CHICAGO, IL – AUGUST 19: Democratic presidential candidate and U.S. Vice President Kamala Harris… [+] A speech is given during the first day of the Democratic National Convention at the United Center on August 19, 2024 in Chicago, Illinois. Delegates, politicians and Democratic supporters gathered in Chicago for the convention, which concluded with current Vice President Kamala Harris accepting the party’s presidential nomination. The Democratic National Convention runs from August 19-22. (Photo by Winn McNamee/Getty Images)
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In 2018, under former President Trump, the corporate tax rate was sharply reduced from 35% to 21%, to the delight of businesses. President Biden initially promised to raise the corporate tax rate again, but that proved difficult and has yet to materialize. The administration’s latest budget had the corporate tax rate at 28%. And in a recent statement, the Harris campaign reiterated President Biden’s proposal to raise the corporate tax rate to 28%.
The amounts are big: Some at the Committee for a Responsible Federal Budget have said Harris’ proposed rate hikes could reduce the US deficit by more than $1 trillion over 10 years. The Congressional Budget Office projects that a one-percentage-point increase in the corporate tax rate would amount to about $100 billion over 10 years.
Vice President Harris has proposed eliminating overseas tax avoidance by taxing foreign corporate income at the same rate as domestic income, in addition to a 28% corporate tax rate. These plans are likely to face resistance in Congress, but they represent clear party divisions. But how will this affect the choices that small businesses and start-ups need to make?
For many years, incorporation was common when individuals moved out of sole proprietorship. In recent decades, however, single-level taxation through limited liability companies (LLCs) has become popular with small businesses. However, since 2018, the 21% tax rate for corporations has caused a reexamination of these issues. The 21% vs. 28% tax rate may invite more detailed questions: If you have a corporation (either one you formed yourself or inherited), should you choose an S or a C?
All corporations are C corporations (under subchapter “C” of the tax code) unless they file for S corporation status. If you do nothing, your corporation will become a C corporation. Corporations, whether S or C, have limited liability. This is one of the traditional reasons businesses incorporate. It’s also a structure that people can understand. It’s a separate legal entity, owned by shareholders and controlled by a board of directors that elects officers and manages the day-to-day.
But C and S status are about taxes. If you file a one-page S election with the IRS, you’re taxed pretty much the same as a partnership or LLC. A corporation may be taxed as a C corporation for many years and then change to S status. Or, if you file an S election when you first form your corporation, you never become a C corporation. That way you don’t have to worry about gains taxes that would accrue on a C to S conversion.
Income from a C corporation is taxed twice: the corporation pays tax on net income (currently 21%). Then, shareholders also pay tax on dividends. Income from an S corporation is taxed once at the shareholder level, most often like an LLC or partnership. S corporations can have 100 or fewer shareholders, only U.S. citizens and resident aliens, usually individual shareholders, and a calendar fiscal year. If there are multiple classes of stock, only differences in voting rights are allowed. For most small businesses, these criteria are easy to meet.
If the owners are more comfortable with a corporate form than an LLC, an S corporation is a good choice. However, the accounting rules for an S corporation are complicated and difficult for existing C corporations to convert. An S corporation may be subject to corporate income tax if it was previously a C corporation and elected S status within the last five years (this is the built-in gains tax mentioned above). Many of these rules can be avoided by starting out as an S corporation. To do this, file an S election within 75 days of forming the corporation.
How do you weigh the positives and negatives of the facts? In many cases, a C corporation is not the best choice for a small business. The main reason is the double taxation on income and capital gains. Plus, if you incur losses, you have to claim them personally over an LLC or S corporation. But a big reason for many small businesses to like a C corporation is the $10 million qualified small business stock discount that some can get. In 2021, it looked like it might be repealed or significantly changed. But it’s still in the law, and even with a 28% tax rate, it could be enough of a reason to set up a C corporation.
Additionally, Silicon Valley wisdom has led some startups to initially incorporate as LLCs, allowing founders to take a tax loss, then switch to C corporation status when the opportunity for a QSBS exemption arises. Large and small companies alike will be closely watching the tax rate debate no matter what.
