For established contractors, entity selection is a long-gone concern. Business owners focus instead on operational strategy and tax optimization within the confines of their chosen entity type. But in light of the ever-changing tax environment, it may be worth your while to take another look at your entity selection. Is your choice of entity serving you now? And will it serve your future goals?
Entity Choice Affects You Now
Whether you realize it or not, your choice of entity is important to your daily activities. Your entity type will dictate your accounting and tax methods in many ways, some of them major.
Unlike all other business forms, C corporations are subject to double taxation. Their revenues first get taxed at the corporate level, then again at the individual level when those revenues get distributed as dividends.
Net operating losses
As a contractor, your net operating losses (NOLs) most likely play an important role in your tax planning strategy; losses in one year can help offset tax bills when business is booming again. NOLs for C corporations are now limited thanks to new rules passed by the Tax Cuts and Jobs Act (TCJA). For losses generated after December 31, 2017, the carryback provision has been eliminated and now C corporations can use only 80% of those losses to offset taxable income. On the bright side, the loss now carries forward indefinitely. For entities other than C corporations, losses are limited to $250,000 (or $500,000 for joint returns) and offset only 80% of taxable income. But again, unused portions can be carried forward indefinitely.
Alternative minimum tax
Not all tax laws are prejudiced against C corporations; the alternative minimum tax (AMT) for C corporations was abolished with the TCJA. Individuals reporting pass-through income from their S corporations or partnerships must still consider AMT.
Shareholders of C corporations and S corporations are often W-2 employees of the corporation. Both these structures are able to deduct the employer’s portion of self-employment taxes, effectively reducing net income. For S corporation shareholders, any pass-through income is not subject to self-employment tax. This is not the case for partnerships and sole proprietors. Instead, net income passed through to participating owners is subject to the full 15.3% self-employment tax (the sum of the employer’s and the employee’s portions), up to the applicable Federal Insurance Contributions Act (FICA) limit.
Whereas C corporations have almost no owner restrictions, S corporations are limited to 100 shareholders, and their owners must be domestic individuals, estates, or certain tax-exempt entities. If S corporations invite foreign taxpayers, other corporations, or partnerships to be owners, they will lose their subchapter S election.
Some states (like South Dakota and Wyoming) do not levy a tax on corporate income or gross receipts. Other states (like Texas, Florida, and Nevada) do not levy a tax on individual income, meaning flow-through income is tax-free. If you reside in one of these states, entity choice can help (or hurt) your tax bill and therefore your bottom line.
Each type of entity has different rules regarding how it can allocate business income, deductions, gains, and losses (also known as tax attributes). C corporations do not allocate tax attributes to their owners at all, but rather reward them with dividends when business is good. S corporations allocate in ratios proportional to each owner’s investment. Partnerships have the most freedom; they can allocate each attribute differently in whatever manner they choose if that latitude is written into the partnership agreement.
Until recently, the cash method of accounting was unavailable to most C corporations. The TCJA removed that limitation, and now any entity whose gross receipts are below $25 million annually is eligible for the cash method of accounting.
Entity Choice Affects You in the Future
Entity choice becomes especially important when planning for the future. When you first opened your doors, you may not have considered what your exit from the industry would look like. But exit strategies are just as important as operational strategies, and entity choice should be the cornerstone of your succession plan.
Although this will not be universally true, contractors may benefit from changing their entity type when they are ready to exit the industry. Switching from a C to an S corporation, for example, can allow them to sell their assets with less of a tax burden and make the offer more appealing to buyers. Under an S election, sellers will not have to worry about the double taxation inherent to C corporations.
Additionally, eligible buyers and sellers have the option to make a Section 338(h)(10) election, which prevents the transaction from being taxed twice. A Section 338(h)(10) election effectively treats a stock purchase like an asset purchase and taxes the transaction only once: on the deemed asset sale. Both buyer and seller must make the election. This can benefit contractors with significant fixed assets (machinery and equipment). There are specific eligibility requirements for this election, so be sure to discuss this with your tax advisor.
Switching from a C to an S corporation will also come with some drawbacks. The most onerous is the built-in gains tax, which is a tax on assets that were formerly owned by a C corporation. Owed upon the sale of the asset, the built-in gains tax can be administratively burdensome at best and can create a large tax bill at worst. Work with your CPA to see if the tax savings of switching to an S corporation would outweigh the costs of the built-in gains tax.
Long-Term Goals for the Business
How closely held do you want your business to be? Getting a firm grasp on your goals will tell you if your entity selection is currently serving your needs. If you want the freedom to accept new investors or accept equity funding from other corporate businesses, a C corporation may be your best bet. But if you want to remain small and have a say in how the business progresses, an S corporation may be easier to handle.
As economists hint at an upcoming recession, it’s important — no matter your entity — that you keep a close eye on your cash flow and working capital. While entity choice is important, any business can thrive if it is well managed. If you have any questions about entity selection, contact your CRI tax advisor today.