Choosing the Right Entity In A Multistate World

Before we get into important multistate considerations, it's important to differentiate between s corporations and c corporations. The chart below breaks down the key features of s corporations and c corporations.  

As it becomes easier to conduct business across state lines, carefully choosing your entity structure is essential to unlock favorable tax outcomes. Let's go through the main multistate tax considerations you need to be aware of.  

State Recognition of S Corporation Status  

For one, not all states recognize the federal s corporation status. In fact, some states, including Louisiana, New Hampshire, and Tennessee, treat s corporations the same as c corporations, requiring taxes to be paid at the entity level. New York and New York City also have differing requirements to unlock pass-through taxation status.  

If you are making the s corporation election solely for pass-through taxation, it's important to be aware of these limitations. Even if your business does not currently conduct business in those states, as you begin to grow, you may exceed the filing requirements, resulting in taxes paid at the state level. While some states offer a credit for state entity-level taxes, others have limitations.  

Pass-Through Entity Tax Election  

In recent years, pass-through entity taxation (PTET) has made the s corporation structure more attractive. Instead of passing income down to shareholders, PTET lets s corporations pay the taxes at the entity level. While the corporate tax rate might be more compared to the shareholder's rate, the business is able to deduct amounts paid toward state taxes from federal income, reducing federal income taxes on the shareholder's return.  

While nearly 40 states offer PTET, there are a few states that do not. If your business is active in the states that do not offer PTET, it can result in confusing shareholder filing requirements. For example, shareholders may not need to file an individual income tax return in states that elected PTET, but they may need to file a return for other states. C corporations pay all state taxes at the entity level, helping streamline reporting and filing requirements.  

Filing Requirements 

Regardless of which entity structure you ultimately choose, most states will require you to file some type of business tax return when certain criteria are met. Most states follow sales nexus requirements. This means that your business does not have a filing obligation unless a certain sales or transaction threshold is met. However, some states may also require a business tax return if you have a physical presence, such as fixed assets or employees in the state. Each state has its own set of criteria, making it important to be aware of when you have a new filing obligation.  

Even if you have an s corporation and pass the tax through to shareholders, you may still be required to file a business income tax return. Managing filing requirements can be more difficult with an s corporation, as each state treats resident and nonresident shareholders differently. For example, some states will allow s corporations to pay taxes at the entity level, while others will require composite payments, and some will not offer any corporate-level taxation. This can make a c corporation more attractive for businesses with growing multistate operations to keep filing requirements simple.  

Taxes are one of the primary considerations when choosing between an s corporation and a c corporation. Let's break down the important tax implications you need to be aware of when forming your entity.  

Federal Double Taxation  

The main drawback of c corporations is potential double taxation. C corporations pay taxes on all profits at the federal level. Then, dividends paid to shareholders are also taxed on the shareholder's individual income tax return. On the contrary, s corporations pass all income through to shareholders. Federal income tax is then imposed on the individual income tax return. If the shareholder has a sufficient basis in the s corporation, distributions from the company are tax-free. Distributions in excess of basis are taxed at long-term capital gains rates.  

QBI Deduction  

S corporations are allowed to take the Qualified Business Income Deduction (QBID), while C corporations are disallowed. The QBID allows business owners to eliminate up to 20% of taxable income for federal tax purposes. For example, if a shareholder reports $100,000 of eligible s corporation income, they may be able to deduct $20,000 through the QBID. C corporations are excluded from taking this deduction.  

While s corporation income is potentially subject to the top tax bracket of 37% on the individual income tax return, it's important to consider the impact of additional deductions like the QBID. Let's look at a quick example. Your total taxable income for the year is $100,000. If the business was incorporated as a c corporation, you would pay $21,000 in taxes (the corporate tax rate is currently 21%). Now, let's say that your business is an s corporation that is eligible for the full QBID, and you are in the top tax bracket of 37%. Reducing your taxable income by $20,000 results in a tax due of $29,600 ($80,000 x 37%).  

In the above example, your business would save more money by being a c corporation; however, this example does not take into consideration other factors, such as dividends and distributions from the company. In addition, the tax rates operate based on a marginal system. This means that a portion of your business income may be subject to lower tax rates, depending on the other factors on your tax return.  

Capital Gains Tax 

C corporations also have special tax deductions that make the structure attractive. While s corporations may have deductions throughout the time you hold ownership, certain c corporations qualify for capital gains tax exclusions upon the sale. Section 1202 stock allows business owners to exclude up to $15 million or ten times the stock's adjusted basis from federal capital gains taxes. This can be a huge tax savings that s corporations are not eligible for. There are specific requirements and tests that must be met. Check out our other post for more information about the Section 1202 exclusion.  

Built-in Gains Tax 

Converting from an s corporation to a c corporation can lead to built-in gains tax on asset sales. Assets sold at a gain within the first five years of the conversion are subject to federal taxation. Built-in gains tax can also apply to accounts receivable and inventory sales that were accrued during the c corporation timeframe. If your business is making an election from a c corporation to an s corporation, it's important to understand when built-in gains tax is triggered. This can be done through careful recordkeeping of your fixed assets, receivables, and inventory.  

Choosing the right entity in a multistate world requires considerations outside of taxation. Here are a few more items to keep in mind.  

Location of Business Operations  

The location of your business operations will undoubtedly impact your state taxation. If your business is already conducting business in multiple states, a c corporation can simplify your filings and tax payments. Additionally, if your business is active in states that don't recognize s corporations, you can avoid mismatching pass-through tax payments with entity-level tax payments by pursuing a c corporation.  

While c corporations can make it simple to expand domestically, an s corporation structure can still make sense to leverage specific tax benefits, like the QBID, entity-level taxes, and more. Factoring in the location of your business operations is a crucial factor that can influence your decision on the type of corporation you form.  

Owner Residency  

Owner residency will also play a role in which type of corporation is right for your business. For example, if you are interested in taking on more than 100 shareholders, an s corporation is automatically ruled out. Similarly, if you want pass-through taxation, a c corporation won't be the right entity.  

Furthermore, owner residency plays a direct role in your state taxation options. Some states will allow nonresidents to make composite and other payments to avoid filing additional state returns on their individual income tax return, while others won't. These problems can be alleviated by paying all taxes at the corporate level through a c corporation. Before incorporating or changing your entity structure, take the time to evaluate how owner residency will impact the state taxation of your business.  

Long-Term Strategy 

Most business owners have growth goals. Your strategic operational and financial goals need to be taken into consideration before choosing your entity structure. S corporations are generally better for closely held businesses with a few owners who do not plan to seek outside investment.  

On the contrary, c corporations are more beneficial for businesses planning to go public, expand domestically or internationally, and issue multiple classes of stock. Take the time to evaluate your long-term strategy to determine which type of corporation fits your goals now and in the future.  

S corporations and c corporations are two popular entity structures for businesses operating in a multistate world. The decision on which type of corporation you should pursue is highly individualized. For assistance evaluating your specific situation, reach out to one of our team members today to schedule your free consultation.