2014–15 tax guide: Business ownership

Tax-guide2014-15 tax guide
Download the PDF to view the whole guide.
See other sections of the guide.

Business ownership is one of the most rewarding investments, but it presents challenges. Business owners have two tax burdens to juggle: their own and their company’s. The key to managing your tax burden starts with understanding your business structure and the tax requirements that come with it.

Corporate tax rates and business tax adjustments
The tax brackets for C corporations are not indexed for inflation like the individual tax brackets and have not changed for 2015. However, many other tax benefits for businesses are indexed for inflation. Unfortunately, two of the most significant tax provisions — bonus depreciation and the increased limits on Section 179 expensing — expired at the end of 2014. There is a good chance these provisions will be extended at some point in 2015, so contact a Grant Thornton professional for the latest information.

Tax reference guide

Choosing an entity: Understanding business tax rates
Business structures generally fall into two categories: C corporations and pass-through entities. C corporations are taxed as separate entities from their shareholders and offer shareholders limited liability protection. Pass-through entities effectively “pass through” taxation to individual owners, so the business income is generally taxed at only the individual level. Some pass-through entities don’t provide limited liability protection, while S corporations, limited partnerships, limited liability partnerships and limited liability companies do.

In choosing a structure, there are many considerations, and one of the biggest differences is that C corporations have two levels of taxation. A C corporation’s income is taxed first at the corporate level and again at the shareholder level when it’s distributed to shareholders as dividends. Generally, the income from pass-through entities is taxed at only the individual level.

So how do the tax rates on pass-through entities and C corporations compare now? Pass-through businesses pay tax on all income regardless of whether it is distributed, so the top rate on pass-through entities is 39.6% if you are not passive (not including any self-employment taxes), and 43.4% if you are. That’s higher than the 35% corporate rate, but only if no corporate earnings are distributed. When earnings are distributed, the combined rate of corporate and dividend tax is actually 50.5%. See the chart for a comparison of the top rates of pass-through entities and C corporations, depending on how much of the earnings are distributed.

If you plan on reinvesting your earnings in the business without distributing it, the top C corporation rate of 35% can be very appealing. But remember, unless you plan to die without ever receiving a dividend or selling the stock, the earnings will eventually need to come out of the business. So the single level of tax enjoyed by pass-through entities still provides a distinct advantage, especially when exiting the business.

Planning tip: Consider converting to an S corporation
The benefit of a single level of taxation is so significant that any privately held company should at least consider the advantages of converting or organizing as an S corporation. A conversion is made with a simple election for tax purposes and doesn’t affect the liability protection of a corporation. But there are many things to consider first.

You must satisfy many requirements to qualify for S corporation status. An S corporation can have no more than 100 shareholders, can have only a single class of stock issued and outstanding, and can be owned by only individuals and certain other entities. The definition of an eligible shareholder has expanded over the years to include estates, certain trusts and tax-exempt organizations. Members of a family can also be considered a single shareholder. Unfortunately, when a C corporation converts to an S corporation, it generally must pay a built-in gains tax on any appreciated assets sold in the first 10 years after the conversion (if the asset was held when the corporation converted). Lawmakers reduced the 10-year holding period for dispositions in 2009 through 2011, but this relief has expired for 2012. There have been legislative proposals to extend the reduced holding period, so check with your local Grant Thornton tax professional for an update.

Tax consequences when buying or selling

When you do decide to sell your business — or acquire another business ¬— the tax consequences can significantly affect your transaction’s success or failure.

Buyers will be looking for an asset sale so they can use future depreciation write-offs. When selling a pass-through entity, an asset sale results in only one layer of tax. For a C corporation, the seller would be taxed twice — first at the corporate level when the assets are sold to the buyer, then at the individual level when the proceeds are distributed. So C corporation owners must either accept a very big tax bill on an asset sale or insist on a stock sale, which isn’t as valuable to the buyer and will reduce the selling price.

Sellers could also consider a tax-deferred transfer. The transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization, but the transaction must comply with strict rules. Although it’s generally better to postpone tax, there are advantages to executing a taxable sale:

  • The seller doesn’t have to worry about the quality of buyer stock or other business risks that might come with a tax-deferred sale.
  • The buyer benefits by receiving a stepped-up basis in the acquisition’s assets and doesn’t have to deal with the seller as a continuing equity owner, as it would in a tax-deferred transfer.
  • The parties don’t have to meet the stringent technical requirements of a tax-deferred transaction.
  • Planning tip: Perform a reasonable compensation study

If you own a corporation and work in the business, you should consider your salary carefully. S corporation shareholder-employees will typically benefit from a low salary because income that isn’t salary generally isn’t subject to Medicare and Social Security taxes. C corporation employee-owners will usually benefit from a higher salary and lower distributions because C corporation income is taxed twice when distributed, but salary is deductible at the corporate level. So salary income is effectively taxed only once at the individual level, though it will be subject to payroll taxes and a top marginal rate of 39.6%.

The IRS understands the benefits taxpayers can receive by setting their salary and will challenge the salary amount if it deems it unreasonable. You may want to consider using a reasonable compensation analysis to ensure your salary meets IRS standards. The factors courts use to determine reasonable compensation will depend on the court jurisdiction, but the IRS will typically look to training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, employee payments and bonuses, the amount comparable businesses pay for similar services, compensation agreements, and the use of a bonus formula to determine compensation.

Mel Schwarz
+1 202 521 1564

Dustin Stamper
+1 202 861 4144

Tax professional standards statement
This document supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document, we encourage you to contact us or an independent tax adviser to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this document is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.