Making the ‘Right’ Choice


You have the idea, you have the funds, and you are ready to start your very own business!  Now what?!

Whether this is the first and only time you will do this or whether you are an established entrepreneur, one of the first decisions that you must make when starting a new business is the type of entity that you will use to operate the business.  With so many different entity types to choose from, it can be quite confusing.

When making this important decision, a key element that you must consider is income taxes.  To help with your analysis, you can separate these different entity types into two categories. One category, the “tax-paying” entity type, pays income tax on its taxable income; whereas, the second category type, the “pass-through” entity, pays no income tax itself, but rather passes its income through to its owner(s), and the owner(s) pay tax on that income.  The most common tax-paying entity is the C corporation.  There are a variety of pass-through entities, but the most common are the limited liability company and the S corporation. 

So, which is better?  Or, said another way, which entity type will cost you more of your hard-earned cash?  Well, the answer to that question depends upon many different variables.  For the past ten years or so, most people simply concluded that the pass-through type entity was the better entity choice since there is only one level of tax with the pass-through entity and two layers (corporate and individual tax) with a C corporation that is making distributions.  Until December 31, 2012, the highest federal income tax rate for individuals was 35% and the Pennsylvania state income tax rate was 3.07%; whereas for taxpaying entities – like C corporations – the top federal income tax rate was 35% and the Pennsylvania state income tax rate was 9.99%.  Some have begun to question whether that conclusion is still the case, however, due to recent tax rate changes.  The right answer might require you to review and analyze a number of issues – some of which are discussed below.

Federal and State Income Tax Rates/Owner’s Income

In order to determine the amount of tax you will pay with a pass-through entity, for starters, you must know the tax rate or rates for the owner(s) of the new entity, which will depend on the amount of income that will pass through to the individual owners, since federal tax rates are graduated (i.e., they increase as taxable income rises).  You also need to know a fair amount about the entity owner’s tax situation.  All of these variables will be needed to determine how much tax the owners will pay on the income that flows through from the new entity.  In addition, you will need to know the state jurisdictions where the owners will be filing income tax returns and the applicable income tax rates in each jurisdiction.

To determine the amount of tax you will pay with a tax-paying entity, you will need to know the applicable federal and state income tax rates for the entity.  You will also need to know the amount of income that the entity will earn, since at the federal level, the entity will pay tax at graduated tax rates.

Will the Entity Distribute Earnings?

When calculating the amount of tax burden you will have with a taxpaying entity, you will have to determine whether the entity plans to make distributions of its earnings (often referred to as a dividend) to its owners and the likely amount of those distributions, since those distributions will also be taxed to the owners.  You will also need to know the tax rate that the owner will pay upon receipt of a dividend from the entity’s earnings, which may necessitate that you understand the owner’s tax situation.  

Are the Owners Subject to the Net Investment Income Tax?

Beginning on January 1, 2013, the highest tax rate for individual taxpayers was increased to 39.6%.  This increase is only applicable to individual taxpayers with incomes of more than $400,000 or joint returns of more than $450,000.  Furthermore, some individual taxpayers are now subject to the additional Medicare tax imposed by the Affordable Care Act.  The Affordable Care Act imposes an additional Medicare tax of 0.9% on wages and self-employment income in excess of $250,000 (for joint filers) and $200,000 (for single filers).  Also new this year is the 3.8% tax on net investment income (interest, dividends and capital gains) for taxpayers with income in excess of $250,000 (for joint filers) and $200,000 (for single filers).  The highest federal and Pennsylvania state corporate rates, however, remain at 35% and 9.99% respectively.  As such, where individual owners expect high taxable income, the bottom-line numbers between a tax-paying entity and the pass-through entity may now be much closer than they had been previously.  Results may vary by year depending upon whether dividends will be paid in a given year.

Long-Term Implications

Although the tax rates are an important element to the analysis, it is not as easy as simply comparing the individual and corporate tax rates; other long-term tax implications should be considered when making the entity selection choice.  For example, one should consider the taxation that will occur upon a sale or other disposition of the business.  When a C corporation sells its assets to a buyer, there will typically be a gain that is taxed at the entity level.  At the present tax rates, one would expect to pay no more than 35% in federal tax and 9.99% in Pennsylvania state tax from this gain at the corporate level.  However, it is likely that the owners of the corporation will want to have the after-tax proceeds distributed to them.  As that distribution would also be taxed at the owner level (with an individual owner), that additional tax must also be considered in the equation as well as the long-term implication of one entity form over another.

When business owners crunch the numbers and look at the long-term implications of the ownership and operation of their business, many may still conclude that the pass-through entity type will be cheaper over the long haul.  If corporate level taxes are reduced in the future, as has been advocated by some over the past few years, the math may work out differently.  However, although taxes are important, it is not the only issue that should be reviewed when making your decision as to which entity you should use to operate your business.  There are many other key areas that should be reviewed prior to making your decision. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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