Tax Factors to Consider When Selecting a Business Structure

Are you starting a business or considering changing your business structure? If so, you’ll need to determine the best way to organize your company. Should you operate as a C corporation or choose a pass-through entity like a partnership, limited liability company (LLC), or S corporation? One of the key factors to consider in this decision is the potential tax implications.

Fundamentals of Tax Treatment

The current federal corporate income tax rate is a flat 21%, while individual federal income tax rates range from 10% to 37%. In a pass-through entity, the income passed through to the owners is taxed at these individual rates. Therefore, depending on your circumstances, operating as a C corporation could result in a lower overall tax rate compared to running the business as a pass-through entity.

However, the difference in tax rates can be mitigated by the qualified business income (QBI) deduction, which is available to eligible owners of pass-through entities, including individuals, and certain estates and trusts.

The QBI deduction is set to expire on December 31, 2025, unless Congress decides to extend it. While the 21% corporate tax rate is currently permanent, it remains subject to change if Congress enacts new legislation.

More to Consider

Several other tax-related considerations should also be taken into account, such as:

• Profit Distribution: If most of the business profits will be distributed to the owners, a pass-through entity may be preferable. C corporation shareholders face double taxation, as they are taxed on both corporate profits and dividend distributions. In contrast, pass-through entity owners are taxed only once at the personal level.
• Appreciating Assets: If the business owns assets likely to appreciate, a pass-through entity might be advantageous. The owner’s basis in the entity is stepped up, potentially reducing taxable gains when their interest in the entity is sold.
• Tax Losses: If the business is expected to incur tax losses initially, a pass-through structure allows owners to deduct these losses against other income. However, if you have insufficient other income or the losses are unusable (due to limitations like passive loss rules), a C corporation might be more beneficial, as it can offset future income with those losses.
• Alternative Minimum Tax (AMT): If the business owner is subject to the alternative minimum tax (AMT), organizing as a C corporation could be more favorable. Only the largest corporations are subject to corporate AMT, whereas individuals face AMT rates of 26% or 28%.

Final Thoughts

Determining the best entity type for your business involves numerous factors, and the considerations discussed here are just a few. To fully assess your options in light of your specific circumstances, it is advisable to contact our office for a detailed discussion.

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