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 /> 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>

<div class="Section1"><br /> <br /> In certain states, groups of professionals performing services in specified fields (such as medicine, accounting and law) are not permitted to establish a traditional corporation that would eliminate the personal liability of the individual professionals entirely. These groups may wish to form a professional corporation in order to obtain some of the benefits of a corporation, such as personal protection against corporate debts, although each individual can still be held liable for his or her own malpractice. While the PC structure does not allow the individual to escape liability for his or her own professional malpractice, it does protect each individual from liability incurred by other members of the group.<br /> <br /> Further, the PC structure allows the group to obtain the benefit of perpetual corporate existence, so that the business will continue if one or more members leaves the PC (in the partnership context, there is always the possibility that the partnership may need to be dissolved if one or more partners leaves or dies).<br /> <br /> Like any other corporation, double taxation is a primary disadvantage of the PC structure. The PC itself is subject to tax, and the individual owners are subject to tax when the PC profits are distributed.<br /> <br /> </div>

<div class="Section1">The IRS has yet to provide guidance as to the tax treatment of B corporations. As such, a B corporation is subject to the same tax rules that govern C corporations (<em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8951">8951</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8965">8965</a>), until the IRS releases guidance to the contra-ry.</div><br />