C corporations have been replaced by “flow-through entities,” which include partnerships and S corporations. Limited liability companies (LLCs) are taxed like partnerships if they have at least two owners.
Recent tax-filing data suggest that five of six business entities are flow-through entities. They are called flow-through because the entity itself does not pay tax, but instead allows its income to flow through to its owners.
In contrast, income from C corporations may be taxed twice – once at the corporate level and again when distributed to the owners. And since the top individual rate is about the same as the top corporate rate, two levels of tax means double the tax.
When one compares the option of one level of tax (partnerships and S corporations) to two levels of tax (C corporations), it is not difficult to understand why C corporations have become less popular.
But why were C corporations once the favored entity type? Before the Kennedy tax cuts, the top tax rate for individuals was 91 percent and the top rate for corporations was 52 percent. With individual tax rates almost double the top corporate rate, it wasn’t crazy to place business income within a corporation rather than directly on the individual owner’s return.
Current law tax rates of 39.6 percent for individuals and 35 percent for corporations are historically low. And more important, the rates are roughly the same for corporate and individual income.
In old law, the second level of tax could be deferred until dividends were paid, but could also be avoided if the corporation sold its assets and distributed proceeds in liquidation.
A corporate asset sale and liquidation could have only one level of tax under old law. Changes made in 1986 make current law quite different. Over the life of the C corporation, it became impossible to avoid two levels of tax.
Things may now be changing. The new tax law proposals would limit the top corporate rate to 20 percent, well below the current 35 percent. The top individual rate may stay at 39.6 percent.
Those changes, if enacted, would return us to a world in which individual rates are double the top corporate rate. In such a world, double taxation may not be such a bad thing.
But a few other things also may influence the choice of the corporate form. First, to somewhat offset the cost of double taxation, the law was changed to limit the tax rate on dividends to 20 percent. There is no proposal to change this.
Second, a preferential tax rate was created for gains from the sale of C corporation stock held for more than five years. To qualify, the stock must be held by an individual who is the original owner. Finally, the corporation cannot have more than $50 million of assets.
In 2010, the law was sweetened to make the individual’s tax rate zero on gains from qualified small C corporations. This means that the second level of tax in C corporations may be avoided entirely.
If corporate income is taxed at a rate that is one-half the individual tax rate, and the individual shareholder of a C corporation can avoid a second level of tax when the stock is sold, C corporations may return from the dead.
Confounding the decision process are discussions to create a favorable tax rate for business income of flow-through entities. A 25 percent rate has been proposed, but it is difficult to define “business” income of flow-through entities.
Kansas tried to tax flow-through business income in a favored way, but the difficulty of defining business income led to a raid on the state Treasury.
Federal tax policy experts know this problem well and are struggling with how to tax flow-through business income. The end result may be a preferential rate for regular corporations not matched by flow-through entities.
If tax advisers recognize the signs, the current tax-change proposals might significantly change the calculus of business entity choice in the coming years.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.