In a blog post last February, I addressed a tax question that is commonly raised by owners of private companies: “Should I consider changing my business to a C corporation?”
At the time, the top marginal Federal individual tax rate was increasing to 39.6 percent, with the prospect of a 43.4 percent rate on pass-through income from a business in which an owner did not materially participate. The top C corporation rate remained at 35 percent, with the top rate applicable to companies reporting less than $10 million at 34 percent.
Word coming out of Washington at the time suggested that both parties were in favor of legislative initiatives that would lower the corporate tax rate to perhaps the mid to upper 20 percent range in order to make U.S. companies more competitive in global markets.
A year has passed and corporate tax rates remain unchanged, with talk of any legislative action that would lower rates over the coming year quiet for now. For some business owners, the prospect of higher individual tax liabilities is now more clearly hitting home with the filing of their 2013 tax returns, leading some to again wonder whether a C corporation would be a more appropriate solution for their tax circumstances.
Most tax advisors continue to have strong reservations about switching from a pass-through entity (S corporation, LLC, partnership, etc.) to a C corporation quite yet. A key component of such thinking remains the avoidance of the "double tax" that arises when a C corporation’s profits are taxed initially when earned and later when distributed to the owners. This double tax generally eliminates the current favorable spread between individual and corporate tax rates. A corporate tax of 34 percent, followed by distribution of the remaining 66 percent which is taxed at 20 percent, yields a combined tax of roughly 47 percent. This combination of corporate and individual level tax can be even higher in cases where the new Medicare tax on net investment income will apply at the personal level.
There may be circumstances in which the potential double tax consequences of operating as a C corporation are not sufficient to overcome personal and business initiatives. The ownership of a business by multiple members of a family, some of whom are not directly involved in the business, can present practical issues which a C corporation would avoid. For example, the pass-through treatment of business earnings can complicate personal tax filings, often delaying filing timelines and putting stress on the planning for payment of personal taxes.
Even in such cases, the potential ramifications of a future sale/liquidation scenario should be appropriately evaluated. Many business owners have operated their businesses as a C corporation following a philosophy of "we will never sell, therefore, why be concerned with double tax," only to be faced with the hard reality of such a tax consequence when actual events turn out to be inconsistent with that philosophy.
Should legislative attention to lowering corporate tax rates heat up going forward, we will keep you advised.