(This column originally appeared in Entrepreneur)
Key Takeaways
- Recent tax changes have made it worthwhile for many business owners to revisit their entity structure, as the long-term tax advantages of a C corporation may now outweigh the traditional benefits of pass-through entities.
- The right business structure depends on your growth plans, succession strategy and exit timeline, making proactive tax modeling and planning essential before making a decision.
Many entrepreneurs spend years focused on growing revenue, hiring talent and winning customers. But one of the most important decisions affecting how much wealth you ultimately keep may have nothing to do with operations at all: your business’s tax structure.
Recent changes under the One Big Beautiful Bill Act (OBBBA) have altered the calculus for many business owners, particularly those operating as pass-through entities such as S corporations, partnerships and limited liability companies (LLCs). While these structures remain popular — and for good reason — the tax advantages that once made them the default choice may not be as clear-cut as they were in the past.
According to the Brookings Institution, as many as 95% of businesses are organized as pass-through entities. For some owners, that structure may still be the best fit. But for others, the combination of lower corporate tax rates and expanded Qualified Small Business Stock (QSBS) opportunities under the OBBBA could make a traditional C corporation worth a fresh look.
A pass-through entity does not get taxed at the company level. Instead, all income “passes through” to the owner’s individual tax return and is taxed there. Pass-through entities have many advantages over a traditional corporation (or C corporation). They’re easier to set up, have fewer compliance requirements and allow owners to take cash out of their business without dividend taxation. In addition, the OBBBA modified provisions related to Section 199A, known as the Qualified Business Income Deduction, which may further reduce taxable income for certain pass-through businesses.
However, depending on your income, growth plans and long-term exit strategy, remaining a pass-through entity could result in a significantly higher tax bill than operating as a C corporation.
That’s because, again, due to the OBBBA, the corporate tax rate is maximized at 21%. However, the tax rate at the individual level can be as high as 37%. Which means that if your company is still a pass-through, and you’re making more than $640,000 per year, you may be paying twice the amount of taxes you would be paying if your company were a C-Corporation. Even if you’re making less than the top amount, individual tax rates could still be above 30%, with state taxes adding to the bill.
There’s also another huge factor to consider: the future.
The OBBBA sweetened the requirements that allow C-Corporations to become eligible as Qualified Small Business Stock under Section 1202 of the IRS Code. Thanks to the law, you can have as much as $75 million in assets to become eligible, and, as long as your company is active, domestic and not primarily performing services, and assuming you hold on to the shares of your company for five years after its formation, you can sell the company and pay no capital gains taxes. Even selling it after three years will reduce this tax burden, which can be as high as 23.8% for long-term gains.
The bottom line: re-organizing your company from a pass-through to a C-Corporation can not only lower your tax rate on current earnings but also eliminate capital gains taxes if you eventually sell it. However, there are some things to consider.
For example, there are some drawbacks to a C-Corporation, among them stricter recordkeeping, more board and annual meetings and additional regulatory requirements.
But one of the biggest hurdles you’d face as the owner of a new C-Corporation is double taxation: getting your cash out of the business without paying tax. With a pass-through, you can take a non-taxable distribution. In a C-Corporation, you would need to either increase your compensation or take a dividend, which are both taxable transactions.
What are your actions? Take these four steps.
Consider your succession plan
If you’re like half of the small business owners in this country, you’re likely older than 50. But that shouldn’t matter — everyone should have a succession plan, regardless of age. Do you plan to sell your business during the next five years? After five years? That decision will impact whether or not you want your company to be Section 1202 eligible. If it’s not a priority, then you may decide not to make any changes, but if it is, then changing your tax status could have an enormous impact when you exit.
Have your accountant do the math
Converting from a pass-through to a C-Corporation will be complex, but in the end, it’s just math. Open up a spreadsheet, sit down with your accountant and have them help you run through two scenarios: staying as a pass-through or switching to a C-Corporation. Project your income over the next five to seven years. Assume you’re selling the business. Look at those angles and the numbers will tell you if it’s worth converting to a C-Corporation or not.
Understand the process
Converting from a pass-through to a C-Corporation will not be done overnight. You will need to consider both legal and tax ramifications. You will need an attorney to file both federal and state paperwork. There will be new tax returns to consider. If you have partners, your buy-sell conditions will need to be discussed and agreed in writing. Make sure you know all that’s involved and how long it will take. Perhaps it’s not worth all the headaches and costs. Hopefully it will be.
Finally, come up with a distribution plan
As mentioned above, when you distribute money from your new C-Corporation, you’ll have to either increase your compensation or pay dividends. Both options will create a tax liability. However, there are some ways to work around this. If you have pass-through real estate entities that own your properties, you may be able to leave them as pass-throughs and move more funds for distribution there through rental payments. Or perhaps you take a shareholder loan. There are rules that need to be considered, procedures to follow and documentation that will be required. This will involve conversations with your financial advisors.
Converting from a pass-through to a C-Corporation will take time, money, planning and effort. But the end result could turn into significant tax savings, both in the short and long term. Before the OBBBA, doing this was still attractive, but now it’s even more so. It’s your responsibility as a business owner — both to yourself and your family — to at least explore this strategy.
