11.5 Choice of Entity & the Taxation of Ongoing Business Operations

11.5 Choice of Entity & the Taxation of Ongoing Business Operations

The official content outline lists "different types of business entity structures" and "general taxation of different business entity structures resulting from ongoing operations" as separate knowledge statements. They are tested together because the exam wants candidates to reason about the operating tax cost of an entity independently from its exit consequences — and those two analyses frequently point in opposite directions.

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1. The Four Structures at a Glance

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2. The C Corporation: Double Tax, and Why It Sometimes Still Wins

Earnings are taxed at 21% at the entity. Distributed earnings are taxed again to the shareholder as a qualified dividend at up to 20% plus the 3.8% net investment income tax.

$\text{Combined} = 21\% + (79\% \times 23.8\%) \approx 39.8\%$

Compared against a pass-through owner's 40.8%, that looks like a wash — but only on fully distributed earnings. The C corporation advantage appears when earnings are retained: a company reinvesting all profit pays only 21% and defers the second layer indefinitely. For a capital-intensive business in a growth phase, that deferral is a genuine cost-of-capital advantage.

The C corporation also uniquely enables:

• §1202 QSBS — potentially $15,000,000 or 10× basis of gain excluded per shareholder (§11.4)
• Unlimited and unrestricted ownership — venture capital, foreign investors, other corporations
• Fully deductible fringe benefits for shareholder-employees, including health coverage, which a >2% S corporation shareholder cannot deduct at the entity level
• Multiple classes of stock for preferred returns and recapitalizations

The offsetting risks: the accumulated earnings tax under §531 (a 20% penalty on earnings retained beyond the reasonable needs of the business), the personal holding company tax under §541, and — decisively at exit — the fact that a C corporation asset sale is taxed twice, once at the corporate level and again on distribution of the proceeds, which is why buyers wanting an asset purchase and sellers holding C stock are structurally opposed.

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3. The S Corporation: the Payroll Tax Engine

An S corporation is a pass-through: income flows to shareholders on Schedule K-1 and is taxed once. Its dominant operating advantage is employment tax.

Worked comparison. A consulting practice generates $600,000 of net profit for a single owner who materially participates.

The $400,000 distribution escapes Medicare tax entirely, and because the owner materially participates it is also not net investment income, so it escapes the 3.8% NIIT as well. That is the entire reason services businesses elect S status.

The constraint is reasonable compensation. The IRS actively litigates understated shareholder salaries, and the factors are well established: duties and responsibilities, time devoted, comparable industry compensation, the company's dividend history, and what a non-shareholder would be paid for the same role. Paying a $30,000 salary on $600,000 of profit is the single most reliable way to draw an examination.

S Corporation Eligibility — the Rules That Break Family Plans

• No more than 100 shareholders (family members may elect to count as one)
• Shareholders may be individuals, estates, certain trusts, and certain exempt organizations only — no partnerships, no corporations
• No nonresident alien shareholders
• One class of stock — differences in voting rights are permitted, but not differences in distribution or liquidation rights

The eligible-trust list is short and consequential: grantor trusts, testamentary trusts (for a limited period), voting trusts, qualified subchapter S trusts (QSSTs), and electing small business trusts (ESBTs). A transfer of S stock into an ordinary discretionary dynasty trust that has not made a QSST or ESBT election terminates the S election for the whole company, with catastrophic consequences for every shareholder. Every gift, sale, or trust funding involving S stock must be screened against these rules first.

Basis mechanics also differ from a partnership in a way that traps owners: a shareholder's basis includes only capital contributions and direct loans from the shareholder to the corporation — never the shareholder's share of third-party entity debt. An owner who guarantees a bank loan gets no basis from the guarantee and therefore cannot deduct losses funded by it.

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4. Partnerships and LLCs: Flexibility Bought With Self-Employment Tax

Partnership taxation under Subchapter K is the most flexible regime in the Code:

• Special allocations are permitted where they have substantial economic effect under §704(b)
• Basis includes the partner's share of entity-level debt under §752, which supports larger loss deductions and tax-free distributions — the reason nearly all real estate is held in partnership form
• §754 elections let the inside basis of assets be stepped up on a transfer or a partner's death, so a buyer or heir gets depreciation on the price actually paid
• Property can generally be contributed and distributed without gain recognition — sharply unlike a corporation, where appreciated property distributions trigger corporate gain

The cost is self-employment tax: a general partner's or actively participating LLC member's distributive share is generally fully subject to SE tax, with none of the S corporation's reasonable-compensation carve-out. Limited partners are excluded from SE tax on their distributive share under §1402(a)(13), but the scope of that exclusion for LLC members has been repeatedly challenged and should not be relied on for an active operator.

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5. Reconciling Operating Tax With Exit Value

The recurring exam scenario: a founder chose an LLC or S corporation for operating efficiency, then discovers at exit that only C corporation stock qualifies for §1202.

Conversion mechanics and their traps:

• LLC or S corporation to C corporation is generally straightforward, but the §1202 five-year clock and the $75,000,000 gross assets test start at the conversion, not at founding — so converting a mature company is often too late.
• C corporation to S corporation triggers the §1374 built-in gains tax on appreciation existing at conversion if assets are sold within the five-year recognition period, and any accumulated earnings and profits from the C years remain exposed to the §1375 passive investment income tax.
• Partnership to corporation can be tax-free under §351, but liabilities in excess of basis produce gain under §357(c).

The advisor's role is to force this analysis before the growth happens, because entity choice is cheap at formation and enormously expensive to change once value has accrued.