Business Tax Preparation · Advising the business taxpayer

Selection of business entity (e.g., benefits and detriments)

Entity choice is usually presented as a comparison of tax rates, which is the least useful way to think about it. The rate comparison is one input among four, it is the input most likely to change before the business matures, and it is the only one a client can revisit later. The others are harder to unwind.

The rule

The first axis: one level of tax or two. A C corporation pays 21 percent of taxable income — a single flat rate with no brackets, imposed on the corporation before anything reaches the shareholder^TY2026 (IRC § 11(b)), and a distribution to the shareholder is taxed again under IRC § 301(c). A partnership and an S corporation pay no entity-level tax on operating income — except as otherwise provided in subchapter S, an S corporation is not subject to the taxes imposed by chapter 1^TY2026 (IRC § 1363(a)) — with the S corporation’s exceptions in IRC § 1374 and § 1375.

The second axis: self-employment tax. a sole proprietor’s entire net profit is net earnings from self-employment, and a general partner’s entire distributive share is too — so the entity choice is also a self-employment tax choice^TY2026 (IRC § 1402(a)), against the distributive share of a limited partner, as such, is excluded from net earnings from self-employment — other than IRC § 707(c) guaranteed payments for services actually rendered, to the extent established to be remuneration for those services^TY2026 (IRC § 1402(a)(13)). An S corporation shareholder’s pro rata share is not net earnings from self-employment at all, which is the source of both the planning and the reasonable compensation exposure.

The third axis: whether the S election is even available. a domestic corporation that is not an ineligible corporation and has no more than 100 shareholders, no shareholder that is not an individual other than a permitted estate, trust or organisation, no non-resident alien shareholder, and no more than one class of stock^TY2026 (IRC § 1361(b)(1)), and a financial institution using the reserve method for bad debts, an insurance company taxed under subchapter L, and a current or former DISC are ineligible to elect S status however else they qualify^TY2026 (IRC § 1361(b)(2)).

The fourth axis: flexibility. A partnership may allocate items other than in proportion to capital, provided the allocation has substantial economic effect under IRC § 704(b); an S corporation must allocate strictly per share per day. A partner takes outside basis in entity-level liabilities under IRC § 752; an S corporation shareholder does not. A partnership may elect under IRC § 754 to adjust the basis of its property on a transfer of an interest; an S corporation has no equivalent.

Current figures

How it works in practice

Ask what the owners intend to do with the money. A business that distributes everything is badly served by a C corporation, because every dollar bears the entity rate and then the dividend rate. A business that reinvests for years and expects to be sold as stock may do very well out of one, particularly where qualified small business stock is in view. The rate comparison is only meaningful once the distribution policy is known.

Then ask who the owners are. The IRC § 1361(b) limits are absolute: more than a hundred shareholders, a corporate or partnership shareholder, a non-resident alien, or a second class of stock each defeat the election outright. Venture financing that requires preferred stock is incompatible with S status for that reason alone, and a business expecting outside investment should not choose the entity that forecloses it.

The self-employment comparison is the most misunderstood. A sole proprietor and a general partner pay self-employment tax on the whole of their business income. A limited partner is excluded from it under IRC § 1402(a)(13), other than guaranteed payments for services. An S corporation shareholder pays employment tax only on wages actually paid — which is the whole attraction, and is exactly why reasonable compensation is examined.

Do not treat section 199A as a tiebreaker until you have computed it. The deduction is available to a partnership and an S corporation and not to a C corporation, but its mechanics differ by entity above the threshold, because the wage and property limitations depend on what the entity pays and owns. An S corporation’s owner wages count toward its own W-2 wage limitation; a partnership’s guaranteed payments do not. That can reverse the answer for a service business near the threshold.

Weigh the exit at the start. Selling a partnership interest gives the buyer an outside basis step-up, and an IRC § 754 election passes it inside to the assets. Selling S corporation stock does not, and there is no § 754 equivalent, so a buyer wanting basis must buy assets — which the seller may resist. A C corporation adds a second layer on an asset sale that often makes it impossible. The structure that is easiest to form is frequently the hardest to leave.

Remember the conversion is not symmetric. Electing S status for an existing C corporation carries the IRC § 1374 built-in gains tax for the recognition period and the IRC § 1375 passive income tax where accumulated earnings and profits survive. Going the other way — revoking S status — starts a five-year bar on re-electing without consent. Neither direction is free, which is a reason to get the first choice approximately right.

Scenarios

Traps

How this has changed

The comparison was transformed in 2017 and has settled since. Pub. L. 115-97 cut the corporate rate to a flat figure with no brackets and made it permanent, while giving pass-throughs the section 199A deduction with a scheduled expiry — so for eight years the standard advice carried an asymmetry: the corporate advantage was permanent and the pass-through offset was temporary. Pub. L. 119-21 § 70105(b)(1) removed that asymmetry by replacing the terminating subsection outright, so section 199A no longer expires and the two regimes are now compared on equal footing.

The same Act widened the section 199A phase-in range by half and added a minimum deduction for taxpayers with a modest amount of active qualified business income, both of which push the comparison further toward the pass-through for smaller service businesses.

The eligibility rules in IRC § 1361 have loosened steadily over decades — the shareholder ceiling has risen repeatedly, electing small business trusts and qualified subchapter S trusts became permitted shareholders, and family members are now counted as one shareholder — but the four core limits in § 1361(b)(1) have not moved, and the one class of stock requirement remains the most common reason a growing business leaves subchapter S.

Exam focus

Learn the four axes rather than a table of conclusions: number of tax levels, self-employment tax, section 199A, and flexibility on allocation, basis and exit. Questions are usually built by varying one of them.

Memorise the IRC § 1361(b)(1) limits exactly — the shareholder ceiling, the permitted shareholder categories, the non-resident alien bar and the one class of stock rule — and know the three ineligible corporation categories.

Know the self-employment treatment of each form: whole profit for a proprietor and a general partner, excluded distributive share for a limited partner other than guaranteed payments for services, and wages only for an S corporation shareholder.

Be ready to explain why section 199A can differ between a partnership and an S corporation above the threshold, and why a C corporation gets none of it.

Finally, know what only a partnership offers: special allocations with substantial economic effect, outside basis in entity liabilities under IRC § 752, and the IRC § 754 election on a transfer of an interest.

Check yourself

1. A corporation has 90 shareholders, one of which is a single-member LLC owned by a US individual. May it elect S status?

Answer: It depends on the LLC’s classification, and the analysis has to go through Reg. § 301.7701-3 first. IRC § 1361(b)(1)(B) bars a shareholder that is not an individual, other than a permitted estate, trust or organisation. A single-member LLC that has made no election is disregarded, so its owner — an individual — is treated as the shareholder and the election is fine. Had the LLC elected to be classified as an association, it would be a corporation, an ineligible shareholder, and the election would fail. The shareholder count of 90 is inside the ceiling either way.

2. A limited partner in a partnership receives a $60,000 distributive share and a $40,000 guaranteed payment for managing a project. What is subject to self-employment tax?

Answer: The $40,000. IRC § 1402(a)(13) excludes a limited partner’s distributive share “as such” from net earnings from self-employment, but expressly carves out IRC § 707(c) guaranteed payments made to that partner for services actually rendered, to the extent established to be remuneration for those services. So the distributive share is out and the guaranteed payment is in. Note the words “as such”: a partner who is a limited partner in form but works in the business full time may find the exclusion contested.

3. A profitable service business near the section 199A threshold is choosing between an LLC taxed as a partnership and an S corporation. Why might the entity choice change the deduction?

Answer: Because above the threshold the deduction is limited by reference to W-2 wages paid by the business, and the two entities generate them differently. An S corporation pays its owner-employee wages, which count toward its own W-2 wage limitation. A partnership pays its working partners guaranteed payments, which are not W-2 wages and do not count. Two businesses with identical profits and identical owner remuneration can therefore reach different section 199A deductions — and for a specified service trade or business above the phase-in range, neither gets one.

4. An existing C corporation with substantial appreciated inventory and accumulated earnings and profits elects S status. What follows it into the new regime?

Answer: Two entity-level taxes that a corporation which had always been an S corporation would never face. IRC § 1374 taxes net recognised built-in gain during the recognition period, so selling the appreciated inventory soon after the conversion produces corporate-level tax as well as pass-through income. And IRC § 1375 taxes excess net passive investment income while accumulated earnings and profits from the C years remain — which can also terminate the election if it persists. Neither is a reason not to convert, but both belong in the advice.

5. Why does the exit belong in an entity selection discussion at formation?

Answer: Because the entity determines how much of a sale price survives the transaction, and it cannot be changed cheaply once value has accrued. A partnership interest sold gives the buyer outside basis at cost, and an IRC § 754 election pushes the adjustment inside under IRC § 743, so the buyer gets depreciable basis without the seller selling assets. S corporation stock gives the buyer no inside step-up and has no § 754 equivalent, so buyer and seller are pushed into opposite structures. A C corporation adds a second layer on an asset sale. The choice made when the business was worth nothing decides the negotiation when it is worth a great deal.