A Brighter Way
A Brighter Way
The expected increase in individual income tax rates next year has some small business owners questioning whether now is the time to change their entity structure. Which structure is best for a business is a complex question – and the answer will be different for each individual. The following are issues you should consider when facing this question.
There are valid reasons you may wish to maintain your current entity type, or conversely consider switching to a different entity type. Assuming that you must maintain a flow-through entity to avoid the double taxation association with a C corporation can be a short-sided philosophy – especially if your business needs to retain capital to expand and grow. You must decide what is most important, and then work with an accounting professional to understand how these factors will impact the choice of entity decision.
If a company changes to an S corporation to avoid double taxes on an eventual sale, the decision to change entities is necessarily based on a critical assumption – that the business is sellable, either as a stock or as an asset deal.
Is there already a plan in place for the future sale? If not, basing the choice of entity on a future event that may not happen for many years, or even at all, could cause the business to experience higher than necessary taxes in the short-term that accumulate over several years. The need for cash flow and maximization of profits to reinvest in a growing business may be a greater priority – and thus should have a greater impact on the choice of entity decision.
This question assumes that a sale of the company will be more than 10 years into the future. If the company expects to experience profits, it will be important to consider how the profits will be used – for example, reinvested in the business, distributed to owners as a return on their investment or used to pay down debt service. And if the company expects to see losses, you must think about how quickly such losses will use up your investment basis, and at what point prolonged losses in a flow-through entity will no longer provide any current economic benefits to you.
Having the right entity can impact how this transition occurs. If the you are considering providing equity to key employees or selling equity to other outside parties, an S corp will typically offer less flexibility because of the limits on types of equity shares, who can be an owner, and the number of shareholders the entity is allowed to have (although for most closely held businesses, this last limitation is normally not an issue).
In addition, an ESOP (Employee Stock Ownership Plan) can be an effective tool for you to sell some or all of the stock to the employee group. Here again, operating as a C corporation versus an S corporation can have implications on your ability to potentially defer or even eliminate some or all of the gain on the sale of the stock to the ESOP.
While federal corporate tax rates are expected to stay at their current levels, individual tax brackets will be higher beginning in 2011. There will be a larger gap, at least 5 percent and perhaps as much as 10 percent when factoring in other surtax rates, between the top tax rates for a corporation versus an individual. As these tax rates increase for individuals, a flow-through entity may be less attractive.
Similarly, state income taxes (or lack thereof) can also have a material economic impact on the choice of entity decision.
For example, Ohio does not currently tax corporations on their net taxable income; however, flow-through income would be subject to Ohio’s individual income tax. With a maximum tax rate of 6.24 percent in 2011, Ohio business owners would incur an additional $4,056 in taxes (net of federal deduction) on every $100,000 of Ohio-sourced taxable income if they operate the business as a flow-through entity versus a C corporation.
Owners of flow-through entities do not receive the same tax-free treatment for their health insurance benefits that C-corporations do. As a result, owners of flow-through entities face an additional tax (typically at 1.45 percent) based on the amount of health benefits paid to each owner.
You must decide what’s most important when deciding the type of entity that works best for you and your business. Factors such as liability protection, industry or regulatory requirements, the goal to “go public,” or other non-tax goals may be more important to the decision than any tax implications.
Determining the right entity type for the business is a complex decision. Tax considerations are important factors, but are not the only factors. Your accounting professional can talk through all of these important considerations.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.
