by Jim Browne
The 2017 Tax Cuts and Jobs Act (TCJA) reduced the maximum U.S. federal tax income rate on corporations from 35 percent to 21 percent, and many startup business owners are now asking whether it makes sense to use a C corporation for their business. A limited liability company (LLC) classified as a partnership remains the generally preferred choice of entity, but due to the TCJA changes, the decision process has become more complicated. Because of their significant limitations, this article will not address the use of S corporations.
Taxation of LLCs
By default, an LLC is not subject to federal income tax on its taxable income. Instead, the LLC’s taxable income or loss flows through to its owners. For a startup business, this flow-through regime means that any losses incurred by the business may be deductible by the owners against other ordinary income, subject to various limitations. Given the high failure rate for startup businesses, the potential to deduct LLC operating losses against ordinary income is a material factor in favor of an LLC relative to a corporation.
If the business is successful and generates taxable income, the TCJA provides for a new deduction of 20 percent of the business income (which expires in 2026). The deduction has the effect of reducing the maximum tax rate on operating income to around 30 percent, but the deduction is subject to a complex mix of limitations based on the owner’s taxable income level, the type of business, and the level of wages and investment in fixed assets in the business. Not all businesses and their owners will qualify for the deduction.
Most entrepreneurs start a business hoping that it can be sold at a substantial gain. If the business is organized as an LLC, and, provided certain holding period requirements are met, all or a substantial portion of any such gain should generally be subject to a 20 percent maximum tax rate. Equally important is the buyer’s ability to obtain a fair market value (“stepped up”) tax basis in the LLC’s assets, a benefit that generally can’t be obtained with a business operated by a corporation.
Taxation of a C corporation
A corporation that has not elected to be an S corporation is a separately taxable entity. If it has a net operating loss, the loss does not flow through to the shareholders. Instead, the loss may be carried forward to offset up to 80 percent of the corporation’s taxable income in future years. If there is a “change in ownership” of the corporation, such loss carryforwards can be further limited. If the business is terminated at a loss, the shareholders generally recognize a capital loss.
If the business is successful, and, provided certain holding period requirements are met, the owners can sell the corporation’s stock at a maximum tax rate of 23.8 percent (20 percent capital gains tax plus 3.8 percent net investment income tax). However, the buyer does not get a stepped up basis in the corporation’s assets, and therefore the buyer is likely to discount the purchase price to account for the deferred tax on the corporation’s assets. Such a discount amounts to a hidden tax, making the tax on stock materially higher than on LLC equity.
An important exception is Section 1202 “qualified small business stock” (QSBS). Gain from the sale of QSBS held for more than five years is exempt from tax up to the greater of $10 million or 10 times the amount paid for the stock at original issuance. This exemption is subject to a number of requirements, including a requirement that the corporation be engaged in a “qualified trade or business,” which excludes most businesses involving professional services, financial services, oil and gas extraction or production, or lodging or restaurant operations. If all of the QSBS requirements can be satisfied, a corporation can have a significant tax advantage over an LLC.
A business that is initially organized as an LLC can later convert to a corporation and qualify for the benefits of QSBS (if all of the requirements are otherwise satisfied). However, the five-year holding period is measured from the conversion date, and any gain accruing with respect to the LLC equity interests prior to the conversion will be ineligible for QSBS benefits.
Tax reform significantly changed the tax treatment of LLCs and corporations after 2017, and made the overall comparison of such entities more complex. An LLC is generally still the preferred choice of entity, but there will be more circumstances in which a C corporation makes sense.
For a more in-depth analysis of this topic, including non-tax considerations associated with the choice of entity for a startup business, please search “btlaw.com Choice of Entity.”
Jim Browne is a partner at Barnes and Thornburg LLP. He can be reached at email@example.com.