Launching a start-up involves many decisions. Among the most important is choosing the right business structure for federal tax purposes. Last year's One Big Beautiful Bill Act (OBBBA) made permanent and modified several provisions of the Tax Cuts and Jobs Act (TCJA) of 2017. Some of these changes should be considered when making the call. If you're pondering the right structure for your next venture, here are some of the most critical tax-related considerations.
For tax purposes, you can generally follow one of two broad paths:
1. Establish a C corporation. It pays taxes at the entity level, and shareholders may face additional tax when they receive dividends, compensation or other taxable distributions, or sell their shares. These two levels of tax obligation are commonly referred to as "double taxation."
2. Form some type of "pass-through" entity. Here, taxable income, losses, deductions and credits pass through from the business to each owner's individual tax return.
When it comes to pass-through entities, options include partnerships, S corporations and limited liability companies (LLCs) treated as partnerships for tax purposes. You can also choose to run your business as a sole proprietorship or single-member LLC. Technically, these don't count as taxable entities separate from their individual owners. But for this article's purposes, we'll include them with pass-through entities.
In the current federal income tax environment, some of the major factors to consider are:
The flat corporate tax rate. The TCJA permanently established a flat 21% federal corporate income tax rate, which is significantly lower than the top individual rate (37%). This provides significant tax benefits to some C corporations, helping to mitigate the impact of double taxation on shareholders.
Tax treatment of qualified small business (QSB) corporations. QSB corporations are a special type of C corporation. At the entity level, QSB corporations are generally treated as regular C corporations for legal and federal income tax purposes. So, most of the standard advantages and disadvantages of C corporation status apply equally to QSB corporations, including the 21% flat federal corporate income tax rate.
However, QSB shareholders can potentially enjoy a significant tax advantage: A special gain exclusion rule may allow them to avoid the federal income tax hit on up to 100% of the gain from selling QSB stock. To be eligible for the gain exclusion, several requirements must be met:
Timing is also critical. To take advantage of the 100% gain exclusion for sales of QSB stock, you must have acquired the shares after September 27, 2010, and held them for at least five years. In addition, for qualifying stock acquired after July 4, 2025, the OBBBA allows a:
The OBBBA also increased the per-issuer dollar limitation on eligible gain from $10 million to $15 million for qualifying stock. (Other limitations may apply.)
Individual tax rates. The OBBBA made the relatively lower individual federal income tax rates established by the TCJA permanent. They are 10%, 12%, 22%, 24%, 32%, 35% and 37%, with annual inflation adjustments to the rate bracket thresholds. If you choose to structure your start-up as a pass-through entity, one of those rates will help determine the tax impact.
Section 199A qualified business income (QBI) deduction. The OBBBA made permanent the QBI deduction for eligible owners of pass-through entities. The deduction generally equals 20% of QBI, not to exceed 20% of taxable income.
QBI is typically the net amount of qualified items of income, gain, deduction and loss that are effectively connected with the conduct of a U.S. business. Excluded are certain investment items, reasonable compensation paid to an owner for services rendered to the business, and any guaranteed payments to a partner or LLC member treated as a partner for services rendered to the business. The deduction is subject to additional limits at higher income levels.
Before the TCJA, the conventional wisdom was that small or midsize business start-ups should usually be formed as pass-through entities to avoid the double taxation associated with C corporations. Although double taxation still exists in practice, its impact has been significantly reduced by the flat 21% corporate income tax rate. Also, double taxation may be further mitigated or deferred if your C corporation:
So, does this mean pass-through entities have lost their luster and C corporations are now the way to go for most start-ups? Well, it's not that simple.
Let's look at four of the most common scenarios that entrepreneurs face when launching a start-up. For all of them, let's assume the business owners are in the maximum 37% marginal federal income tax bracket. (Obviously, that won't always be the case.) Our examples also generally disregard state and local taxes and assume that the taxpayers are subject to the specified federal surtaxes.
Scenario 1: You expect to incur multiyear tax losses. Many start-ups operate at a loss during their first few years as they invest in growth and establish their market presence. If your main concern is deducting expected ongoing tax losses on your individual return, you should probably operate your start-up as a pass-through entity so you can, indeed, deduct those losses. Just be sure to understand potential tax law limits, such as the passive loss rules and the excess business loss disallowance rule. (Your tax advisor can explain further.)
Scenario 2: Your business will hold assets that are likely to increase significantly in value. It's generally not a good idea to hold substantial appreciable assets (such as real estate or certain intangibles) in a C corporation. The reason: If the assets are eventually sold for substantial gains, you may not be able to get the profits out of your corporation without incurring double taxation. In contrast, if you use a pass-through entity to hold appreciable assets, sale gains will typically be taxed only once for federal income tax purposes on your individual return.
Scenario 3: Your business will pay out all profits to owners. If you believe your start-up will generate a profit right away, you'll have a tricky decision to make when it comes to entity choice. Let's first assume that your profitable venture will be owned by one or more individuals (including you) and operated as a C corporation. The company will pay all its after-tax profits to shareholders as taxable qualified dividends that are subject to the 20% maximum federal rate. So, the maximum combined effective federal income tax rate on those profits, including the 3.8% net investment income tax (NIIT) on dividends received by shareholders, will be approximately 39.8% [21% + (79% × (20% + 3.8%))].
Although this double taxation, further inflated by the NIIT, is substantial, it's still favorable compared to historical standards. Before the TCJA, the maximum combined effective federal income tax rate in this scenario would've been approximately 50.47% [35% + (65% × (20% + 3.8%))].
Now let's say you operate the same profitable business as a pass-through entity that pays all its profits to the owners. For purposes of this simplified example, we'll assume the income will be subject to the 37% top individual rate plus an additional 3.8% through the NIIT or applicable Medicare taxes. In that case, the maximum effective federal income tax rate will be 40.8% (37% + 3.8%). However, if you, as an owner, can claim the QBI deduction on your individual return at the full 20% rate, the maximum effective rate would fall to 33.4% [(80% × 37%) + 3.8%].
In this scenario, forming a pass-through entity may be preferable if meaningful QBI deductions are available. If not, the optimal result will depend on various factors including applicable employment taxes, the NIIT and state taxes.
Scenario 4: Your business will retain all profits to finance growth. Sometimes a start-up's initial objective is to grow the business, not generate wealth for the owners. In this scenario, the 21% corporate income tax rate gives C corporations a potential advantage. Why? Assuming the retained profits increase the value of the corporation's stock dollar-for-dollar, when the shares are eventually sold, shareholders will pay federal income tax at the maximum 20% rate for long-term capital gains. So, the maximum combined effective federal income tax rate on the venture's profits, including the 3.8% NIIT on stock sale gains, will be approximately 39.8% [21% + (79% × (20% + 3.8%))].
Again, this result comes from double taxation plus the NIIT. But the 39.8% rate is still relatively low by historical standards. And remember that the shareholder-level tax on stock sale gains is deferred until the sale occurs. Plus, thanks to current first-year depreciation rules, eligible businesses can deduct 100% of the cost of many types of qualifying property the year they're placed in service. (Note: This rate generally applies to qualifying property acquired after January 19, 2025.) So, a capital-intensive C corporation may have little or no current federal taxable income.
Now say you operate that same profitable business as a pass-through entity owned by one or more individual taxpayers (including you). Assuming the income will be subject to the 37% top individual rate plus an additional 3.8% through the NIIT or applicable Medicare taxes, the maximum effective federal income tax rate on income passed through to the owners will be 40.8% (37% + 3.8%). That's a bit higher than the 39.8% rate that would apply to a C corporation. And unlike retained C corporation earnings, pass-through income is generally taxable to the owners currently, even if the business doesn't distribute enough cash to cover their tax liabilities.
But here's an important plot twist: If you, as an owner, can claim the full 20% QBI deduction, the maximum effective rate will be reduced to 33.4% [(80% × 37%) + 3.8%]. That's significantly lower than the 39.8% rate with a C corporation.
In addition, eligible businesses can deduct 100% of the cost of many types of qualifying property the year they're placed in service. So, a capital-intensive start-up operating as a pass-through entity may also have little to no current federal taxable income. However, reducing pass-through income with first-year depreciation could reduce allowable QBI deductions.
In this scenario, operating as a C corporation may be preferable — especially if your company is a QSB corporation. In such a case, you may be eligible for the 100% gain exclusion when you sell your stock after holding it for at least five years. If so, the maximum combined effective federal tax rate on the company's profits could be as low as 21% (21% for the corporate-level tax and no tax at the shareholder level when you sell your shares).
However, if you expect to benefit from the full 20% QBI deduction, structuring your start-up as a pass-through entity might provide a better result. Just remember, federal income taxes will be due currently, whereas with a C corporation, shareholder taxes generally aren't due until appreciated stock is sold.
Of course, you need to think about more than just taxes when choosing an entity. Liability protection, ownership requirements, administrative costs and your eventual exit strategy may also influence the decision.
That said, the initial choice can have significant and lasting tax consequences — and changing structures later may be costly or complicated. So be sure to work with your tax and legal advisors to evaluate your options and all the surrounding circumstances.
If you're leaning toward forming a C corporation for your start-up, consider paying out essentially all income to shareholder-employees as deductible salaries, bonuses and fringe benefits. Many companies do this to mitigate the negative impact of double taxation. (See main article.)
However, such payments aren't tax-free to recipients. Salaries and bonuses are generally taxable to shareholder-employees and subject to applicable payroll taxes. Fringe benefits may also be taxable, depending on the type of benefit and whether applicable requirements are met. Thus, the strategy generally shifts some of the immediate tax cost from the corporation to its shareholder-employees rather than eliminating it.
Important: Salaries and bonuses must represent reasonable compensation for services actually provided. If the IRS determines that compensation is excessive, it may recharacterize a portion as a nondeductible corporate distribution.
Under the current federal income tax rules, this strategy may be attractive because individual income tax rates are relatively low by historical standards. In addition, any taxable income left will be taxed at the flat 21% corporate income tax rate. A C corporation can also provide shareholder-employees with certain tax-advantaged fringe benefits. Some of these benefits may receive less favorable tax treatment when provided to sole proprietors, partners or more-than-2% S corporation shareholders.
Just bear in mind that shareholders can't claim the potentially valuable qualified business income (QBI) deduction on a C corporation's earnings. If operating as a pass-through entity would likely allow substantial QBI deductions, that may be the better choice. Work with your tax advisor to evaluate the potential tax consequences of each option before deciding what's right for your situation.
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