For years, the recommended choice of entity for most family-owned businesses has been the S-corporation or the LLC/partnership (“pass-through entity”), because the income of the business is taxed only once, directly to the individual owners. The C-corporation makes sense in certain circumstances, but many closely held businesses have avoided this structure because it subjects the business profits to double taxation, once at the corporate level and then again as the owners take dividend distributions from the corporation.
Although we don’t have much guidance yet, it’s pretty clear that the top individual tax rate will increase to 39.6% in 2011, either by enactment of a tax rate increase under President Obama’s proposed budget or through expiration of the Bush tax cuts at the end of this year. As for corporations, there have been no proposals to increase the federal corporate tax rates, so it appears that the top rate of 34% (for taxable income under $10 million) will continue into the foreseeable future. Also, for corporations doing business in Ohio, there are no additional state corporate income taxes, because the Ohio corporate income tax was completely eliminated for 2009 and subsequent years.
In view of the pending increase in the top federal individual tax rate and the absence of an Ohio corporate income tax, it may be time, at least for Ohio businesses, to reconsider the overall tax status of the enterprise. Going forward, will it be better to be taxed as a pass-through entity or as a regular tax-paying C-corporation? The quick math favors the Ohio C-corporation. The top corporate tax rate of 34% is much lower than the top individual tax rate, which is close to 45.6% when the 39.6% federal tax is combined with an approximate 6% tax for Ohio individuals in the top tax bracket.
However, the corporation begins to lose its tax advantage if you assume that the owners will take cash distributions from the business. The future tax rate on dividends is unclear, but if you assume that a 20% federal tax rate will apply as under the Obama proposed budget, then an additional tax burden of approximately 17% would result from the distribution of corporate profits; calculated as a 26% combined federal and Ohio tax rate applied to 66% of the corporate profits (i.e., the amount remaining after federal taxes). That puts the total corporate tax burden at 51% on a fully-distributed basis. But if the owners only remove half of the profits (reinvesting the other half in the business), then the all-in effective tax rate would be lowered to approximately 42.5%, which is still lower than the 45.6% effective tax rate for the pass-through entity.
The big problem for C-corporations comes about in connection with a sale of business assets. Unlike for individuals, there is no special capital gains tax rate available for corporations. So, if a corporation sells appreciated assets and distributes the proceeds to the owners, the combined tax rate of 51% would be much higher than the pass-through entity. The individual owners of a pass-through entity would likely incur a tax rate of about 26% on a sale of business assets, which includes a 20% capital gains tax (as under the Obama-proposed budget) and the 6% Ohio tax.
But if the exit strategy for the corporate business is for the individual owners to sell the stock of the corporation (as opposed to a sale of corporate assets), then the pass-through entity would hold no advantage over the corporate form in a sale scenario, because the 26% combined individual tax rate would apply to both.
Finally, it’s important to keep in mind that the choice of entity decision involves many other tax and non-tax factors that need to be evaluated. Also, converting the tax status of an existing entity should not be undertaken without consulting a tax professional and carefully analyzing all potential tax consequences.
Schneider Downs provides accounting, tax, wealth management and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA, and Columbus, OH.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.