Entity Tax Status Choice
An important consideration when starting a business is how the business will be taxed. US law permits a company to be taxed as either a “Pass-Through Entity” or as a “C-Corporation”. Which entity the business chooses can have significant ramifications for the tax rate, the timing of the taxes, how losses function, and potential exit strategies. Knowing what entity is a “Pass-Through Entity” and which is a “C-Corporation” can save time and money to budding startups.
A Pass-Through Entity is a type of tax treatment that permits the taxable income by a business to be “passed through” directly to the stockholders. For instance, if Don and Judy each own 50% of a Pass-Through partnership. The business has $100,000 in taxable income in a year, the business doesn’t pay its taxes, and the partnership passes through $50,000 of taxable income to each partner’s individual tax return through submission of a K-1 Form.
In contrast to Pass-Through Entities such as partnerships, C-Corporations are treated as a legally distinct entities. If, instead of owning a partnership together, Don and Judy were shareholders in a C-Corporation, the $100,000 would be taxed entirely to the business, with Tom and Judy each showing $0.00 additional individual tax income.
However, there is a catch—there is an additional gross tax on distributions from C-Corps to shareholders called the dividend tax. For instance, if the C-Corporation earns $100 in income (assuming the current 21% corporate rate), the income tax would be $21 and the business would retain $79; if the business then dividends that $79 (assuming a 20% qualified dividend rate + 3.8% NIIT), the investor would be entitled to retain $60.20, which implies a taxable rate of 39.80% instead of Don and Judy being taxed at their individual income rates in their Pass-Through partnership example.
Additionally, entities taxed as C-Corporations can make it very difficult to exit with an asset sale. This is because the assets will be sold at an ordinary income rate and then distributed to the shareholders as a qualified dividend, for the 39.80% rate discussed above. In contrast, a business taxed as a partnership can sell certain assets and receive capital gains treatment, which is 20% as of 2019, plus potential 3.8% NIIT for high income partners.
While the Tax Cuts and Jobs Act has made substantial headway in leveling the playing field between Pass-Through Entities and C-Corporations, the choice of entity is extremely important. Which choice is right for a business depends on the goals, the type of business, and a variety of other considerations.