While choosing a business entity seems simple, the Tax Cuts and Jobs Act, combined with today’s changing business landscape, complicates the decision. As discussed in my previous article, there are certain questions you must be able to answer as a business owner planning any new venture. Here are several more for review.
How do I get profits out of the business?
A business has a choice of either reinvesting its profits back into the business or distributing them to the owners. If there is intent to distribute profits, then the effective tax rate on distributed funds should be taken into consideration. A flow-through entity, for example, is taxed on its profits only once at the owner level.
On the other hand, when a C corporation decides to distribute previously taxed profits to its shareholders, it does so in the form of a dividend that is subject to tax at the individual owner level, thereby adding a second level of tax to previously taxed profit.
Currently, the highest stated individual tax rate which pass-through entity owners would be subject to is 37%. If a C corporation is planning to retain profits inside the business, the company must be able to demonstrate that amounts retained beyond $250,000 are for the reasonable needs of the business. A service business structured as a C corporation may have a problem demonstrating the need to retain the excess capital – and may be forced to distribute after tax cash.
What happens when I sell?
The tax consequences on the sale of a business play a key role in planning the company’s structure. There are several advantages of the corporate entity structure, such as preferential tax rates on the sale of corporate stock. When corporate stock (held longer than one year) is sold, any gain from the sale is generally considered capital gain income subject to capital gain tax rates of 15% or 20%.
As far as corporate stock is concerned, there is no difference in the tax treatment between a C corporation and an S corporation when stock is sold. However, under IRC Section 1202, up to 100% of the capital gain from the sale of qualified small business C corporation stock, purchased at original issuance after 2010, may be exempt from federal tax if certain conditions are met.
A buyer that wants to purchase the assets of a business, rather than the corporate stock, can create adverse tax implications to the C corporation seller. The buyer will want to purchase assets rather than stock in order to receive a “step up” in tax basis, or the difference between the fair market value and the current net tax basis of the assets purchased.
By stepping up the tax basis of the assets purchased, the purchaser will have greater future tax depreciation/amortization to offset future taxable income. In this scenario, the corporation will be subject to a tax on the sale of its assets and the individual owners will also be subject to a second tax upon distribution of the sales proceeds.
Future events, such as the modifying or repealing of current legislation, can cause any prior tax planning to be rendered obsolete. We cannot predict the future, but we can certainly perform a diligent analysis on all current facts and circumstances.
Every situation is unique and there is no one-size-fits-all solution. Please make sure to consult your tax advisor for assistance when choosing your entity structure.
This article originally published in the Houston Business Journal.