The American Taxpayer Relief Act of 2012 was signed into law on January 2nd. Although the recent headlines suggest the “fiscal cliff” was averted with this legislation, for most business owners, dealing with significantly higher tax rates is now a reality. With tax rates now set, one question many business owners are asking is what type of entity is best suited to minimize exposure to income taxes? Should C corporation owners consider making an S election, or is a C corporation now more tax efficient? Several commentators, noting that the highest C corporation tax rates will in most cases be lower than the individual tax rates effectively paid by pass-through entities, have suggested that it may be time for businesses to consider operating as a C corporation.
If income is allocated to owners who are active in the business, the profits generated by pass-through entities will be taxed at a maximum rate of 39.6 percent. To the extent the owners of a pass-through entity are not active in the business, the Medicare Tax must be added. This makes for a total tax rate of 43.4 percent on pass-through income for these owners. In either case, these rates are significantly higher than the maximum effective tax rate of 35 percent for most C corporations. This disparity is an issue even with pass-through entities having some or even most owners in lower tax brackets, since tax distributions are usually (in the case of a LLC) and must be (in the case of a S corporation) made in proportion to ownership, not based on owners' individual tax rates. The chart below shows that if tax distributions are made proportionately, a hypothetical pass-through business can have a tax rate of 43.4 percent, even though some (or even most) of the owners are in the 25 percent tax bracket. An owner in the 43.4 percent tax bracket might feel like tax distributions are a windfall to the owners in the lower brackets.
In fact, the current rate structure makes operating as a pass-through much more complicated. Historically, owners of pass-through entities generally were subject to the same, or at least similar federal tax rates on allocations of income. Under the current rate structure, it is much more likely that owners will be subject to very different rates of tax depending on their income levels and whether they are active in the business. A single pass-through entity with five owners could easily be taxed effectively at five different rates, as follows:
Passive or Active
Taxable income less than $146,400
AGI more than $250,000 but taxable income of $398,450 to $450,000
Taxable income exceeding $450,000
AGI of more than $250,000 but taxable income of $398,450 to $450,000
Taxable income exceeding $450,000
Since there are actually five tax brackets for taxable income between $146,400 and $450,000, and the numbers above reflect the thresholds for taxpayers filing jointly, the number of variations based on the owner’s Adjusted Gross Income (AGI), filing status and whether the owner is active in the business is much greater than set forth above.
It is fairly obvious that strictly from the standpoint of tax rates on business income, C corporation rates will generally be less than pass-through rates, and operation of a C corporation from a tax standpoint will be more straightforward. The issue with this analysis is that it does not take into account: 1. whether the corporation will be paying dividends year to year; and 2. the taxation of the business and its owners upon an exit event with respect to the business. Adding these factors to the analysis will often change the conclusion regarding which type of entity is more tax efficient.