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Key Takeaways
- State law classification does not necessarily control tax classification.
- Tax classification, subject to certain conditions, can be changed.
- Converting from a C corporation to a partnership is a taxable event, although a C corporation can convert to a S corporation.
For tax purposes, the decision on whether to operate as a “flow-through entity” (generally, a sole proprietorship and a schedule C filer, partnership, or S corporation) or as a C corporation is often referred to as a “choice of entity” determination. While the 21% corporate rate may favor the C corporation as a choice of entity for certain businesses, there are other factors, both tax and non-tax, to consider when making the determination.
Here are the things you need to consider when deciding on choice of entity.
Operations
Generally, contributions of capital into flow-through entities and C corporations (provided certain “control” requirements are met) are tax-free to both the contributor and the business entity.
However, distributions of cash and property are treated differently:
- Flow-through entity distributions can be tax-free.
- C corporation distributions are usually taxable transactions.
For instance, the distribution of appreciated property from a C corporation triggers two layers of taxation—one at the corporate level, and another at the recipient shareholder level. But the distribution of appreciated property from a partnership can be tax-free.
Accordingly, businesses that routinely distribute earnings may choose the flow-through form over a C corporation to avoid the double layer of tax, especially if the income from the business will be taxed at a lower rate due to the 20% QBI deduction.
- For example, a C corporation distributing 100% of its earnings can be subject to an effective 39.8% rate, while a flow-through business eligible for the full QBI deduction can be subjective to a 29.6% tax rate.
Certain capital-intensive businesses that reinvest earnings (rather than making distributions) may find the C corporation form advantageous because those earnings are only subject to the 21% rate.
Change in Ownership
Businesses with frequent changes in ownership may favor the flow-through form. A purchaser a LLC interest (when the LLC is classified as a partnership) can receive a basis step-up in the purchaser’s share of the LLC’s assets (provided a section 754 election is properly made), entitling the purchaser to potentially higher depreciation and amortization deductions.
This step-up in basis can also occur upon the death of a owner when the ownership interest transfers to an estate and heirs. In contrast, the purchaser of stock in a C corporation is not entitled to the same benefits. This is also true for the purchase of stock in an S corporation.
However, a purchaser may still prefer the S corporation stock over C corporation stock because future gains from operations or sales of property will generate only a single layer of tax.
On the other hand, a business with a relatively static ownership structure may be indifferent to possible basis step-ups. These types of businesses may prefer the C corporation form.
Sale/Exit Scenario
In addition to taking less liability risk, a purchaser of a business may pay a premium to purchase business assets over equity because the purchase of assets generates cost recovery tax benefits like depreciation and amortization.
Generally, an asset sale can be accomplished more efficiently from a tax perspective when the assets are held by a flow-through entity because the gain is only subject to a single layer of tax. For a business entity classified as a partnership, the sellers can sell their partnership interest and pay tax at capital gains rates (subject to the “hot asset” ordinary income rules) while the purchaser can take a cost basis in the underlying partnership assets via a section 754 step-up election discussed above.
Also, the sale of S corporation stock can be structured as an asset sale via an election under sections 338 or 336 of the code, and the gain is only subject to a single layer of tax. In contrast, the purchase of a C corporation’s assets results in a tax liability for both the C corporation and its shareholders (assuming the sales proceeds are paid out) and the availability of a section 338 or 336 election is limited in comparison to an S corporation.
The Pros and Cons of Various Entity Determinations
The chart below contains a non-exhaustive list of some of the tax pros and cons of various entities:
|
Type of Entity |
Pros |
Cons |
|---|---|---|
|
C Corporation |
No restriction on number or type of shareholder |
Two levels of taxation |
|
|
|
Potential for accumulated earnings tax |
|
|
Currently favorable tax rate of 21% |
Potential for built-in gain tax |
|
|
Eligibility for IRC section 1202/QSBS exclusion |
May limit buyer pool due to no step-up in tax basis |
|
|
Generally not subject to passive loss rules |
Change in control limitations as well as built-in loss limitation |
|
|
|
Taxable conversion to partnership |
|
S Corporation |
Single level of taxation |
Restrictions on number and types of shareholders |
|
|
|
Avoiding S election “termination” events |
|
|
Income and expenses are born by all shareholders equally |
No flexibility with allocations and distributions |
|
|
QBI deduction |
No tax basis step-up for buyers |
|
Partnership |
Single level of taxation |
Tax compliance burden |
|
|
No restriction on number or type of partners Step-up for purchasing partners |
|
|
|
Flexible in the allocation of income/deductions |
Complexity of substantial economic effect rules |
|
|
QBI deduction |
|
|
|
Partnership debt provides tax basis |
|
|
Single-Member LLC |
Single level of taxation |
Cannot have more than one owner |
|
|
No tax returns |
|
|
|
Generally can convert to another tax classification with minimal tax consequences |
|
