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Choice of entity is one of the first and most important tax-planning decisions that any entrepreneur must make. Conventional wisdom holds that most entrepreneurs should organize their businesses as “pass-through” entities – primarily limited liability companies, partnerships, subchapter S corporations, or sole proprietorships. Pass-through entities are not themselves taxable. Rather, all of their income is “passed through” and taxable to their owners. By contrast, operating a business in the other main form – a corporation – subjects the business’s income to the dreaded “double tax” because the corporation itself is subject to tax, and then the shareholder is subject to tax when he receives dividends from the corporation or sells its stock at a gain.
Historically, the expense associated with the double tax has varied, depending on the prevailing tax rates, but it almost always exceeded the tax expense on pass-through income. At this unique time, however, entrepreneurs following the conventional wisdom may be missing a valuable tax-planning opportunity: two features of the American Taxpayer Relief Act of 2012 make corporations much more attractive compared to pass-through entities.
First, corporations now pay less tax than many individuals do on income allocated from pass-through entities. The Act increased the highest tax rate on ordinary income taxable to individuals from 35% to 39.6%. However, corporations remain subject to a maximum 35% income tax rate.
Second, entrepreneurs may be able to eliminate the double tax on corporate income. The Act extended a narrow income tax exclusion on the sale of “qualified small business” (QSB) stock issued by a corporation. If an entrepreneur’s stock qualifies for the exclusion, then the entrepreneur’s gain is not subject to income tax. The exclusion is subject to a number of conditions, but it’s broadly available. To qualify for the exclusion, the following conditions must be satisfied:
- The stock must be issued before 2014 – which means the entrepreneur must incorporate his or her business this year;
- The entrepreneur must hold the stock for five years;
- The corporation itself must operate an active business; and
- The corporation must have less than $50 million in assets.
Stock of corporations engaged in business in a narrow set of industries do not qualify. For instance, businesses that primarily trade on the reputation of an employee (e.g., law firms and doctors) do not qualify, nor do banks, insurers, farms, mines, hotels, or restaurants. Just about all other businesses qualify.
Taken together, these two changes weigh heavily in favor of organizing a business as a corporation. And, while nobody can predict future tax changes, momentum has been building for several years to lower the corporate tax rate – perhaps all the way down to 25%. If that happens, businesses that incorporated in 2013 will retain a permanent tax advantage over those that missed the opportunity.