Heckscher, Teillon, Terrill & Sager, P.C.
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CHOOSING A BUSINESS ENTITY

Choice of entity is a key component in starting any new business enterprise. Attorneys who represent small business owners often steer their clients away from forming C corporations because of the dreaded “double taxation” of C corporation earnings—that is, the corporate income tax on the income of the corporation, and then the individual income tax on the dividends upon distributions to the shareholders. Instead, clients are frequently encouraged to form partnerships or S corporations because of the single layer of tax of the pass-through system of taxation for these entities. Practitioners oftentimes will recommend that their clients convert their small businesses from C corporations to S corporations for this reason.

However, recent changes to the tax law have given practitioners reason to reconsider advising clients of the benefits of C corporations, particularly if the client is likely to sell the company after a few years. On December 18, 2015, President Obama signed the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act) into law. The PATH Act renewed and permanently extended Section 1202 of the Internal Revenue Code, the exclusion from gross income of capital gain upon the disposition of qualified small business stock. In fact, for stock in qualifying small businesses created after September 27, 2010, a taxpayer can exclude 100% of the capital gain upon the sale of such stock in certain circumstances. There are a number of technical requirements and certain holding periods necessary to qualify for the 100% exclusion of capital gain; however, for many entrepreneurs, this potential tax benefit should not be overlooked when weighing the formation of a C corporation against a pass-through entity. The tax benefit of Section 1202 is simply not available to partners in a partnership or S corporation stockholders.

S corporations and partnerships are still useful in many situations and all of the benefits of pass-through taxation pertain. However, in situations in which the business is not likely to generate much income or make distributions to the owners over the next few years, but the owners are hopeful for a lucrative exit, forming (or keeping) a C corporation may be more advisable given the potentially substantial tax benefit of Section 1202.

Categories: Business Planning