Prior to 2017 U.S. tax reform legislation (the "T.C.J.A."), the higher corporate income tax rate made it much easier to decide whether to operate in the U.S. market through a corporate entity (i.e., a C-corporation) or a pass-thru entity (i.e., a partnership or limited liability company ("L.L.C."), or a corporation that has elected S-corporation status). With a Federal corporate income tax rate of up to 35%, a Federal qualified dividend rate of up to 20%, and a Federal net investment income tax on the distribution of 3.8%, the effective post-distribution tax rate was 50.47% pre-T.C.J.A. This did not include potential state and local taxes. In contrast, assuming an active business, a pass-thru entity would have resulted in only one level of Federal tax of up to 39.6% for individual owners.
With the post-tax reform corporate income tax rate of 21% and the introduction of the qualified business income ("Q.B.I.") and foreign derived intangible income ("F.D.I.I.") deductions, this choice is no longer apparent. This is even more true when taking into account the net investment income tax ("N.I.I.T."), self-employment tax, and state and local tax exposures.
This article looks into some important tax considerations for an individual planning to start a U.S. business. While this article does not attempt to look at all relevant provisions in detail, it highlights potential points of friction. It does not focus on non-Federal tax issues or non-tax considerations, such as limits on the number or types of shareholders.
PROS AND CONS
Now, more than ever, and as shown below, pro-forma tax returns and short- and long-term investment goals are key to structuring the most tax-efficient entity. Taxpayers must weigh the positives associated with C-corporation status:
- A 21% flat Federal rate of tax
- In certain cases, the ability to qualify for the qualified small business stock ("Q.S.B.S.") exemption for capital gains on a sale (or potentially no tax in the case of a foreign investor)
- A special reduced tax rate on export activities
- And they must consider the negatives:
- A second level of tax upon distribution
- The N.I.I.T. on dividends
- The possibility of the accumulated earnings tax ("A.E.T.") or personal holding company tax
On the pass-thru entity side, there are also numerous positives:
- One single level of tax
- The possibility of a reduced rate of tax if the entity is eligible for the 20% Q.B.I. deduction
- The ability to pass losses on to equity holders
- The ability to increase tax basis for undistributed earnings
- Avoidance of the A.E.T.
And these must be compared with the disadvantages:
- The possible imposition of self-employment tax on all earnings (except in the case of an S-corporation, where self-employment tax may be limited to wages)
- The possibility of the N.I.I.T. on passive income
- The possibility of facing the highest individual tax rates
- The possible recognition of ordinary income on the sale of a partnership or L.L.C. interest and, in the case of a foreign investor, possible tax on capital gain income on the sale of a partnership or L.L.C. interest
U.S. individuals, trusts, and estates are subject to the 3.8% N.I.I.T. on the lesser of (i) their net investment income or (ii) the excess of (a) their modified adjusted gross income over (b) $250,000 (for married taxpayers filing jointly).
U.S. and foreign corporations, foreign trusts, and nonresident alien individuals are not subject to the N.I.I.T.
For this purpose, net investment income is defined as the excess of the following over appropriately allocable deductions:1
- Gross income from interest, dividends, annuities, royalties, and rents derived in a trade or business of trading in financial instruments or commodities, or in a trade or business in which the taxpayer does not materially participate
- Gross income from interest, dividends, annuities, royalties, and rents derived in a for-profit activity that is not a trade or business
- Net gain from the disposition of property held in a trade or business of trading in financial instruments or commodities, or in a trade or business in which the taxpayer does not materially participate
- Net gain from the disposition of property held in a for-profit activity that is not a trade or business A special rule exists for the disposition of partnership and S-corporation interests.
The capital gain generated from such a sale is subject to the N.I.I.T. only to the extent of the net gain that the transferor would take into account as net investment income if all property of the partnership or S-corporation was sold for fair market value immediately before the disposition of the interest. Otherwise, to the extent the partnership or S-corporation's activity is not passive and constitutes a trade or business, the income flowing up to the partner or shareholder is not subject to the N.I.I.T.2
Thus, one important aspect in comparing C-corporation investments with pass-thru entity investments is whether the underlying activity constitutes an active or passive trade or business. If the activity constitutes a passive activity, the N.I.I.T. will apply in either case.3
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.