Revisiting the Choice of Entity Decision for Closely Held Business

There are new factors to consider, but have our recommendations changed?

November 19, 2018
Legal Update

During the past year, numerous articles have summarized and analyzed the changes made by the Tax Cuts and Jobs Act (the "2017 Tax Act").  Both the adoption of the 21% flat corporate tax rate and the 20% qualified business income deduction have attracted attention, along with a number of other tax law changes that affect closely held businesses. Now with the benefit of the passage of time, we can shift our focus from understanding what has changed and how it works to consider whether these changes have significantly altered the choice of entity landscape.

1. Should the C corporation now be the default entity choice for the closely held business?

No – for the reasons outlined below, pass-through entities such as LLCs (taxed as partnerships) and S corporations remain the entity of choice unless a business plan fits squarely within the C Corp Business Model described below. The bottom line is that the aggregate federal income taxes paid by a closely held business and its owners if a closely held business is operated as a C corporation almost always exceed the taxes paid if the business is operated through a pass-through entity. At the end of this article, there is an appendix called "crunching the numbers" that approaches the choice of entity issue as a number-crunching exercise. Although results of exercises like these are always driving by key assumptions, the exercise does confirm that under a narrow set of circumstances referred to below as the C Corp Business Model, the C corporation proves to be the superior choice for the closely held business. But outside of those narrow set of assumptions, the pass-through entity remains the entity of choice. Although it is difficult to quantify for purposes of the exercise, a key factor that should be considered in the choice of entity analysis is how risky it is for planning purposes to assume that the assumptions underpinning the choice of the C corporation can, in fact, be achieved.   The numbers suggest that if business owners operate their business through a C corporation and ultimately fail to qualify for the best-case scenarios afforded by the C Corp Business Model, the financial results can fall well below those achieved by operating the business through an LLC.

2. Exploring the C Corp Business Model – is the C corporation a viable entity choice now that there is a 21% flat corporate tax rate?  

The 2017 Tax Act reduced the federal corporate tax rate from a graduated rate topping out at 35% to a flat 21% rate. Does this 21% tax rate change the usual recommendation that owners of closely held businesses should operate through a pass-through entity?

"Yes" in a narrow and very qualified set of circumstances. The C corporation would be the best choice for a closely held business if the business plan fits precisely within what I refer to as the C Corp Business Model.  For owners of a closely held business, the C corporation would be the correct entity choice if:

It is true that business owners will generally end up with more dollars in their pocket if they can fit within the C Corp Business Model and operate their business as a C corporation. Generally, $10 million of gain on the sale of an owner's QSBS escapes taxation under IRC § 1202. Other benefits of selling QSBS include avoiding employment taxes, avoiding the 3.8% net investment income tax, avoiding the individual alternative minimum tax, and in many states avoiding state and local income taxes.  Obviously, a very attractive tax result if it can be achieved. As discussed in detail below, while the benefits of qualifying for the C Corp Business Model are real, there are few business plans for closely held businesses that will comfortably check off each of the factors outlined above.

If the benefits outlined above aren't enough, there are additional benefits associated with operating through a C corporation, but these benefits generally won't themselves move the dial away from selecting the pass-through entity:

The 2017 Tax Act also added several international tax benefits only available to corporations, such as the 100% dividend received the deduction for 10% owned foreign corporations and a reduced effective tax rate on foreign-derived intangible income. This article does not focus on international tax considerations. But if a business will receive a meaningful volume of income from foreign sources, international tax planning should certainly be considered in the choice of entity analysis.

Looking at the assumptions underpinning the C Corp Business Model and other C corporation planning points

As mentioned above, operating a business through a C corporation results in best-case tax treatment given the 21% rate and capital gains on the sale of C corporation stock, but only if everything works out as planned.   As the discussion below illustrates, best case tax results can quickly turn into worst-case tax results if the assumptions that favor the C Corp Business Model aren't achieved:

3. Why does the LLC (taxed as a partnership) remain the entity of choice for most closely held businesses?

The main benefit of operating a business through an LLC (for purposes of this discussion, the LLC is taxed as a partnership) is that the income of the business is not subject to double taxation. The taxable income of an LLC passes through to the members who receive a Schedule K-1 and is taxed at the individual member level. In contrast, unless a C corporation shareholder can take advantage of the Section 1202 gain exclusion when the business is sold, C corporations are subject to double taxation if the goal is to get cash into the hands of owners through dividends on in connection with the sale of the corporation's assets. LLC members also benefit from a tax basis step-up when they are allocated taxable income. For example, if the LLC earns $100 in 2019 and distributes $35 to pay taxes, the members' tax basis will increase by $65. This basis increase can add up if the LLC operates over a number of years and will be very beneficial if the business is sold. C corporation shareholders do not benefit from any basis step-up because there is no pass-through of gains.

There are other benefits associated with operating a business through an LLC taxed as a partnership:

There are some negative aspects of using LLCs as the vehicle through which to operate a closely held business. But most of these problems can be mitigated through thoughtful planning.

How much does the introduction of IRC § 199A's 20% deduction affect the choice of entity equation?

The 2017 Tax Act introduced not only the 21% flat corporate tax rate but also the 20% deduction for a pass-through entities' qualified business income.

IRC § 199A added a special 20% deduction for income that falls within the category of "qualified business income" from a non-service business (professional practices, financial services firms and businesses where the principal assets of the business is the reputation or skill of employees or owners are excluded from the benefits of IRC § 199A). Qualified business income is generally ordinary income from a business (the deduction isn't available for investment-related income).   Qualified business income is reduced by reasonable compensation paid to the taxpayer for services rendered, and the deduction is lost for married couples with taxable income over $415,000 unless the business has sufficient W-2 income or depreciable assets to support the deduction. Also, if the amount of a taxpayer's taxable income is less than qualified business income, this will place a ceiling on the deduction. As the definition of a “qualified trade or business” for purposes of IRC § 199A is derived in part from IRC § 1202, taxpayers will have to weigh the benefits of IRC § 199A (available to disregarded and pass-through entities) against the benefits of IRC § 1202 (available to C corporations) as part of the choice of entity equation.

4. When is the S corporation a better choice than the LLC (taxed as a partnership)?

Both S corporations and LLCs taxed as partnerships are pass-through entities. In most cases, the LLC allows for the same potential tax benefits as the S corporation without the many potential downsides associated with the S corporation in terms of eligibility, issues with passive income, inflexibility in terms of allocations of profits and distributions of cash (no preferred equity) and no basis credit for company-level borrowing. So, is there ever a situation where the S corporation should be selected instead of the LLC?

Using an S corporation may be the correct choice where the business qualifies for the IRC § 199A 20% business income deduction. In some cases, a business will not have sufficient W-2 wages to support the deduction after the owner hits the taxable income limits. In those instances, the owner may be able to become an employee of his or her S corporation and receive a salary that is included in the W-2 wage basis for IRC § 199A purposes. An owner cannot be an employee of his or her own sole proprietorship.

Two other possible benefits of operating the business through an S corporation include the potential to engage in some employment tax planning (the owner takes a reasonable salary and takes the rest of the profits as a shareholder distribution not subject to employment taxes) and the ability to take various expense deductions as top-line expenses in reaching the S corporation's taxable income.

5. Choice of entity planning tips for single owner businesses.

Never operate a business through an unincorporated sole proprietorship unless the business is uniquely free from contractual and tort liabilities and obligations. While an LLC or corporation won't generally shield an individual from responsibility for his or her own acts and omissions (the most often example is a tort of one sort or another – the owner and manager of a company runs over a pedestrian while delivering a chest for Kentucky Furniture, LLC), the entity will often effectively shield the owner and management from contract claims against the entity, subject to withstanding a piercing the entity veil attack.

The best entity choice where there is one business owner is likely a single member LLC, unless a check-the-box election is made for the LLC to be taxed as a corporation is treated as a disregarded entity for tax purposes, with the tax items from the business usually rolling over onto the owner's Form 1040, Schedule C. The single-member LLC will work fine in most cases.

Choice of Entity Analysis – Crunching the Numbers

Key assumptions for this choice of entity planning exercise:      

1.  In the first comparison, the business nets $100,000 in taxable income per year for five years. In the second comparison, the business breaks even over the five-year period.

2.  The comparison assumes that corporate income is taxed at a 21% rate, individuals are taxed at a 37% rate, and long-term capital gains are taxed at a 20% rate. The comparison ignores the sometimes significant impact of state and local taxes, employment taxes and the 3.8% net investment income tax (don't do this in a real-world planning situation).   For the pass-through entity examples, the comparison assumes is that there would be an annual tax distribution to cover the owners' individual-level income taxes triggered by taxable income passing through on their Schedule K-1s.

3.  The comparison assumes that (i) the business issues equity (either C corporation stock or LLC interests treated as partnership interests) in exchange for the contribution of $20,000 from each of five investors, (ii) the business is operated for five years after formation, and (iii) the equity of the business or the assets of the business are then sold for $1,000,000. References to the "net" amount in the pockets of investors refer to the sales proceeds net of taxes and doesn't take into account the amount that they initially invested in the business (an aggregate of $100,000 in this example).

Obviously, some start-ups are sold before the fifth anniversary and many aren't sold for many years thereafter, and some aren't sold but instead go public, go bankrupt or are passed on to new ownership groups through arrangements that don't fit within the neat assumptions underpinning these comparisons.

The results of operating in a C corporation versus a pass-through entity where the business is held rather than sold may dramatically change the choice of entity analysis as the benefits of IRC § 1202 are only available when stock or assets are sold. The C corporation structure can be problematic to work with if the company is held instead of sold and there is pressure to distribute profits out to owners – this is difficult to accomplish in a tax-efficient way.

Pass-through entities are much more efficient vehicles for distributing earnings subject only to a single level of tax (although that tax rate will exceed the corporation's 21% rate).

4.  The comparison assumes (perhaps incorrectly in the real world) that there will be no reduction in the purchase price offered for C corporation stock, even though the buyer won't receive the benefit of an inside tax basis step-up. The reality is probably that many buyers will discount the price if it won't obtain the full benefit of writing off the purchase price over time.

5.  The comparison assumes that all of the LLC's assets qualify will qualify for capital gains treatment. In the real world, it's likely that some portion of the consideration will be taxed at ordinary income rates because of the "hot assets" rules under IRC § 751 (ordinary income treatment for depreciation recapture, the sale of cash basis receivables, etc.).

6.  In order to simplify the comparison, there are numerous tax factors that are not taken into account that could move the dial in a real-world choice of entity analysis.   For example, here are some factors that might favor use of a C corporation: (i) the $10,000 cap on itemized deduction of state and local taxes; C corporations do not have a similar limitation on its ability to deduct state and local taxes, (ii) owners of a pass-through entity are often required to file returns in multiple states where the company does business is another factor favoring C corporations, and (iii) the 3.8% net investment income tax and some state income taxes don't apply where IRC § 1202 (QSBS) treatment is applicable.

Other factors might be seen to favor the pass-through entity: (i) losses can pass through and be used at the individual level subject to certain limitations, (ii) lack of flexibility in structuring allocation of income and waterfalls, and (iii) limitations on tax-free contributions and distributions of appreciated property.

Results of First Comparison Where the Business  Has Annual Net Income of $100,000 for the Five Years of Operation

The business owners decide to operate as a C corporation. For each of the five years of operation, the C corporation pays $21,000 in taxes (21% of $100,000).

$1,000,000 NET. IRC § 1202 APPLIES AND STOCK IS SOLD. Assuming IRC § 1202 (QSBS) treatment is available to stockholders and the C corporation's stock is sold, the stockholders would have no taxes under IRC § 1202 in connection with the sale of their stock for $1,000,000. The stockholders would net $1,000,000. This is the result of fitting within the C Corp Business Model discussed above in the body of the article.

$893,950 NET.   IRC § 1202 APPLIES AND ASSETS ARE SOLD. Assuming IRC § 1202 (QSBS) treatment is available to stockholders and the C corporation's assets are sold, after five years, the C corporation's basis in its assets is $495,000 (the initial $100,000, plus $79,000 per year - $100,000 net income minus $21,000 in federal tax). The corporation would have $505,000 of gain on sale of assets for $1,000,000 and pay $106,050 in taxes at the 21% corporate rate.   There would be $893,950 left after payment of taxes for distribution to stockholders. Liquidating distributions to stockholders would be shielded from taxes under IRC § 1202, so the net amount in the stockholders' pockets would be $893,950.

$820,000 NET. NO IRC § 1202 AND C CORPORATION STOCK IS SOLD. Assuming IRC § 1202 (QSBS) treatment isn't available to stockholders and the C corporation's stock is sold: Investors have a $100,000 basis in the stock. A gain of $900,000 on the sale is taxed at the 20% capital gains rate ($180,000) for a net amount in the stockholders' pockets of $820,000.

$735,160 NET. NO IRC § 1202 AND C CORPORATION ASSETS ARE SOLD. Assuming it turns out that no IRS § 1202 (QSBS) treatment is available to stockholders and the C corporation's assets are sold, after five years, the C corporation's basis in its assets would be $495,000. The corporation would have $505,000 of gain on sale of assets for $1,000,000 and pay $106,050 in taxes at the 21% corporate rate.   There would be $893,950 left after payment of taxes for distribution to stockholders. The stockholders would have $793,950 in capital gains ($893,950 - $100,000) taxed at 20% ($158,790) for a net amount in the stockholders' pockets of $735,160.

The business owners decide to operate the business as a pass-through (LLC taxed as a partnership).

$883,000 NET. LLC ASSETS ARE SOLD. Assuming the business is operated as pass-through (LLC taxed as a partnership) and its assets are sold, the LLC members would pay aggregate taxes of $37,000 tax on the LLC's $100,000 annual income and the LLC would make an aggregate $37,000 tax distribution. The LLC's starting tax basis of $100,000 in its assets would increase each year by $63,000 and after five years, the LLC's tax basis in its assets would be $415,000.   When the assets are sold for $1,000,000, there would be $585,000 of gain passing through to the LLC's owners to be taxed at the 20% capital gains rate.   The LLC's owners would pay $117,000 (20% of $585,000) on this gain. So, the $1,000,000 in assets sales proceeds distributed to the LLC owners in liquidation would be reduced by $117,000 for a net amount in the LLC members' pockets of $883,000.

$883,000 NET. LLC INTERESTS ARE SOLD. Assuming the business is operated as pass-through (LLC taxed as a partnership) and the members sell their LLC interests, the members would have a $415,000 tax basis in their LLC interests after five years. After selling their LLC interests for $1,000,000, they would have $585,000 of gain taxed at the 20% capital gains rate. The $1,000,000 in sales proceeds is reduced by $117,000 (20% of $585,000) for a net amount in the LLC members' pockets of $883,000.

Results of First Comparison Where the Business Has Annual Net Income of Zero for the First Five Years of Operation  

$1,000,000 NET. IRC § 1202 APPLIES AND STOCK IS SOLD. Assuming IRC § 1202 (QSBS) treatment is available to stockholders and the C corporation's stock is sold, the stockholders would have no taxes under IRC § 1202 in connection with the sale of their stock for $1,000,000. The stockholders would net $1,000,000. This is the result of fitting within the C Corp Business Model discussed above.

$811,000 NET.   IRC § 1202 APPLIES AND ASSETS ARE SOLD. Assuming IRC § 1202 (QSBS) treatment is available to stockholders and the C corporation's assets are sold, after five years, the C corporation's basis in its assets is $100,000 (the initial $100,000). The corporation would have $900,000 of gain on sale of assets for $1,000,000 and pay $189,000 in taxes at the 21% corporate rate.   There would be $811,000 left after payment of taxes for distribution to stockholders. The stockholders' distribution would be shielded from taxes under IRC § 1202, so the net amount in the stockholders' pockets would be $811,000.

$820,000 NET. NO IRC § 1202 AND C CORPORATION STOCK IS SOLD. Assuming IRC § 1202 (QSBS) treatment isn't available to stockholders and the C corporation's stock is sold, investors have a $100,000 basis in the stock. A gain of $900,000 on the sale is taxed at the 20% capital gains rate ($180,000) for a net amount in the stockholders' pockets of $820,000.

$669,000 NET. NO IRC § 1202 AND C CORPORATION ASSETS ARE SOLD.   Assuming it turns out that no IRS § 1202 (QSBS) treatment is available to stockholders and the C corporation's assets are sold, after five years, the C corporation's basis in its assets would be $100,000. The corporation would have $900,000 of gain on sale of assets for $1,000,000 and pay $189,000 in taxes at the 21% corporate rate.   There would be $811,000 left after payment of taxes for distribution to stockholders. The stockholders would have $711,000 in capital gains ($811,000 - $100,000) taxed at 20% ($142,200) for a net amount in the stockholders' pockets of $669,000.

The business owners decide to operate the business as a pass-through (LLC taxed as a partnership).

$820,000 NET, LLC ASSETS ARE SOLD. Assuming the business is operated as pass-through (LLC taxed as a partnership) and its assets are sold, the LLC members would net out zero taxes for the first five years of operation and the inside and outside basis for the LLC interests and assets would remain at $100,000. When the assets are sold for $1,000,000, there would be $900,000 of gain passing through to the LLC's owners to be taxed at the 20% capital gains rate.   The LLC's owners would pay $180,000 (20% of $900,000) on this gain. So, the $1,000,000 in assets sales proceeds distributed to the LLC owners in liquidation would be reduced by $180,000 for a net amount in the LLC members' pockets of $820,000.

$820,000 NET. LLC INTERESTS ARE SOLD.   Assuming the business is operated as pass-through (LLC taxed as a partnership) and the members sell their LLC interests, the members would have a $100,000 tax basis in their LLC interests after five years. After selling their LLC interests for $1,000,000, they would have $900,000 of gain taxed at the 20% capital gains rate. The $1,000,000 in sales proceeds is reduced by $180,000 (20% of $900,000) for a net amount in the LLC members' pockets of $820,000.

Key takeaways from the comparisons:

If you can bring yourself within the C Corp Business Model and, in fact, are able to take full advantage of IRC § 1202, do it if you are willing to accept that the after-tax results of operating a C corporation that fails to qualify for IRC § 1202 treatment are substantial when compared to the results of operating the business through a pass-through entity. Obviously, there are risks associated with relying on a business plan that calls for operating the business for five years, qualifying for IRC § 1202 treatment, and finding a buyer who will pay full value for the company's stock.

Other than where the C Corp Business Model is achieved, the pass-through entity provides the best tax results. The results of operating through a C corporation that doesn't qualify for the benefits of the C Corp Business Model are either only comparable to those of the pass-through entity or, where Section 1202 doesn't apply, substantially underachieve the results of operating through the pass-through entity.

Operating as a C corporation where the stock doesn't qualify under IRC § 1202 and the buyer insists on purchasing assets opens the door for a very poor after-tax result that should be avoided.

Let's be clear that what is missing from these comparisons is actually what often happens in real life planning. The owners' plans change over time and the business isn't actually sold after five years. Instead, the business is sold after three years or after 10 years, or perhaps the business isn't sold and other succession planning options are employed. In most cases, the efficiency of using a pass-through entity to distribute income that is taxed at only one level will achieve superior results to operating as a C corporation and those results don't have the same degree of planning risk associated with chasing the C Corp Business Model.


1.  This article has been prepared for information purposes only and is not intended to provide, and should not be relied upon for, tax, legal or accounting advice. You should consult with your own tax, legal and accounting advisors before engaging in the business entity selection process. This article does not create an attorney-client relationship between you and the author or Frost Brown Todd LLC.

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