Choice Of Entity

<div class="Section1"><br /> <br /> For many pass-through business owners, the choice of entity decision may be strongly impacted by whether the business intends to distribute most of its income to the owners each year (as many small businesses do). Regardless of the form the distribution takes, the double tax structure (discussed in Q Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8581">8581</a>) that arises in the C corporation context will often result in a C corporation generating a higher effective tax rate, depending upon the business owner&rsquo;s income tax bracket.<br /> <br /> If a C corporation does not distribute most of its income, the accumulated earnings tax and personal holding company tax must be considered. Both taxes are designed to prevent a C corporation from stockpiling earnings within the corporate structure in order to avoid tax at the individual level. The 20 percent&nbsp;accumulated&nbsp;earnings&nbsp;tax applies when the corporation accumulates earnings beyond the reasonable business needs of the corporation. The 20 percent personal holding company tax can also become important for closely held corporations that derive more than 60 percent of adjusted gross income from passive investments (such as dividends, interest and rent).<br /> <p class="PA">Businesses that would most likely benefit from C corporation structure after enactment of the 2017 tax reform legislation generally include capital-intensive businesses, such as a manufacturing company that has a legitimate business reason for leaving large amounts invested within the corporation (e.g., for purchasing and maintaining equipment).</p><br /> <br /> </div><br />

<p>Beyond the pure tax aspects, small business clients should be advised that tax laws have a tendency to change even when they are characterized as permanent. If the small business converts to C corporation status, problems can result if it turns out that the conversion was ill-advised or the rules change in the future. For example, once an S corporation converts to C corporation status, it cannot convert back to an S corporation for five years.<br /> <br /> Further, if the owner does decide to convert back to an S corporation in the future, taxes on built-in gains may apply and issues surrounding accumulated earnings and profits arise.<br /> <p class="PA">Accounting issues can arise if the pass-through entity is required to change its accounting method as a result of the conversion. Under the new legislation, any accounting adjustments under IRC Section 481(a) that are required because of the conversion of an &ldquo;eligible terminated S corporation&rdquo; (such as changing from the cash to accrual method of accounting) must be taken into account ratably during the six tax years beginning with the year of the change. Eligible terminated S corporations are basically S corporations that convert within two years of the passage of the tax legislation, where the ownership structure remains the same. See <em>2023 Tax Facts on Individual and Small Business</em>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9045">9045</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a more in-depth discussion of small business accounting issues post-reform.</p></p><br />

<div class="Section1"><br /> <br /> Sole proprietors and S corporations with only a single shareholder may wish to examine their choice of entity decisions to more fully take advantage of the Section 199A deduction for QBI. Generally, reasonable compensation paid by an S corporation to its shareholder is included in the W-2 wage limit and excluded from QBI.<a href="#_ftn1" name="_ftnref1">¹</a> A sole proprietor is not subject to similar requirements (the Section 199A proposed regulations clarified that the reasonable compensation rule applies only in the S corporation context).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the business’ income for the year exceeds the relevant threshold levels, these rules would maximize the QBI deduction if the business was organized as an S corporation. If income fell below the relevant thresholds, the sole proprietor would obtain the larger QBI deduction, as illustrated in the examples below.<br /> <blockquote><em>Example 1</em>: A sole proprietorship and S corporation with one shareholder each generate $500,000 in QBI for the year, and neither business has any qualified property. The S corporation shareholder pays himself reasonable compensation for the year of $100,000. The sole proprietor is not required to pay himself a wage. Both businesses are subject to the W-2 and UBIA limitations because their income exceeds the relevant threshold levels. The S corporation’s QBI deduction for the year is limited based on the statute’s W-2 limitation, so is limited to $50,000 (50 percent of W-2 wages, i.e., the shareholder’s reasonable compensation). The sole proprietor’s QBI deduction (also phased out) is zero, because wages and UBIA both equaled zero.<br /> <br /> <em>Example 2:</em> If each business described in the example above instead earned $100,000 (i.e., below the income thresholds), the W-2 wage and UBIA limitations would not apply. Assume the S corporation shareholder paid himself $40,000 in reasonable compensation for the year. The sole proprietor’s QBI deduction is $20,000 (simply 20 percent of $100,000). The S corporation shareholder must reduce his QBI for the year by the amount of reasonable compensation ($40,000) before calculating the deduction. Thus, his QBI deduction for the year is only $12,000.</blockquote><br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.  IRC § 199A(c)(4)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.  Prop. Treas. Reg. § 1.199A-3(b)(2)(ii)(H).<br /> <br /> </div>