OPINION:
The One Big Beautiful Bill Act, signed into law this summer, includes many tax benefits for businesses and individuals. Because of this bill, I’m seeing a growing number of clients taking a much harder look at their tax structure. Many are planning to change their structure from a “pass-through” to a regular C corporation. For many, doing so could cut their tax rates almost in half.
“Pass-through” businesses — partnerships, S corporations, limited liability companies — are the most popular forms of tax structure among small businesses. In this setup, any income earned at the company level is not taxed at the company level. It “passes through” to the owner’s individual return and is taxed there. A pass-through business owner who wants cash can distribute it from the company without incurring any additional tax.
A C corporation is more traditional and restrictive. Under it, taxes are incurred at the corporate level. When a shareholder of a C corporation wants more cash, they have to get it in the form of dividends, which are taxed on top of the income the corporation has earned. This is the main reason small-business owners prefer pass-throughs.
Until now.
That’s because this summer’s tax legislation made a popular deduction enjoyed by pass-through owners, the qualified business income tax deduction, permanent. It now allows owners of pass-through businesses to take up to a 20% deduction on their company’s earnings before being taxed at the individual level. Which means it’s even more enticing to be a pass-through business owner, right? Not necessarily.
Individual tax rates are still as much as 37%. Thanks to the bill, the corporate tax rate has now been left alone at 21%, which means that if you own a C corporation, you could be paying almost half the taxes of a pass-through owner. Now that these rates have been made permanent, owners and accountants can conduct a longer-term analysis to determine which form of business makes the most sense. Many are finding that the C corporation route is better. Why?
For starters, the qualified business income tax deduction has limitations. Certain categories of income are excluded. Many types of small businesses — particularly service businesses such as consultants, accountants and lawyers — aren’t eligible. The deduction is complex to calculate and cuts off at certain income levels, so higher-earning entrepreneurs can’t really benefit from it.
Unlike a pass-through entity, a C corporation is a more formally governed entity (bylaws and annual meetings are required) that provides more liability protection and allows for unlimited shareholders and multiple classes of stock that can be more easily bought and sold. Because of this, banks and investors prefer this type of organization. That’s important now more than ever because more than half of business owners are older than 55.
Many will be selling their companies to private equity firms, employees, family members or other entrepreneurial investors over the next 10 years, and C corporations are the preferred structure for transferring ownership because of these rules. It’s why most larger companies are structured this way.
Also, many business owners own and control multiple businesses that are pass-throughs, such as real estate partnerships. Having the C corporation charge a management fee to those businesses moves this income to a lower corporate tax rate than the individual rate.
The biggest issue is cash. As these corporations accumulate it, getting the money into the business owner’s hands is more complicated. Dividends get taxed. Higher compensation levels also get taxed. Loans don’t get taxed.
This is why a growing number of business owners are borrowing against this cash buildup and avoiding taxes altogether. Yes, these are loans that will have to be paid back. A loan, if structured formally and correctly, can give the business owner the opportunity to enjoy this cash while avoiding dividends now rather than later. The IRS does have specific rules against excessive borrowing schemes like this, so it is important to take these rules into consideration when structuring any loans.
I don’t want to sugarcoat this strategy. Besides being careful about the IRS’s loan rules, converting from a pass-through to a C corporation is also a tedious (and potentially costly) affair. The methodology is subject to federal and state laws and usually includes formal approvals from shareholders, board resolutions, annual meetings, bylaw creation, the issuing of new certificates and additional filings. Operating in multiple states can complicate the process further.
Thanks to the One Big Beautiful Bill Act, if a business owner is willing to spend the time and money to ensure they are doing it right, this conversion can significantly cut their tax rates. This decision was much tougher before the tax bill became law because of the uncertainty around rates and rules.
Now that we have permanence, it’s easier to figure out the structure that will provide the greatest tax benefits in the long term. If you are a small-business owner, this is a conversation worth having with your accountant.
• Gene Marks, CPA, runs The Marks Group PC, a financial and technology consulting firm near Philadelphia.
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