Starting in January 2013 because of the American Taxpayer Relief Act of 2012, owners of small businesses face a question regarding using a corporation as a business entity: Should the business elect to be an S corporation, or remain as a C corporation for tax purposes? Today there are higher tax rates than in 2012 and before. This article will focus only on the higher tax rates as part of the various factors to decide whether or not to make an S corporation election. John N. Evans and Maria L. Castilla recently wrote an article on this subject and portions are included below.
The American Taxpayer Relief Act of 2012 increased the highest federal tax rate for individuals to 39.6% and provides for an additional 3.8% tax on net investment income. Prior to this legislation, the highest tax rate for both individuals and corporations was 35%. The highest corporate tax rate, however, remains 35%.
C vs S Corporation Overview. Despite a number of statutory constraints, conventional wisdom has generally favored an S corporation classification. An S corporation is a pass-through entity whose shareholders are subject to personal income tax based on the income of the corporation. A C corporation, by contrast, is taxed as a separate entity at corporate rates, and its distributions to shareholders are subject to the personal income tax. A small business corporation electing under Subchapter S may have no more than 100 shareholders, and may not have more than one class of stock. There are no similar constraints on C corporations. Nevertheless, an S corporation classification provides business owners a superior degree of flexibility and is therefore generally preferred. Specifically, by having its income flow directly to its shareholders, an S corporation is not subject to the double taxation that a C corporation may be unable to avoid.
Tax rates are not the whole story. Given that the highest federal individual tax rate is now higher than the corporate rate, it may seem like operating a business through a C corporation rather than a flow-through entity would present a preferable alternative for owners of small, growing businesses. They may reevaluate their decision to elect a classification under Subchapter S and consider such restructuring to take advantage of the lower corporate rate available to C corporations, with the intent to reduce the overall tax obligation that would otherwise burden its shareholders. Such a simplistic analysis, however, is imprudent. A number of tax considerations may still favor an S election, even in light of the generally increased personal income tax rate.
Medicare tax exclusion for material participation. The Medicare tax on net investment income applies to trade or business income resulting from a passive activity or the trading in financial instruments or commodities. As a result, the income received by a taxpayer from a trade or business in which that taxpayer materially participates is not subject to the additional 3.8% tax. This exclusion is not available to shareholders of a C corporation unless they are closely held. The exclusion is, however, available to shareholders of S corporations that materially participate in the trade or business of the entity. As a result, S corporation shareholders that are involved in the operations of the entity’s trade or business activity on a regular, continuous, and substantial basis are not subject to the additional 3.8% tax on net investment income received as a shareholder of that entity.
Double taxation disadvantage. Other than the carve out from the additional 3.8% tax for material participation by shareholders in S corporations, a major reason to consider electing S corporation status is to avoid double taxation imposed on income earned by a C corporation and distributed to shareholders. In addition, the risk of double taxation of corporate income arises in any scenario involving the sale of a business.
Conclusion. Choice-of-entity decisions are complex, and factors beyond the applicable personal or corporate income tax rates should be evaluated before determining whether to be a C corporation or elect to be an S corporation. Organizing as a C corporation is not always an advantage. Paying the higher rate on income flowing from an S corporation can still provide a more beneficial long-term tax situation.