Many accountants and tax professionals wonder if they could save their clients big money simply by helping them make a business entity switch. The short answer is, yes, you can — in the right circumstances. An entity selection can generally be made at any time it is deemed beneficial, but the three milestones that are typical triggers are the establishment of a business, a change in ownership structure or when circumstances change.
Let’s look at when it could be beneficial to switch, particularly with regard to tax savings, outside of milestone moments.
Reasons to make an entity change
Making an entity change is something that should be considered not only for tax savings but also when there are other factors in play. Some of these factors can include having a partnership structure in place where there is unequal distribution to owners, if there is a desire to eventually go public or if the owner plans to exit or retire from the business and wants to transfer the wealth to children.
That said, lowering taxes is the main driver behind an entity switch most of the time. With higher taxes on the horizon with both President Biden’s and the House Ways and Means Committee’s proposals, now is the time to get prepared to help your clients. Some “lowlights” of the new tax proposals include:
- Increased corporate tax rate;
- Increased individual top rate;
- Increased capital gains tax rate;
- New Social Security tax on income above $400K;
- Expanded coverage of the net investment income tax (NIIT); and,
- Phase-outs/caps on deductions (including QBID) for high-income taxpayers.
These higher tax rates will give you the opportunity to potentially save a business money by switching its entity type. For clients with a business that is not netting over $400K, the changes probably won’t be a big factor in the decision. But for businesses with significant net profits, the changes may shift the balance toward corporate entities in order to better manage the timing and effect of higher tax bills. In addition, taxpayers with low liquidity needs may find that highly profitable businesses would be better off shifting to C corporation status.
As an example, let’s look at a $1.3M business case study. Your clients are married, filing jointly, with a Schedule C business that has a payroll of $475K. They need only $150K cash to maintain their standard of living and would have to pay themselves a wage of $70K if they were an S corporation.
An entity switch from a Schedule C to a C corporation would generate big savings for them. And those only get bigger with the possible changes that are out there. Of course, that doesn’t mean all your Schedule C clients will be better off making this change – it’s effective only on a case-by-case basis.
For example, if your business owners needed $750K cash to maintain their lifestyle rather than $150K, the C corporation ceases to be viable under current law because the tax on the large dividend and loss of the QBID would offset any savings from the lower corporate tax rate.
Under the Biden plan, however, the C corporation would remain an option. In part, that is due to the large increase in tax that would be incurred if the business remains a Schedule C. But it is also the result of the corporation keeping the taxpayers from triggering the higher capital gain rate at the individual level (which would kick in at $1M) and shielding the $550K not needed under a lower rate, even with the increased corporate rate.
A similar scenario — or one with an even larger difference in tax — would exist under the Ways and Means plan. The C corporation would shield the original income from the 39.6% individual rate, as well as the NIIT that would be imposed on the business income. Plus, the dividend payment would be subject to only a 25% tax (contrasted with a 39.6% rate included in the Biden plan).
Pros and cons of each entity type
Each entity type comes with various positives and negatives. Here is a quick summary of what to keep in mind for your clients, starting with the positives of each entity type.
Potential positives of sole proprietorships and single-member LLCs:
- Ability to deduct eligible business-related expenses directly;
- Simple organizational structure; and,
- Does not require an additional tax return to be filed.
Potential positives of partnerships:
- Greater access to capital;
- Ability to share tasks and responsibilities across partners; and,
- Greater flexibility in operational allocations.
Potential positives of S corporations:
- Additional liability protection on the company; and,
- Reduced self-employment tax.
Potential positives of C corporations:
- Additional liability protection on the company;
- Eligibility for a lower tax rate; and,
- Ability to defer dividends (and taxes on those dividends) to future years.
These are the most likely reasons your clients might want to switch from one entity to another. But remember, it’s not just about the positives. There are negatives of each as well. Below is a quick summary of negatives to keep in mind.
Possible negatives of sole proprietorships and single-member LLCs:
- All earnings are subject to self-employment tax and individual income tax; and,
- There’s unlimited liability if the business is not covered by an LLC.
Possible negatives of partnerships:
- There is potentially unlimited liability, with each partner liable for all of the partnership debts, including those attributable to other partners; and,
- General partners are subject to income and self-employment tax on net profit.
Possible negatives of S corporations:
- Payroll is required on an ongoing basis after the S corporation election has been accepted by the IRS, including employment tax filings; and,
- It is recommended to launch a reasonable compensation analysis to back up the calculation of owner compensation.
Possible negatives of C corporations:
- Shareholders are subject to double taxation on the dividends.
The Added Complexities of the Decision: Consequences and Collateral Effects
There are further complexities to consider beyond just the basic positives and negatives of each entity. This is because each decision you make carries further consequences and has collateral effects. Take, for example, determining which type of corporation is best suited to an entity’s needs:
- S corporations that converted from C status are subject to an entity-level tax on any unrealized built-in gains that existed at the time of conversion if any of the assets are sold in the five-year period after conversion.
- A C corporation that is electing S status must include in its final C corporation tax year built-in gain attributable to LIFO inventory.
- An S corporation that was previously a C corporation will have to account for earnings and profits accumulated while a C corporation. Shareholders of the S corporation will have to treat distributions as taxable dividends if the S corporation’s distributions exceed amounts taxed to shareholders but not distributed until the accumulated E&P is entirely distributed.
- Conversely, an S corporation that revokes its election and becomes a C corporation will have a period of at least one year after the conversion in which to distribute tax-free those amounts previously taxed but undistributed at the time of conversion.
All in all, choosing an entity type is a huge decision no matter where your client is in the process. Your job is to walk through the options and consider what’s most important to the individual situation. With big tax changes on the horizon, now is the time to begin thinking about switching entities.
