Almost all small businesses in the U.S. are end-to-end entities—sole proprietorships, partnerships, limited liability partnerships, and S corporations. When it comes to small business, of those with no employees (other than owners), 98.5% are passers, and of those with employees, 77.5% are passers. These organizations were advertised as a way to avoid double taxation. C corporations are taxable, but dividends paid to shareholders are not deductible by the corporation, although they are taxed…again…at the shareholder level. But in today’s tax and economic climate, are pass-throughs the best entities to do business with? Should I consider converting to C corporation status?
Here are 5 good reasons to make the switch:
1. Uniform income tax
C corporations pay a flat 21% income tax. This tax rate applies regardless of whether the corporation is a micro business or a multinational. The tax paid by a corporation consists only of net profits – net income. Deductions include reasonable compensation paid to owner-employees.
In contrast, owners of cut-through entities paid tax on their share of business profits on their personal returns. It can be at rates up to 37%. The qualified business income (QBI) deduction up to 20% was created when a flat corporate rate came into effect, equal to the tax levied on businesses. Therefore, owners with losses or only modest gains can pay a low tax rate (remember that income tax rates are graduated, so only the top dollars are taxed at the highest tax rate. But successful pass-through owners can pay a high rate tax They may not claim the QBI deduction because their income is too high, so they pay 37% of their share of the profit.
In addition, pass-through owners may be subject to tax on net investment income, explained below.
2. Modest NII tax on owners
The tax on net investment income (NII) of 3.8% applies, as the term implies, to investment income for holders with modified adjusted gross income that exceeds the threshold amount applicable to their filing status. Investment income includes dividends as well as income derived from a pass-through in which the owner is not materially involved (i.e. a “silent investor”). Yes, a pass-through investor can pay up to 40.8% tax on their profit share.
Congress is now considering expanding the NII tax apply to owners of end-to-end entities, whether they are active in their business or passive. While the income threshold for NII tax may be raised and headlines suggest that it would only apply to “high-income” individuals, extending the tax to owners’ share of active business income means a tax rate for successful pass-through owners that is double the rate for C corporations — even multinationals.
3. Ease of crowdfunding
Raising capital and/or obtaining loans can be a challenge for small businesses. Today, online platforms make it easier to find the money you need. If a company wants to seek equity financing – bringing in new investors – through crowdfunding, becoming a C corporation is the easiest way to do it. S corporations, by definition, cannot have more than 100 shareholders, which greatly limits crowdfunding. And arranging joint ownership through partnerships and LLCs can be difficult.
4. Lower Social Security and Medicare taxes
Self-employed individuals—sole proprietors, independent contractors, partners, and LLC members—pay the employee and employer shares of Social Security and Medicare taxes, which are collectively called self-employment tax. Yes, one half is deductible, but only as a personal deduction, not as a business deduction.
In contrast, employee-owners in C corporations (as well as S corporations) pay only the employee share FICA. The corporation pays the employer’s share and deducts it as a business expense.
5. The ability to receive tax-free
Gains on the sale of qualified small business stock held for more than 5 years can be tax-free up to $10 million. So called Section 1202 actions, named after the section of the Internal Revenue Code that governs it, applies only to stock issued by a C corporation that meets certain conditions. While it is true that these tax breaks are limited to C corporations operating in certain industries such as manufacturing, technology, wholesale and retail, and are prohibited for businesses in professional and other specified industries, for those who qualify, it a significant tax benefit.
Final thought
I’m not advocating that every pass-through entity today change its status to a C corporation. I’m in no rush to do it for my business. I think it’s a good idea to discuss your business with a CPA or other tax professional and weigh your options. Consider the costs of making the change (e.g., professional fees; government filing fees) and hassles (e.g., filing two tax returns if the year of the change has short tax years; creating new documents if the old business was not incorporated). The most important thing: to see what is happening in Congress.
