Effective January 1, 2013, the American Taxpayer Relief Act of 2012 (“ATRA”) was enacted into law, finally settling years of debate over the fate of the Bush era tax cuts. On the same day, the 3.8% Medicare Tax on net investment income that was part of 2010’s Health Care Act went into effect. These two developments have changed some of the fundamental assumptions made over the last decade concerning how to structure ownership of business interests from a tax perspective. During that time period, the top individual and corporate federal income tax rates were equal, with both being set at 35%. Although qualified dividends were accorded a preferential 15% tax rate, a C corporation was generally the least tax-efficient form of doing business. A C corporation’s net income was subject to tax at a maximum rate of 35% at the corporate level, and then after-tax net income that was distributed to shareholders was subject to tax at the 15% rate imposed on dividends. In contrast, “pass through” forms of doing business, such as S corporations, partnerships and limited liability companies (“LLCs”)taxed as partnerships or disregarded entities were (and still are) subject to only one level of tax. The net income of such entities was taxed directly to their individual owners, at the same maximum rate of 35%. Distributions from such entities, however, were (and still are) not subject to tax, thus avoiding the second level of tax imposed on dividends from C corporations. Even if a business contemplated reinvesting profits back into the business rather than distributing profits to the business’ owners, using a pass-through entity would leave the business in no worse shape from a tax standpoint because profits were subject to the same top 35% tax rate whether they were taxed directly to the owners or at the corporate level.

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