Making the Right Entity Choice in Today’s Tax Environment

From a tax perspective, pass-through structures — such as limited liability companies (LLCs), S corporations and partnerships — have been the preferred business entity choice in recent years.  But increases in individual income tax rates have made the decision a closer call.

Is it time to convert your business into a C corporation?  For most companies, the answer probably is “no” or “not yet.”  But it is a good idea to evaluate the impact of higher individual rates on your tax-planning strategies.  And if lawmakers reduce the federal corporate tax rate, C corporations may become more attractive.

Higher Taxes on Individuals

This year, several tax law changes take effect that increase tax rates for individuals — and thus for owners of pass-through entities:

• The top marginal income tax rate increased from 35% to 39.6% for single filers with taxable income exceeding $400,000 ($450,000 for joint filers).
• The top tax rate for long-term capital gains and qualified dividends increased from 15% to 20% for taxpayers in the 39.6% bracket.
• An additional 0.9% Medicare tax now applies to FICA wages and self-employment income in excess of $200,000 ($250,000 for joint filers).
• A new 3.8% Medicare tax applies to net investment income  — including dividends, net capital gains and passive business investments — to the extent a taxpayer’s modified adjusted gross income exceeds $200,000 ($250,000 for joint filers).

There are also several “stealth taxes,” such as itemized deduction reductions and personal exemption phase-outs for higher-income taxpayers, that may increase your effective income tax rate.

C Corporation vs. Pass-Through

Owners of pass-through entities are taxed at individual income tax rates on their share of the company’s current income, whether it is distributed or not.  Now, for the first time in many years, the top individual tax rate is higher than the top corporate rate of 35%.  At first blush, this may seem to give C corporations an advantage.  But keep in mind that C corporations that distribute their earnings to shareholders or sell their assets are subject to double taxation.

Corporate income or sale proceeds are taxed twice:  Once when they are received by the corporation, potentially at a top marginal rate of 35%, and again when they are distributed to shareholders in the form of dividends, at a rate potentially as high as 23.8% (the 20% capital gains rate plus the aforementioned 3.8% net investment income tax (NIIT), which applies to C corporation dividends).  This means that the maximum combined corporate and individual tax rate on corporate earnings is 50.47%.

For instance, on $100,000 of income taxed at the highest rate, the C corporation would pay $35,000, leaving $65,000 to be distributed as dividends to the individual.  Presuming that this $65,000 is taxed at the highest rate of 23.8%, the tax would be $15,470, for a total combined tax of $50,470 or 50.47%.  This example excludes the impact of state income tax.

So, for now, double taxation continues to place most C corporations at a disadvantage — at least in terms of tax efficiency — in comparison to pass-through entities.  This may change, however, if Congress reduces the corporate tax rate.  For example, if the top corporate rate drops to 25%, as some members of Congress have proposed, the maximum combined corporate and individual tax rate would be 42.85%.

Review Your Entity Choice

Choosing the right entity type requires a multilayer analysis involving a variety of business, financial, liability and tax considerations. Make sure you review your entity choice periodically to make sure it is still a good fit in light of changing business circumstances and evolving tax laws.

Sidebar: The S Corporation Advantage

In the current tax climate, S corporations may have some unique advantages, particularly for shareholders who are active in their businesses.  Shareholder-employees of S corporations are subject to payroll taxes on their wages, but so long as their compensation is reasonable, they are not subject to self-employment taxes (Social Security and Medicare) on their share of the corporation’s income or on any distributions they receive.

At the same time, S corporation shareholders who “materially participate” in the business avoid the 3.8% Medicare tax on net investment income on their nonwage income (subject to certain limitations discussed below).  This means that S corporations that minimize wages paid to shareholder-employees and maximize nonwage income (while ensuring that salaries are not unreasonably low) can minimize payroll taxes while avoiding both this net investment income tax (NIIT) and self-employment taxes on nonwage income.

Caution — even if you are actively involved in the business, the NIIT would — absent special circumstances — apply to S corporation earnings in the form of investment income such as interest, dividends and capital gains.

The AMT:  Treacherous Waters are Waiting to Trap You

For years, like a worn-out record, Congress repeatedly went through the motions of temporarily patching the alternative minimum tax, with the goal of limiting the number of taxpayers who were liable to pay it.  Fortunately, a law signed at the beginning of 2013 made the AMT patch permanent.  But even with the patch, many taxpayers will fall into the AMT “trap.”

What Triggers the AMT?

The AMT is a separate tax system with its own set of rules.  You must calculate your tax under both the regular and AMT methods and then pay the higher amount.  Certain deductions, credits, exclusions and other benefits that are allowed to reduce your regular income tax are not allowed for the AMT.  The AMT calculation starts with regular taxable income and then adds back those disallowed items.

Some of the most common AMT triggers include:

• State and local income tax deductions (especially if you live in a high-income-tax state);
• Long-term capital gains and dividend income;
• Real estate and personal property tax deductions;
• Accelerated depreciation adjustments and related gain or loss differences when assets are sold;
• Large amounts of miscellaneous itemized deductions; and
• Tax-exempt interest on certain private-activity municipal bonds.

In certain situations, exercising incentive stock options (ISOs) can also trigger significant AMT liability.

What is the AMT Patch?

The AMT patch is an exemption that reduces the amount of AMT income that is subject to the AMT.  The new tax law sets higher exemptions permanently.  It also calls for annual inflation adjustments to both the exemptions and the AMT brackets.  The exemption amount varies according to your filing status.  For 2013, it is $51,900 for single filers and heads of household and $80,800 for joint filers.

How Does the AMT Credit Work?

In limited situations you may get some relief in the form of the AMT credit.  By paying the AMT in one year on deferral items, such as depreciation adjustments, passive activity adjustments or the tax preference on ISO exercises, you may be entitled to a credit in a subsequent year.  In effect, this takes into account timing differences that reverse in later years.  But the credit might provide only partial relief or take years before it can be fully used.  Fortunately, the credit’s refundable feature can reduce the time it takes to recoup AMT paid.

To take advantage of the credit, plan for the AMT when anticipating significant transactions, such as the selling off assets or exercising ISOs, as well as in your year-end tax planning.

How Should You Plan Going Forward?

Knowing where you stand AMT-wise may allow you to adjust your income and deductions to minimize the tax.  For example, if it looks like you will be subject to the AMT this year, consider postponing until next year payment of deductible expenses that are not allowed for AMT purposes and recognizing additional income this year to take advantage of the AMT’s lower maximum rate (28% vs. 39.6%).

Or, if you do not expect to be subject to the AMT this year or next, consider accelerating deductible expenses.  This will defer tax, which is usually beneficial.  But if you expect to be in a higher tax bracket next year, the opposite approach may be beneficial.

Work with a Pro

Even with the higher exemption amounts now permanent, it is still critical that you be aware of the AMT’s tax impact. Consult your tax advisor. He or she can help you navigate the treacherous waters of the AMT.

If you have questions concerning the AMT and how it may apply to your situation, please contact Rob Swenson at [email protected] or call him at 312.670.7444.