <br /> &ldquo;Combined qualified business income&rdquo; for the year is the sum of the deductible amounts for each qualified trade or business of the taxpayer and 20&nbsp;percent of the taxpayer&rsquo;s qualified REIT dividends and qualified publicly traded partnership income.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Final IRS rules have clarified that REIT dividends received by RIC shareholders qualify for the 20&nbsp;percent deduction. In other words, the dividends qualify for &ldquo;conduit&rdquo; treatment and are simply treated as though they are received directly by the RIC shareholder. However, the rules don&rsquo;t provide a similar rule for PTP income&mdash;even though direct receipt of qualified PTP income would qualify the recipient for the 20&nbsp;percent QBI deduction. RIC investors may wish to take this disparity into account when determining whether to invest indirectly in a PTP.<br /> <br /> <hr><br /> <br /> Qualified REIT dividends do not include any portion of a dividend received from a REIT that is a capital gain dividend or a qualified dividend.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> &ldquo;Qualified cooperative dividends&rdquo; includes a patronage dividend, per-unit retain allocation, qualified written notice of allocation, or any similar amount that is included in gross income and received from (a) a tax-exempt benevolent life insurance association, a mutual ditch or irrigation company, cooperative telephone company, like cooperative organization or a taxable or tax-exempt cooperative that is described in section 1381(a), or (2) a taxable cooperative governed by tax rules applicable to cooperatives before the enactment of subchapter&nbsp;T of the Code in 1962.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> &ldquo;Qualified publicly traded partnership income&rdquo; means the sum of:<br /> <p style="padding-left: 40px;">(1)&nbsp; the net amount of the taxpayer&rsquo;s allocable share of each qualified item of income, gain, deduction, and loss from a publicly-traded partnership that does not elect to be taxed as a corporation (so long as the item is connected with a U.S. trade or business and is included or allowed in determining taxable income for the year and is not excepted investment-type income, also not including the taxpayer&rsquo;s reasonable compensation, guaranteed payments for services or Section&nbsp;707(a) payments for services), and</p><br /> <p style="padding-left: 40px;">(2)&nbsp; gain recognized by the taxpayer on disposing its interest in the partnership that is treated as ordinary income.<a href="#_ftn7" name="_ftnref7">⁷</a></p><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;199A(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; IRC &sect;&nbsp;199A(b)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp; IRC &sect;&nbsp;199A(b)(3).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp; IRC &sect;&nbsp;199A(b)(1).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp; IRC &sect;&nbsp;199A(e)(3).<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.&nbsp; IRC &sect;&nbsp;199A(e)(4).<br /> <br /> <a href="#_ftnref7" name="_ftn7">7</a>.&nbsp; IRC &sect;&nbsp;199A(e)(5).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Professional corporations are governed by state law, so the requirements will vary from state to state. In many states, each member of the PC must be licensed in the same profession (i.e., law or medicine) and many states require the PC to submit proof of licensing and obtain state approval upon formation. Some states also require that the PC obtain approval from their state licensing body at the time of formation.<br /> <br /> The letters &ldquo;PC&rdquo; must generally follow the name of the professional corporation. Depending upon the state and the industry, requirements may also apply to the actual name of the PC (for example, while a group of lawyers will often be required to use some form of &ldquo;professional corporation&rdquo; after the corporate name, a group of doctors may be required to use &ldquo;medical corporation&rdquo;).<br /> <br /> Unlike traditional corporations, some (or all) of the officers and directors of a professional corporation often must be licensed to perform the activity that the PC is engaged in. States may specify the number of directors that must be on the PC&rsquo;s board (for example, in California, three directors are required unless the PC has fewer than three shareholders).<br /> <br /> To form the PC, articles of incorporation must generally be filed in the same manner as required of a traditional corporation. In fact, most states require that a professional corporation take the same formation steps as a traditional corporation. In Delaware, for example, the PC is required to select an official address and registered agent for the PC, choose a board of directors and officers, file a certificate of incorporation with the state, obtain a federal employer identification number and issue stock certificates to initial shareholders.&nbsp;The board of directors must meet to adopt official bylaws, and shareholder and director meetings must be held annually. For more information on the formation requirements that apply to C corporations, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8952">8952</a>.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> For many business owners, the opportunity to limit personal liability may be the most attractive feature of the corporate form. This can be an advantage and even a necessity for a business that faces substantial liability for the actions of its agents, the hazardous nature of its business, or the liability exposure of its products. Also, any venture has an inherent risk of loss, especially in the early years. Shareholders in a corporation (as well as members of a limited liability company and limited partners in a limited partnership) are not liable for the corporation’s actions beyond the amount of their capital contribution to the corporation. However, there are still important considerations that must be noted, because limited liability is not absolute.<br /> <br /> First, the corporation and its shareholders must follow strict state law requirements relating to shareholder meetings, election of a board of directors, directors’ meetings, and other matters of internal governance required by the corporation’s articles of incorporation and the state of incorporation’s laws. These are not mere formalities—a corporation which fails to follow these rules may lose its status as a corporation and limited liability in a process known as “piercing the corporate veil.” However, many states have close corporation statutes relaxing these rules and giving shareholders in a closely held corporation greater freedom to determine their own internal governance.<br /> <br /> Second, a shareholder’s limited liability may be illusory for bank financing, because most lending institutions demand that stockholders personally guarantee close corporation indebtedness.<br /> <p class="PA">Finally, potential incorporators who wish to do business under an umbrella of limited liability can find other ways to do so without incorporating. One way to do so may be to set up a limited partnership with an existing corporation, S corporation or LLC as the general partner.</p><br /> <br /> </div>

<div class="Section1"><br /> <br /> A QSST is a trust that has only one current income beneficiary (who must be a citizen or resident of the U.S.), all income must be distributed currently, and the trust corpus may not be distributed to anyone else during the life of such beneficiary.&nbsp;The income interest must terminate upon the earlier of the beneficiary&rsquo;s death or termination of the trust. If the trust terminates during the lifetime of the income beneficiary, all trust assets must be distributed to that beneficiary.&nbsp;The beneficiary must make an election for the trust to be treated as a QSST.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> When the stock is initially transferred to the trust, the taxpayer must file a separate S corporation election. For both the QSST and the electing small business trust (ESBT, <em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8974">8974</a>), the election must be filed &ldquo;within the 16 day and two month period beginning on the day that the stock is transferred to the trust.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <hr><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp; IRC &sect;&nbsp;1361(d).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp; Treas. Reg. &sect;&sect;&nbsp;1.1361-1(j)(6)(iii); 1.1361-1 (m)(2)(iii).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> Dividends received by a domestic corporation which owns at least 10 percent of a foreign corporation are subject to a domestic corporation deduction only to the extent that the dividends are deemed attributable to U.S. source income of the foreign corporation. This is computed by applying to the dividends received a ratio equal to the ratio of U.S. source income to total income of the foreign corporation. Once the U.S.-source portion is determined, the deduction is then limited, depending on the percentage ownership of the foreign corporation. If the domestic corporation owns at least 10 percent, but less than 20 percent, the deduction is 50 percent (70 percent prior to 2018) of the U.S.-source portion of the dividends received. If the percentage ownership is at least 20 percent, the portion deductible increases to 65 percent (80 percent prior to 2018) of the U.S.-source dividends received.<br /> <br /> A 100 percent deduction is allowed for dividends received from a foreign wholly-owned subsidiary of a domestic corporation, provided that all of the subsidiary’s income is effectively connected with a U.S. trade or business. Special rules apply in the case of dividends received from certain foreign sales corporations (FSCs).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <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 § 245.<br /> <br /> </div>

<div class="Section1"><br /> <br /> A person becomes a partner in a partnership through the ownership of a capital interest in a partnership in which capital is a material income-producing factor, whether the interest is acquired by purchase or gift.<a href="#_ftn1" name="_ftnref1">¹</a> Generally, such a person will be taxed on his or her share of partnership profits or losses. If capital is not an income-producing factor in the partnership, the transfer of a partnership interest to a family member may be disregarded as an ineffective assignment of income, rather than an assignment of property from which income is derived.<br /> <br /> Generally, the partnership agreement will provide how income and losses will be allocated. However, where an interest is acquired by gift (an interest purchased by one family member from another is considered to have been acquired by gift), the allocation of income, as set forth in the partnership agreement, will not control to the extent that:<br /> <p style="padding-left: 40px;">(1)  it does not allow for a reasonable salary for services rendered to the partnership by the donor of the interest; or</p><br /> <p style="padding-left: 40px;">(2)  the income attributable to the capital share of the donee is proportionately greater than the income attributable to the donor’s capital share.<a href="#_ftn2" name="_ftnref2">²</a></p><br /> The transfer must be complete and the family member donee must have control over the partnership interest consistent with the status of partner. If the donee is not old enough to serve in the capacity of partner, the interest must be controlled by a fiduciary for his benefit.<br /> <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 § 704(e)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  IRC § 704(e)(2).<br /> <br /> </div>