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How EY can help
The three primary business entities each have their own tax implications that affect a family enterprise’s financial health.
- C corporations: These used to be viewed as the least favorable option due to the double taxation they incurred — once at the corporate level and again when dividends were distributed to shareholders. Before the Tax Cuts and Jobs Act (TCJA) of 2017, the corporate tax rate was as high as 35%, making the effective tax rate for C corporations nearly 50% when accounting for individual dividend taxes. However, the TCJA reduced the corporate tax rate to 21%, making C corporations more attractive, especially for businesses that plan to retain earnings rather than distribute them.
- S corporations and limited liability companies (LLCs): These are both considered pass-through entities, meaning they avoid double taxation. Income is taxed only at the individual level, which can be advantageous for owners looking to reduce their tax obligation. However, family enterprises must be aware of the distinctions between S corporations and LLCs. For instance, S corporations have strict eligibility requirements, including limitations on the number of shareholders and the types of entities that can hold shares. This rigidity can be a disadvantage compared with the more flexible structure of LLCs.
Nitti and Martin shared five key considerations to help family enterprises choose between the three entities.
- Tax rates and deductions: The TCJA introduced Section 199A, allowing pass-through entities to deduct up to 20% of their income, effectively lowering the top tax rate for many owners. However, not all businesses qualify for this deduction, particularly service-oriented enterprises, including law firms and consulting agencies.
- Distribution of earnings: One of the most significant differences between C corporations and pass-through entities is how distributions are taxed. In a C corporation, any distribution is subject to double taxation, while distributions from S corporations and LLCs are generally tax free depending on the owner’s basis in the entity.
- Loss utilization: C corporations can carry forward losses but are limited to offsetting only 80% of future income. In contrast, pass-through entities allow losses to be passed on to owners. However, S corporations and LLCs have different rules for how much of the loss owners can use on their personal tax returns.
- Flexibility in ownership and structure: LLCs offer greater flexibility in ownership structures and profit-sharing arrangements compared with S corporations, which must adhere to strict rules regarding stock classes and ownership types.
- Exit strategies: C corporations benefit from Section 1202, which allows for the exclusion of up to 100% of capital gains on the sale of qualified small business stock held for more than five years. This is a significant advantage that can make C corporations appealing for long-term planning.
Nitti and Martin stressed the importance of considering the entire lifecycle of the business when making entity choices. For example, transferring appreciated property into a C corporation can trigger tax liabilities, while doing so in an LLC may not.
As tax laws continue to evolve, family business owners must remain vigilant about the implications for tax strategy, financial health and long-term planning. By carefully evaluating the five key factors, they can make informed decisions about which entity structure best aligns with their business goals and circumstances.