The TCJA is still impacting business decisions startup companies are making, with many considering the benefits and consequences of converting their business entity type to achieve more beneficial tax positions. As the first filing season under tax reform is well underway, we will revisit the tax pros and cons of C Corporations (C Corp) vs limited liability companies (“LLC”) taxed as partnerships.
Historically, C Corporations have been the preferred entity type for startup companies for a variety of reasons, most notably the small business stock exception and the fact that C corp do not pass through the income or loss to the individual investors. Moreover, companies also prefer the lesser complexity in issuing stock options to employees in the C corporation space. However, some companies have preferred LLC if they are closely held businesses with minimal future plans to raise outside funding or if they are looking to take advantage of early stage losses.
The federal C corporate tax rate was reduced from 35% to 21%. However, C corporation are still subject to double taxation, which means that income is taxed at the corporate entity level when it is earned and then taxed again when the earnings are distributed to its owners. This would not be favorable for owners looking to frequently distribute money out of the business. Moreover, C corporations looking to retain their earnings in order to defer taxation will have to compete with the accumulated earnings tax, an additional tax which could be imposed on these accumulated earnings. It should also be noted that at the eventual sale of the company, if the deal is structured as an asset sale, the corporation will recognize a gain and pay tax at a 21% corporate tax rate. The shareholders, in turn, would also pay tax on the distribution of any remaining sale proceeds.
A major advantage of investors in startup companies which are taxed as C corporations is the Qualified Small Business Stock exception. A shareholder may be eligible to exclude up to $10 million of the gain recognized on the sale or exchange of qualified small business stock that is held for more than five years. The stock must be issued by a domestic C corporation, and therefore precludes investors in LLC from claiming this benefit.
Unlike C corporations, LLC do not have an entity level federal income tax. Accordingly, any income or losses are passed through to the members and included on their personal tax returns and taxed at the member’s personal income tax rate. Currently, the highest federal tax rate is 37%. It is noted that many restrictions apply which limit the amount of losses a member can deduct in any given year. Generally, a member cannot deduct losses in excess of the contributions or loans made to the LLC.
A new provision of the TCJA is Section 199A permits a member to deduct of up 20% of qualified business income (QBI). There are various limitations to QBI including the type of business that the LLC operates as well as taxable income limits. For example, a startup company that provides consulting services may be classified as a Specified Service Trade or Business (SSTB) and may not be eligible for the 20% deduction, depending on certain facts and circumstances.
In summary, if QBI is applicable, the federal tax rate for LLC pass through income would be approximately 29.6%. This is in contrast to the 21% corporate tax rate. However, as mentioned above, there is generally an additional 23.8% rate on distributions to shareholders. As a result, once distributions are made, as a result of double taxation, the C corporation rate is less favorable.
While a single level of taxation is generally favorable for LLC members, it should be noted the members maybe subject to self-employment taxes on the income which is passed through in addition to their personal income taxes.
State taxes are complex and depending on where the shareholders or LLC members reside, can result in different answers. Therefore, careful planning should be considered for entity structure depending on the resident state of the owners. One of the most significant tax law changes was limitation of the state and local itemized tax deduction to $10,000 for individuals. On the other hand, the ability to deduct state taxes remains intact for C corporations, which is a significant advantage for C corporations.
In terms of entity level taxes, generally C corporations are taxed at the entity level in states where they are considered doing business. For example, the New York State Tax rate is currently 6.5% with an additional surcharge in the Metro area. In addition, the New York City tax rate is 8.85%. Therefore, a C corporation doing business in New York City could have a state rate tax rate of 17%. In New Jersey, C corporations are taxed at a 9% rate (there could be a surcharge based upon income).
On the contrary, LLC are generally not subject to entity level taxes. However, various local jurisdictions including New York City impose an entity level tax on LLC known as the Unincorporated Business Tax (“UBT”). Currently, the UBT LLC tax rate is 4%, which is about half of the C corporation New York City tax rate.
The TCJA amended Section 163(j) to disallow deduction of business interest expense of any taxpayer in excess of 30% of the company’s adjusted taxable income. For corporations, this limitation only applies a single corporation or group of controlled corporations whose 3-year average gross receipts exceeds $25 million. The gross receipts test also applies to members of LLC.
The TCJA has also imposed a limitation for C corporations to deduct net operating losses up to 80% of taxable income for losses incurred after December 31, 2017. Furthermore, losses incurred 2018 or later maintain an unlimited carryforward period and cannot be carried back.
A substantial differentiator between C corporations and LLC are the excess business loss limitations. This limitation is only imposed on individual taxpayers. This new provision limits the available deduction attributable to all trades or businesses to be $500,000 if married filing jointly and $250,000 if filing single. Excess business losses that are disallowed are treated as net operating losses in subsequent tax years.
The TCJA enacted substantial changes to the International tax regime, most of which are beneficial to corporations. These changes include Global-Low-Taxed Intangible Income (GILTI) and Foreign Derived Intangible Income (FDII).
GILTI was imposed to establish a minimum tax on income with characteristics of highly mobile income which could avoid tax, such as patent income. This has a broad impact on startups because many companies need to decide where to hold the rights to valuable intangibles while the value is low. There are many advantages to being a corporation with respect to GILTI, in that it is taxed at a 10% tax rate with an 80% foreign tax credit offset available. Unfortunately, GILTI is taxed at the individual owner level is at the highest ordinary rate with no foreign tax credit available. There are several structuring options for individual taxpayers to pursue such as making an election for the individual to be taxed as a corporation. However, there are many different aspects for a taxpayer to consider before making this election.
FDII is a preferred category of income that is taxed at only a 13.125% tax rate, which is only available to corporations. Income derived from abroad on sale of goods, royalties, services, etc. is eligible for this substantially reduced tax rate. This serves as a huge benefit to US corporations with a large amount of export sales.
It is important to note that all of the federal corporate tax changes mentioned above are permanent while the federal individual changes are temporary in nature for now. It is clear there are many factors to consider for any business that is considering a change in entity-type or a new business that is looking to choose what suits their needs. For more information about what entity type might be right for you and your business please fill out the below form to contact a Withum advisor.