Almost all small businesses in the U.S. are pass-through entities—sole proprietorships, partnerships, limited liability companies, and S corporations. When it comes to small businesses, of those with no employees (other than owners), 98.5% are pass-throughs and of those with employees, 77.5% are pass-throughs. These entities have been touted as a way to avoid double taxation. C corporations are taxed, but dividends paid to shareholders are not deductible by the corporation although taxed…again…at the shareholder level. But in today’s tax and economic environment are pass-throughs the best entities to use for conducting business? Should pass-throughs consider switching to C corporation status?
Here are 5 compelling reasons to make the change:
1. Flat tax on profits
C corporations pay a flat 21% tax on profits. This tax rate applies whether the corporation is a microbusiness and multinational. The tax, which is paid by the corporation, is only on net income—revenue minus deductions. Deductions include reasonable compensation paid to owner-employees.
In contrast, owners of pass-through entities paid tax on their share of business profits on their personal returns. This can be at rates up to 37%. The qualified business income (QBI) deduction of up to 20% was created when the flat corporate rate went into effect to equal the tax imposed on businesses. So, owners with losses or only modest profits may pay a low tax rate (remember that income tax rates are graduated, so only top dollars are taxed at the top tax rate. But successful owners of pass-throughs may pay a high tax rate. They may not qualify for the QBI deduction because their income is too high, so they’re paying as much as 37% on their share of profits.
In addition, owners of pass-throughs may be subject to the net investment income tax, explained next.
2. Modest NII tax on owners
The net investment income (NII) tax of 3.8% applies, as the term implies, on investment income for owners with modified adjusted gross income over a threshold amount applicable to their filing status. Investment income includes dividends, as well as profits derived from a pass-through in which the owner does not materially participate (i.e., a “silent investor”). So, an investor in a pass-through may pay tax up to 40.8% on his/her share of profits.
Congress is now considering expansion of the NII tax to apply to owners of pass-through entities, regardless of whether they’re active or passive in their businesses. While the income threshold for the NII tax may be raised and headlines suggest it will only apply to “high-income” people, the expansion of the tax to the owners’ share of active business income means a tax rate on successful owners of pass-throughs that is double that of the rate on C corporations—even multinationals.
3. Ease of crowdfunding
Raising capital and/or obtaining loans can be challenging for small businesses. Today, online platforms facilitate finding needed money. If the business wants to seek equity financing—bringing in new investors—through crowdfunding, being a C corporation is the easiest way to do this. S corporations, by definition, cannot have more than 100 shareholders, which greatly limits equity crowdfunding. And arranging ownership-sharing through partnerships and LLCs can be complicated.
4. Lower Social Security and Medicare taxes
Self-employed individuals—sole proprietors, independent contractors, partners, and LLC members—pay the employee and employer share of Social Security and Medicare tax, collectively called self-employment tax. Yes, one half is deductible, but only as a personal deduction and not as a business deduction.
In contrast, owner-employees in C corporations (and S corporations as well) only pay the employee share of FICA. The corporation pays the employer share and deducts it as a business expense.
5. Tax-free gain opportunity
Gain on the sale of qualified small business stock held more than 5 years can be tax free up to $10 million. So-called Section 1202 stock, named after the section in the Tax Code that governs it, applies only to stock issued by a C corporation that meets certain conditions. While it’s true that this tax break is limited to C corporations operating in certain industries, such as manufacturing, technology, wholesale, and retail, and is barred to businesses in professions and other named industries, for those qualifying it is a dramatic tax break.
I’m not advocating that every pass-through entity should today change their status to a C corporation. I’m not rushing to do it for my business. What I think is advisable is to discuss your business with a CPA or other tax professional and weigh your options. Consider the costs of making a change (e.g., professional fees; state filing fees) and the hassles (e.g., filing two tax returns if there are short tax years for the year of the change; creating new documents if the old entity wasn’t incorporated). Most important: watch what’s happening in Congress.