By: John S. Morlu II, CPA
When starting or restructuring a business, one of the most important decisions you’ll face is choosing the type of entity your business will operate as. Whether you go with a C corporation (C corp) or a pass-through entity (PTE) like an S corporation or partnership can significantly impact how your business is taxed, how much of your profits you keep, and even how your business operates day-to-day. The Tax Cuts and Jobs Act (TCJA) of 2017 added new complexities to this choice, making it more nuanced than ever.
Understanding the benefits and drawbacks of each structure, and seeing how they perform in real-world scenarios, can help business owners make informed decisions. Let’s dive into the details.
The Basics: One Layer of Tax vs. Two
Pass-Through Entities (PTEs):
- Single Taxation: Income flows directly to the owner’s personal tax return, bypassing corporate taxes. This avoids the “double taxation” that applies to C corporations.
- Flexibility: Owners can use business losses to offset other personal income, and capital gains often receive preferential tax rates.
- Tax Savings Through QBI Deduction: Eligible PTE owners can claim the Qualified Business Income (QBI) deduction, reducing their taxable income by up to 20%.
However, pass-through income is taxed at the owner’s individual tax rate, which can climb as high as 37% for top earners. Owners may also face self-employment (SE) taxes on earnings, which can further increase the tax burden. Whether profits are retained in the business or distributed, they are taxed in the year they are earned.
C Corporations:
- Flat 21% Tax Rate: A consistent and low corporate tax rate makes C corporations appealing for businesses with high earnings.
- Deferred Second Taxation: The second layer of tax on distributed earnings (dividends) can be avoided by reinvesting profits back into the business.
- Fringe Benefits for Shareholder-Employees: Shareholder-employees enjoy favorable treatment for benefits like health insurance, retirement contributions, and more, which are deductible for the corporation and often tax-free for the employee.
However, the major downside is double taxation. Profits are taxed at the corporate level and again when distributed to shareholders as dividends, which can significantly erode total income.
Scenario Analysis: C Corp vs. S Corp
To better understand the implications of entity choice, let’s analyze two scenarios: one for a high-income business owner and another for a small business with lower income levels.
Example 1: High-Income Business Owner
A business earns $1,000 in income. Here’s how the after-tax cash breaks down for a C corporation and an S corporation, with and without the QBI deduction:
| Scenario | C Corp | S Corp | C Corp (No QBI) | S Corp (No QBI) |
| Corporate income | $1,000 | $1,000 | $1,000 | $1,000 |
| QBI deduction (20%) | $0 | ($200) | $0 | $0 |
| Taxable income | $1,000 | $800 | $1,000 | $1,000 |
| Corporate tax (21%) | ($265) | $0 | ($265) | $0 |
| After corporate tax | $735 | $1,000 | $735 | $1,000 |
| Dividend/personal tax | ($226) | ($352) | ($226) | ($440) |
| After all taxes | $509 | $648 | $509 | $560 |
Key Takeaway: The S corporation consistently leaves more cash in the owner’s pocket due to its single layer of taxation and the QBI deduction’s impact.
Example 2: Small Business with Lower Tax Rates
For a smaller business earning $100, the picture is slightly different:
| Scenario | C Corp | S Corp | C Corp (No QBI) | S Corp (No QBI) |
| Corporate income | $100 | $100 | $100 | $100 |
| QBI deduction (20%) | $0 | ($20) | $0 | $0 |
| Taxable income | $100 | $80 | $100 | $100 |
| Corporate tax (21%) | ($26.50) | $0 | ($26.50) | $0 |
| After corporate tax | $73.50 | $100 | $73.50 | $100 |
| Dividend/personal tax | ($16.20) | ($26.00) | ($16.20) | ($33.00) |
| After all taxes | $57.30 | $74.00 | $57.30 | $67.00 |
Key Takeaway: Even for smaller businesses, S corporations still tend to be more tax-efficient due to the lack of double taxation and the benefit of the QBI deduction.
Additional Considerations
When to Choose a C Corporation:
- Earnings Retention: Businesses that reinvest profits can defer the second layer of tax, maximizing the benefit of the 21% corporate rate.
- Fringe Benefits: Shareholder-employees in C corporations enjoy tax-deductible health insurance, retirement contributions, and more.
- Rapid Growth Plans: Businesses expecting high growth can retain earnings tax-efficiently to fund expansion.
When to Choose a Pass-Through Entity:
- Avoiding Double Taxation: S corporations and partnerships bypass the second layer of taxation, making them ideal for businesses distributing most of their earnings.
- Taking Advantage of QBI: The 20% deduction significantly reduces the effective tax rate on eligible income.
- Simpler Tax Structure: PTEs are generally easier to manage and tax-efficient for smaller businesses with straightforward needs.
Other Key Factors
- Ownership Flexibility: PTEs, especially LLCs, allow for flexible ownership arrangements, while C and S corporations have stricter rules on shareholders.
- Liability Protection: Both C corporations and PTEs offer limited liability, shielding owners’ personal assets from business debts.
- Exit Strategy: If planning to sell the business, a C corporation may qualify for Section 1202 treatment, which allows for tax-free gains on the sale of qualified small business stock.
Nontax Considerations
Taxes are only part of the picture. Liability concerns, growth goals, and administrative requirements can also influence the decision. Limited liability entities like C corporations, S corporations, and LLCs protect personal assets, which can be a deciding factor for many business owners.
Final Thoughts
Choosing between a C corporation and a pass-through entity requires a thorough understanding of both tax and nontax implications. While the TCJA lowered the corporate tax rate, double taxation remains a hurdle for C corps. Conversely, pass-through entities often deliver greater tax savings due to their single-tax structure and the QBI deduction.
Ultimately, there’s no universal answer—the best choice depends on your business’s unique needs, income level, growth plans, and long-term goals. Consulting with a tax professional can help you analyze your specific situation and forecast future outcomes to make the most informed decision.
Author: John S. Morlu II, CPA
John Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
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