Making the ‘Right’ Choice

by McNees Wallace & Nurick LLC
Contact

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.

© McNees Wallace & Nurick LLC | Attorney Advertising

Written by:

McNees Wallace & Nurick LLC
Contact
more
less

McNees Wallace & Nurick LLC on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.