Can Changing My Business Entity Improve Tax Treatment?

Christopher Axene | July 21st, 2010

The expected increase in individual income tax rates next year has some small business owners wondering if now is the time to change their entity structures. Which structure is best for your business is a complex question – and the answer is different for everyone. The following are issues to consider if you are facing this question.

What are the projected federal and state corporate and individual tax rates?

While corporate tax rates are expected to stay at their current levels, individual tax brackets will be high beginning in 2011. There will be a larger gap (at least 5 percent and perhaps as much as 10 percent when factoring in other surtax rates) between the top tax rates for a corporation versus an individual. As these tax rates increase for individuals, a flow-through entity may be less attractive to the business owner.

What is the exit strategy?

The choice of entity can impact this transition. If you are considering providing equity to key employees or selling some all or some to the employees in an ESOP plan, an S-corp will offer less flexibility because it limits allowable types of shares and number of shareholders.

What is the company’s projected profitability in five to 10 years?

If you plan to sell the company more than 10 years from now, and if you expect to experience profits, you should consider how the profits will be used. Will they be reinvested in the business, distributed to owners or to pay down debt service? And if your company expects to see losses, you must think about how quickly the business will use up its basis, and at what point prolonged losses in a flow-through entity will no longer provide economic benefits to the owners.

Is the company marketable?
If your company changes to an S-corporation to avoid double taxes on an eventual sale, the decision to change entities is based on a monumental decision – that the business is sellable, either as stock or as an asset deal. If there is no plan currently in place to sell, basing the choice of entity on a future event that may not happen for many years, or even at all, could cause the business to experience higher than necessary taxes that accumulate over several years. The need for cash flow and maximization of profits to reinvest in a growing business may be a greater priority.

What healthcare benefits does the business provide?
Owners of flow-through entities do not receive the same tax-free treatment for their health insurance benefits that C-corporations do. As a result, owners of flow-through entities face an additional tax based on the amount of health benefits that are paid to each owner.

What other issues are trump cards?
You must decide what’s most important when deciding the type of entity that works best. Factors such as liability protection, industry or regulatory requirements, the goal to “go public,” or other goals may be more important to the decision than any identified tax implications.

There are valid reasons you may wish to remain a C-corporation, or conversely consider switching to a different entity type. Assuming that you must maintain a flow-through entity to avoid double taxation can be a short-sided philosophy – especially if your business needs to retain capital to expand and grow. Work with your accounting professional to understand how the factors most important to you will impact your choice of entity decision.

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