Revisit Your Choice of Entity—Is Pass-Through Taxation Right For You?

May 16, 2014

Did you pay more tax on the income generated by your business or investments in 2013 than in years past? With the 2013 tax year in the books, we are getting our first look at the impacts of the American Taxpayer Relief Act of 2012 and the 3.8% net investment income tax enacted by the Affordable Care Act. With the filing of their 2013 returns, many taxpayers are realizing they are paying higher taxes and should now be asking the question, “Do I have the right entity for my business or investment holdings?” As you may know, C corporation entities are taxed at corporate tax rates and income earned by pass-through entities, such as limited liability companies and S corporations, is passed through to the individual owners and taxed at individual rates.

If you recall, the American Taxpayer Relief Act of 2012 was passed into law on January 1, 2013, and signed into law by President Obama on January 2 following the heated debate over taxes and the so-called “Fiscal Cliff.” Among other things, the American Taxpayer Relief Act of 2012 increased income tax rates for certain individuals, raised the top tax rate for capital gains and dividends from 15% to 20%, and reinstated phase-outs for certain deductions. Additionally, the Patient Protection and Affordable Care Act, as amended by the Health Care and Reconciliation Act of 2010, imposed the additional 3.8% tax on net investment income of individuals and trusts and estates. As a result of these changes, the top individual income tax bracket is at least 4.6% more than the top corporate income tax bracket, but that difference could be much more with limited individual deductions and the 3.8% net investment income tax.

Recognizing the disparity between applicable individual income tax and corporate tax rates, it is clear that many taxpayers need to revisit their choice of entity. Some taxpayers may pay less tax by utilizing a corporation entity rather than a pass-through entity such as a limited liability company because income will be taxed at a lower rate. Whether a taxpayer would benefit from such tax rate leveraging is an important question and, in true lawyer fashion, the answer is, “it depends.”

As you may have guessed, the “choice of entity” decision is a complicated one that not only involves a complex tax analysis but also an analysis of a variety of non-tax factors. First, before we can even start crunching the numbers (don’t worry, I won’t even mention the algebraic equation sitting on my desk right now that sets forth the formula for the number crunching), we need to have an understanding of a variety of factors. For example, what are the plans with respect to the earnings in the entity? Will the entity retain the earnings and reinvest them or will the earnings be paid out to the owners? Next, what are the long term plans for entity ownership? Will the current owner own the entity until death? If so, capital gains tax on corporate stock could be eliminated, thereby offsetting the disincentive effect of the second level of tax on distributed C-corporation earnings. Did I lose you yet?

I’ve only scratched the surface when it comes to the tax analysis of the “what entity is best?” question and there are many non-tax factors to also consider (never let the tax tail wag the economic dog). The point is, now is the time to revisit and re-ask, “What entity is best for me?” While the answer to the question “what entity is best” is not a straight forward one, it is a question that the Ruder Ware attorneys are happy to help you answer by considering all tax and non-tax issues.

Follow Amy on Twitter @AmyTaxEsq

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